It has been over 10 months since the S&P 500 has seen a new high and many market pundits are of the belief that the bull market starting in 2009 is now over. It is my belief that stocks overall are priced within the realm of reason, and are neither extremely expensive or extremely cheap. With 10-year Treasuries yielding approximately 1.9%, stocks are attractively valued compared to most bonds; but on an absolute level, stocks as an asset class don’t offer an extremely compelling margin of safety. It is for this reason that stock selection will be so very important moving forwards. As the tidal shifts that have raised most equities over the past seven years has lost momentum, identifying those securities that are still dramatically undervalued becomes of increasing importance. Below is a link to a Bloomberg article that states that is quite common for bull markets to take a breather, like we have seen over the last few years, and often when the bull market resumes the returns can be quite significant.
While stocks as a whole might not be that attractive, there are clearly areas of the market that are as attractive as we have seen in some time. It is becoming increasingly clear that the U.S. economy is continuing its slow growth pattern that has been the status quo over the last five years or so and we aren’t in a recession as many predicted earlier in the year. With that being the case, it seems awfully silly to me that the most important financial institutions in the world are trading at massive discounts to book value. A stock like AIG for instance that has a book value of around $80 per share, trades at around $53, while it is buying back stock aggressively with excess capital. I’m not going to argue that AIG has been or will be as well run as a company such as Berkshire Hathaway, but the price offers a huge margin of safety and opportunity for profit. AIG is just one of many names where you could say the exact same thing, whether we are talking about Citigroup, Bank of America, AGO etc. All of these companies are already at some stage of returning increasing amounts of capital to shareholders, and stock buybacks are massively accretive so that is the main way that they are choosing to do so. This excess capital is a clear sign of the position of strength in their financial condition and improving prospects for earnings, despite today’s low interest rate environment.
While it is very easy to obsess about short-term market returns, the long-term picture is vastly more important. For these stocks to return 50-75% from current levels, no herculean feats are needed. Instead the companies just need to continue incrementally improving their profitability, buy back their own stock and enhance their dividend yields as regulators allow, and ultimately the stocks will either trade at/or above book value. Even better, the book values per share continue to grow on an annual basis at reasonable rates. When you have a concentrated portfolio, you are inevitably going to have periods of outperformance and underperformance relative to an index. To be clear, we make no effort to mimic an index and instead focus exclusively on maximizing risk-adjusted returns over the long-term.
We can look stupid when areas such as financials are out of favor as they are now, while we can look incredibly intelligent when they recover. The impact of a regression to the mean will have a massively positive impact for our portfolios. When you compare that to other opportunities in the market such as mutual funds, annuities etc., the relative attractiveness of these opportunities seems that much more pronounced. It would take a recession as bad or worse than 2008, in my opinion, for the bear case on financials to have any credibility and I see that as being highly unlikely. We’ve got covered calls working at much higher prices and we’ve continued to add to our positions on selloffs. In my opinion, there is a real opportunity to double our portfolio values over the next 5 years, even if the indices don’t do half that. What will the catalysts be? Each quarterly earnings report brings us closer, as do dividend increases and stock buybacks at discounts to intrinsic value. When people realize that these aren’t the same companies that they were in the past and this isn’t 2008, investor sentiment will change and valuations will adjust. It could happen in 3 months or it could happen in 3 years. The timing is impossible to predict, but I’ve seen nothing that has dissuaded me in any way that these are by far and away the most attractive opportunities that we have seen in some time. I hope you enjoy the article below:
Bull Market in S&P 500 Goes AWOL as History Rewards Patience