Q3 Note & Commentary: Dogs Living With Cats

By Jason Lesh, Managing Principal


It used to be so simple and straight-forward: republicans believed in free trade; Trump and the Clintons were friends; my car took regular gasoline; and the market always went up.

Now the republicans sound like democrats. The democrats sound like republicans. The Clintons won’t ever be invited to another Trump wedding. My next car will plug into the wall. And evidently markets go up AND down. Next thing you know, dogs and cats will be living together.

This is certainly a remarkable time. But the way we approach investing and our understanding of value is still timeless. The investment decisions we make and the holdings we own are based on our long-term projections. The volatility we have seen of late is in the long-term portion of the portfolio and only increases our expected future returns. We have been reducing our exposure to the United States in favor of emerging and international markets for quite some time because we are being adequately compensated for the volatility and risk. The same cannot be said for stocks in the United States in general, especially those that are most speculative.

And this gets to the essence of our investment philosophy: occasionally it runs counter to the style of the day. We want to buy dollars for $0.80 or even $0.60. The prevailing flavor has been to just own the index. But what index? And what if the index is overvalued? What if instead of buying a dollar for $0.80, it’s actually selling for $1.15? That’s a risk we’re not willing to take. So instead of speculating on overpriced companies and indexes, we have found value elsewhere.

Nick’s quarterly commentary provides a phenomenal look at the necessary mindset to be a value investor and the changes we see affecting the markets and how we are prepared for them.

Wishing you all the best,

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Is Value Investing Dead?

By Nick Fisher, Portfolio Manager


We are coming up on the 10th anniversary of the financial crisis and it seems so long ago that the stock market fell so precipitously. A 50% decline in stocks, recession, and the fear that accompanies both, leaves investors glad they own other assets that zig when stocks zag. We call this benefit diversification. And diversified investors have received little benefit over the last 10 years. As a matter of fact, diversification has been a drag on portfolios causing widespread underperformance by investors.

Nearly all of legitimate investing strategies have underperformed. Why?

The cost of borrowing has been near 0 (after inflation) ever since the Fed took control of this market in 2009 and began flooding the US with liquidity (note the Japanese, Chinese and European Central Banks all following suit) . This has caused growth-oriented, speculative stock market investing strategies to outperform all other strategies. Meanwhile, any diversified strategy to reduce risk has only diluted returns.


Growth vs Value

 Growth stock investing, or investing in the most expensive companies, has outperformed value investing (investing in the least expensive) 6 times since World War II. Each of these 6 times have been relatively short lived. They have come right before a market top and have been succeeded by significant outperformance by value stocks. Not surprisingly, each of these periods in recent memory have touted the death of active investing. When everything goes up, especially the most expensive stocks, it pays to be less discerning. In other words critical thinking didn’t pay!

 The US stock market has never in its history been more overvalued compared to the rest of the world. Furthermore, we are very near the peak valuations we saw in the early 2000 dot-com bubble. Today we have 332 of the 3000 largest companies in the US valued at 10 times revenues (a very high valuation). As the bubble popped in March 2000, there were less than 300 companies with that valuation. You might say, so what?

 Here is what the CEO of Sun MicroSystems had to say in a 2002 interview about its valuation of 10 times revenue during the dot-com boom:

‘At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?’  Scott McNealy, Business Week, 2002

Having broad exposure to stocks that are selling for lofty valuations (like 10x revenue) has been a losing proposition, with significant losses not far behind. As Mark Twain has been attributed to saying, “History doesn’t repeat itself, but it does rhyme.” The details may differ, but the themes, behaviors, and ultimate reflexivity are constant.

In 1999, some of the most famous investors were being railed for their prudence and underperformance. Not surprising, they went on to post magnificent track records in the subsequent years. Value investing, or buying investments that are undervalued, works great over long periods of time.


Interest Rates

We have often discussed how important interest rates are to the valuation of all other assets. Warren Buffett has compared interest rates to gravity. Just like the constant pull of gravity, higher interest rates will eventually cause stock prices to come down. Interest rates have moved higher due to the market realizing that perhaps inflation is greater than everyone has anticipated. This is pretty obvious for anyone who has gone to a restaurant recently, right?

As of 10/4/18, the 5 year treasury note is paying 3.05%. As an investor you look at the S&P 500 paying a dividend of 1.7% currently compared to the 5 year treasury note and you have to wonder what incentive is there to own the S&P 500 that has historically averaged a 2.8% dividend yield. To us, frankly neither is very attractive. The risk of rates moving higher and negatively impacting US stock prices is significant.


Emerging Market Update

Of course, not all assets are over-valued. Despite the fact that emerging market stocks are so much cheaper than US Stocks, they can still go down in the short-term due to currency and trade uncertainties. The difference is that an investor is likely to get a reasonable return over the long-run, and therefore be compensated for the risk taken in the short-run. Again, the reason is simple: stock markets around the world are a lot cheaper than the US.

The following chart compares the recent S&P 500 price change versus the rest of the world.  Notice the increased divergence in prices over the last several months. As these markets get cheaper, they are even more attractive over the long-term.

S&P vs World MSCI.jpg

As value investors, we always prefer what is cheap to what is expensive. We detailed the case for emerging market stocks last quarter. According to Wisdom Tree, this significant of a gap in valuation has happened only a handful of times. In those instances, the emerging market stocks returned 18.7% and the S&P 500 returned 3.9% annually over the subsequent 5 years.[1] This of course is not guaranteed, but the risk is well worth the potential returns.

 This type of risk/return profile defines us as value investors. We have proven that we are unafraid of looking silly over short periods of time as we wait for what is cheap to be recognized by the market. We can never time it perfectly, but it has worked well in the past. We eagerly wait for the time when value will be en vogue again.

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[1] https://www.wisdomtree.com/blog/2017-07-27/strong-buy-signal-em-valuation-gap-vs-sp-500