07 Jul Valuations and Future Expectations
Many of you may remember the rhetoric in the aftermath of the Financial Crisis and the corresponding bear market, that market participants might be permanently scared-off from the stock market. The crisis and loss of wealth was just so severe, coming just eight years after the Tech Bubble burst, leaving investors down for over a decade. It seemed like just about every other commercial was an advertisement for gold or an annuity, as salesmen took advantage of that pervasive fear to the detriment of the clients.
Over the last decade, gold is up just 29%, versus 118% for the S&P 500. That period includes the 2nd half of 2008, which was of course horrible for the market. It also doesn’t factor in the egregious commissions that many of these gold salesmen charge for coins, etc., preying on retirees hard-earned capital. Time goes by fast and that seems like a lifetime ago in many respects. Now I see the financial services industry engaged in a complete group-think mentality that index funds are a no-brainer, without paying any respect to valuations. How did that work out for Bitcoin after its euphoric run? Barring a continued economic expansion of unparalleled duration in this country, this group-think is likely going to end very badly!
There is a firm that I won’t mention the name of, that had about $50MM in assets in 2012, and now manages very close to $1 billion. They have some very smart people involved and they create entertaining content, with prominent media exposure. However, when it comes to the actual money management aspect of the business, the firm does the cookie-cutter asset allocation model. They talk about how great index funds are, yet they might only have 60% exposure to stocks and 30% bonds, then 10% in some absurd momentum strategy to supposedly mitigate volatility even further (likely with much higher fees).
Asset allocation is important, and most people have gotten that wildly wrong. If you had 20-40% invested in bonds over the last 10 years, you would have wildly underperformed. Yes, it means less volatility, but with interest rates so incredibly low, bonds in general were a sucker’s bet. That doesn’t mean you should have 100% exposure to stocks now, in fact I think that would be a massive mistake. The key is valuations. Investing without paying attention to them is like driving at night without headlights, but that is exactly what so many market participants are doing at this very juncture in time!
Now valuations themselves are not great predictors of short-term performance. The market was expensive in 1997 and it rallied robustly for 3 years until the Nasdaq dropped by 75%, wiping away years of gains, for those that got in early enough. However, valuations are a very good indicator of future longer-term returns, such as 5-10 years. This is where these index jockeys are going to run into trouble. On an inflation-adjusted basis, the market has only been more expensive during the tech bubble. That alone should grab your attention a bit.
There have been multiple periods where stock returns have been negative for more than a decade. The S&P did nothing between 1966-1982, but value stocks generated very reasonable returns. According to CFA Eric Nelson of Servo Wealth, Large Value were up 3.2% per annum in real returns, while Small Value were up 9.2% per annum. From the same source, between 2000-2009, the S&P 500 was down 3% per annum. Large Value was up by 1.6% and Small Value was up 9.1% per annum over that same period.
When the crowd is moving like a flock of sheep towards a very dangerous path, we must go the other way. How do we do that? Well firstly, we put a laser-like attention to valuation on every investment that we make. Many of our investments were made after periods of industry or company-specific stress. For instance, the generic drug industry has been facing massive pressures in the United States due to regulatory changes, causing major declines in the stocks of the leading companies. That has created a disconnect between price and value, which we have been able to exploit. While we were a little early in our investments in TEVA, we added on the way down, allowing us to take advantage of the stock’s 122.4% increase from the lows.
Mylan is a similar company that we have been building positions in at very cheap prices that we believe has the potential to increase by 50% over the next 3-5 years. Our largest investment is in an insurance company with a tangible book value that will likely exceed $60 per share and an adjusted book value that should exceed $80 per share, after reporting 2nd quarter results, yet the stock trades in the mid-$30’s.
Obviously, there are issues, but these are unique situations that should produce very different results than the overall market. Nearly all of our investments trade at either a discount to book or a 10-14 multiple on earnings, which is dramatically different than the valuation of the S&P. Our average dividend yield is also far higher than the respective indices yields.
Just as importantly, we intertwine unique strategies such as cash-secured puts to provide alternative investment mechanics. This allows us to manufacture cheaper entry-prices into stocks, which should dramatically reduce our downside when we do see a major correction. If the stocks are flat or up, it allows us to generate income at rates of return that are significantly better than yields offered by junk bonds, let alone investment grade yields, which hardly would offset inflation.
One time I had a client tell me that we didn’t have a bear market strategy, because we don’t all of the sudden start shorting stocks when our crystal ball magically tells us we are going into a bear market. Our bear market strategy is actually implemented in bull markets too. That is focusing on valuations and avoiding permanent losses of capital. Our research process entails demanding a large margin of safety, specifically to weather the inevitable storms that will come our way. There will be years when our disciplined nature will cause us to underperform a buoyant market, but over the long-term we believe we are poised to outperform.
Meanwhile, I believe we will see a familiar pattern play out with this obsession with index funds. Those that are going into them based on long-term historical track records will not be comfortable holding on to them through the 40% to 60% type of declines that are an inevitability when you are 100% invested in stocks. Then this seemingly passive strategy becomes very active and falls victim to the worst aspects of psychological investment behavior. Market participants panic and sell when stocks get materially cheaper, and they get back in when stocks are much more expensive. I’d bet that a very large percentage of these so-called passive investors just got into the market again in the last 4 to 5 years, and if you look at flows going into Vanguard etc., this seems like a pretty sure bet. There has been some volatility during that period but the recoveries have been quite swift.
The thought of allocating my money to where future 10-year returns are likely negative, or up 2 or 3% per annum in a more bullish scenario, is not appealing to me whatsoever, especially when you are likely to see material downside during interim periods. We will stick with our bread and butter, which is hand-selecting attractive investments and formulating the best strategy to take advantage of the disconnect between price and value. Our money will be invested in the same securities and strategies as our clients and we will feel the same pain or joy that future results bring. In addition, we can’t just blame the indices when they perform poorly, which I believe will be a common excuse for many firms that have jumped on that bandwagon. Below is a link to a very good article by Charlie Bilello of Pension Partners that you may enjoy if you are a valuation nerd like me. Thank you very much and let me know if you need anything at all!