After a month and a half of low volatility, where stock indexes failed to move by more than 1%, volatility has rushed back onto the scene over the last several days. Frankly, this is very normal market behavior, as periods of calm usually presage periods of volatility. One shouldn’t get complacent when things are quiet, nor should they get too concerned when volatility rears its head once again.
Key Points to Consider
In identifying why the market is seeing increasing volatility, most pundits would likely point to concerns over potential interest rate hikes. Below are a few important elements to keep in mind:
- If rates go up it will be in very small increments, likely followed by a pause unless there is a massive pickup in inflation.
- The Fed will raise rates because they see strength in the U.S. economy, not weakness. This is beneficial for most businesses, especially TTCM’s positions, which I’ll go into more later.
- Bonds and bond-like investments such as utilities, telecom, and consumer staples trade at incredibly expensive valuations. This makes a selloff in these assets very rational. This is very significant for market participants that are invested in them, index funds, or most overly-diversified mutual funds.
- Increased volatility creates opportunities to find securities that fall too far. In addition, volatility increases prices on options, which allows us as sellers of cash-secured puts to generate higher premiums than are available when volatility doesn’t exist. Often our best returns arise from volatile times.
- The stocks getting hit hardest seem to be bond-like investments, that have outperformed recently due to the massive influx of investors that are searching for yield and have been willing to pay just about any price to obtain it, regardless of valuation.
- U.S. growth is adequate. Unemployment rates are very low. China is showing signs of improvement. The Brexit has had very little material financial impact on the U.K. thus far.
Our Investment Portfolios
All year, I have written about the fact that our investment portfolios are currently as different from the overall index benchmarks as they have ever been. The reason is quite simple. Because valuations are extremely high and interest rates really can only go up over time from here, both stocks and bonds are unlikely to perform very well, especially when you consider earnings growth has been anemic to negative over the last 18 months.
In saying this you’d think that we wouldn’t want to invest, but nothing could be further from the truth.
The beauty of active investment management is that we are not obligated to follow the indices like sheep, when it is clear that they are heading towards a den of wolves.
We are able to focus on individual securities that trade at tremendous discounts to any conservative estimate of intrinsic value. Past periods of adverse market conditions have proven that there are still securities that can perform well, even when the overall market is not. A perfect example were value stocks between 2000-2003. Despite the Nasdaq dropping 75%, from peak to trough, many value investors generated some of their best performance of their career.
I believe the market has a similar setup in that most of the market is expensive, but the opportunities that do exist are far too good to pass up.
For example, many of our largest positions are financial stocks. These securities trade in most cases at very large discounts to tangible book value. Balance sheets are in the best condition they have ever been in. For instance, in the 1990s Tier 1 capital levels for banks were often around 4%. Tier 1 capital is generally the amount of common stock equity, as opposed to higher other forms of capital which may be more expensive, such as debt or preferred stock. Now these capital ratios are generally between 10-13%.
Our financial stocks not only are inexpensive but they are also showing improvement each quarter. Areas such as efficiency, dividend payouts, and capital ratios are constantly improving.
This ultimately will lead to higher returns on equity, despite the fact the macroeconomic picture has been average at best. These companies will actually see increasing earnings from higher interest rates, which is very different than most companies in the S&P 500.
When you combine earnings, dividend and book value growth with low valuations, you generally get excellent growth in stock prices.
These factors are why we often see nice increases in our core holdings prices after they release earnings, as they have been mostly beating expectations and showing material improvement in their fundamentals.
The major selloffs that we have seen over the last year or so have been based on macro fears that didn’t come true. For instance, in the beginning of the year there was a great deal of talk about a U.S. recession which never materialized. The Brexit and the volatility that immediately followed it actually increased bank earnings instead of hurting them. In major selloffs, most stocks will go down over the short-term and deep value stocks are no exception. Ultimately what matters is how the businesses perform and what valuations they are available at.
Having an understanding about intrinsic value and the ability to take advantage of mispriced securities is a huge advantage.
Below is an article that highlights how some sectors are quite obviously overvalued and are likely to be subject to corrections. I can safely tell you that all of our holdings are materially undervalued and are positioned to grow intrinsic value even if the economy remains average at best. As always, if you have any questions or perhaps you are invested elsewhere and are looking for protections, please don’t hesitate to contact me directly at 805-886-8140.