As earnings season continues to develop, we have seen a bit of divergence in favor of value stocks. Companies that have been out of favor, due to difficult short-term business conditions, and that have incredibly low valuations have outperformed glamor stocks that trade at high multiples, based on the perception of safety. It is essential to understand that the “baby boomer” generation is a huge proportion of our population and their investment decisions can certainly impact overall valuations. With the Federal Reserve keeping interest rates as close to zero as is possible for this long, it has created massive distortions to “normal” investment behavior. Retirees can’t get adequate yields in investments with less credit risk such as U.S. Treasuries, municipal bonds, CD’s, or savings accounts. This forces them out further on the yield curve towards junk bonds, which have been hit quite badly since the start of the year, and stocks with higher dividend rates.
The rationale is very simple. If 10-year Treasury bonds are yielding 1.8%, the idea of buying a stable company such as a Coca-Cola or Procter & Gamble, that pay dividends considerably above that level, makes a lot of sense. These companies are known for stable cash flows and strong balance sheets. At a recent price of $44.54, Coca-Cola has a dividend yield of about 3%, and the stock trades at 26.83 times forward earnings. While the 3% dividend yield looks attractive relative to 10-year Treasuries, the high P/E ratio is a major concern. It is roughly a 20-25% premium to historical averages and Coca-Cola is growing at a much slower rate than it has in the past, warranting an even lower multiple. Any regression to the mean could wipe out many years of dividend income, and could very well result in permanent losses of capital. PG trades at a similar multiple and yields about 3.25%. Earnings have actually been dropping, and while there is a restructuring going on, it is very hard to argue that this slow growth company is cheap by any measurement. Paying too much for businesses is a very risky endeavor.
Because the baby boomer generation controls huge flows of investment dollars, their decisions can have a major impact on things. This is especially true with the increasing dominance of ETFs and index funds, where flows of funds really dictate short-term prices. When ETFs or index funds receive investment dollars, they immediately buy the same securities in a cap-weighted manner that is consistent with the representative index or ETF. This means that if Apple is the highest weighting in the index, it will receive the most dollars, further pushing up the valuation. In an environment where many of these seemingly safe stocks such as Coca-Cola and Procter & Gamble have historically high valuations, the flow of funds manages to keep prices out of whack even longer. Many market participants might think that they are invested for the long-term, so if a Coca-Cola were to drop 20-25% to its historical average valuation they would be happy with the income from the dividend and could wait it out. While logical, this is contrary to the actual behavior of most market participants, including most money managers. When these people panic and then start pulling money out of the same indices and ETFs, price drops could be further exasperated in the same way that these stocks have benefited from this shift in investment behavior on the way up.
Last Friday was a very interesting day as it showed what can happen when prices get out of whack, for even great companies. Starbucks was down 4.88%, Microsoft dropped 7.17%, and Alphabet (holding company of Google) was down 5.32%. All 3 companies reported strong earnings and are performing well, but the valuations have gotten far ahead of themselves. This means that any miss on unrealistic expectations can cause a significant reversal in the stock. These stocks still are not cheap and are representative of a market that is a bit inflated.
Conversely, we have seen significant rallies in the bank stocks since they reported earnings, which were predictably disappointing due to the terrible first quarter in financial markets. These companies trade at some of the lowest valuations in their history, which is an astounding thing to say. They all are very profitable, with the potential to grow profits dramatically when rates rise. Dividends and book values should grow at a very high rate due to increasing capital returns over the next 3-5 years. The highest capital and liquidity ratios in history make the companies more financially strong than they have ever been. All of these factors show that there is a very strong likelihood we will see explosive stock returns and very low risk, as defined by the risk of taking permanent losses of capital. The key is being patient and letting things play out. Over time, valuations do indeed matter. Even if markets are flat or down slightly over the next 3-5 years, which I view as being very possible, I believe the stocks we own are capable of positing double-digit returns. It won’t be steady and there will be periods of outperformance and underperformance, but that is what investing is all about. One of the key benefits of investing with TTCM is that we can avoid the areas of the market which are truly risky. Ask anybody how great indexing and diversification were for them in 2000 or 2008. It is in those periods when the true value of value investing is exhibited, and I believe the stage is set for such an environment moving forward. Below is an article highlighting this phenomenon, towards consumer staples stocks irrespective of valuations.