As we sit in year-7 of a historic bull market, with earnings likely to decline for the 3rd consecutive quarter, the lack of a margin of safety in most stocks, bonds, and real estate is becoming painfully obvious. The Federal Reserve’s record-low interest rate policies have driven all asset classes higher, to levels where the risk of taking permanent losses of capital seems to outweigh the potential return potential.
Cookie-Cutter Approach
If you are investing in index funds, overly-diversified mutual funds, or bond funds, it is very difficult to imagine annual returns in excess of 5-5.5% over the next 5-10 years.
The reason is that interest rates can’t go significantly lower and are instead likely to go higher, which means that it is mathematically impossible for bonds to do what they have been doing for the last 30 years. Think about this the next time your annuity sales rep or financial advisor is using historical market data to project you meeting your retirement goals.
Equities as a whole are unattractive with a mid to high 20’s P/E multiple on trailing twelve month earnings.
Investors starving for yield have bid up prices of high quality companies that are known to pay reasonable dividend yields, to levels that we used to only see for explosive growth stocks.
Intelligent Investing
While it seems like a very high probability that most assets will have low returns over the next 5 years, that isn’t to say that there are not prudent ways to make money and grow your portfolio to meet your retirement goals.
Firstly, you don’t have to invest in mutual funds but instead can focus on individual securities. In any market, there are certain areas or securities that are undervalued due to short-term pessimism. Between 2000-2003, the S&P 500 was down by around 30%, but many value investors including the likes of Warren Buffett, Seth Klarman, Bruce Berkowitz etc., nearly doubled their portfolios despite the market being down. While the Tech Bubble was different than today’s bubble, I believe that we will see a similar scenario play out. Selling begets more selling, so if we see bonds get hit, than bond-like stocks such as utilities and telecom would likely follow suit. As attention is drawn to the outlandish multiples being paid for slow to no-growth businesses, these stocks would also likely take permanent losses of capital.
Now the logical question is, how do we believe that we can generate returns in excess of the indices given our pessimistic outlook for most assets classes?
Right now, the vast majority of TTCM client money is invested in well-financed businesses trading at material discounts to book value, and/or at multiples less than 10 times normalized earnings.
These companies are cheap because their earnings are not at their peak, either due to the low interest rate environment, lower commodity prices, or perhaps pricing pressure on drug prices. For our financial stocks, we have the strongest balance sheets in our companies’ respective histories, combined with growing dividends and accretive stock buyback programs.
These are stocks that easily should compound tangible book value by an excess of 10% per annum, so even if valuations stay flat, the stocks should generate double-digit returns.
In addition to focusing on individual securities that meet our risk/reward criteria, we intertwine conservative income-generating strategies such as cash-secured puts and covered calls. When we use these strategies we are able to predefine our return criteria at levels often above 10%. Our worst case scenario is that we will own the stocks that we want to own at an even cheaper price.
In a bubble it is not smart to obsess about short-termism. Overvalued markets exhibit the same psychology that you’ll observe when your kids play musical chairs. Everyone thinks they will get out in time, but the reality is very different. When you invest in individual securities you will experience more volatility than in a broad-based fund. This is the price for the ability to minimize permanent losses of capital when markets are expensive.
Business fundamentals for our core positions are improving each quarter, as exhibited by book value growth, dividend increases, and improving margins.
While various political events and speculation on interest rates has created some very volatile turns in 2016, the actual business progress has been quite steady and should continue to be. As always, we expect returns to be lumpy and that should work to our benefit. The reality is that the stocks we own are highly undervalued. A perfect example is Citigroup. The stock trades in the mid $40’s, with a tangible book value around $63 and a book value in excess of $70. The dividend is around 1.5%, and CFO expects to triple that over the next two years or so. Even better, the dividend payout is actually the smaller part of the capital return equation, as Citigroup is executing a massive stock buyback which is enormously accretive due to the cheap valuations.
The only way that we lose money over the long-term on this type of position, in my opinion, would be a recession far greater than even what we saw in 2008.
I can go position by position and make similar arguments backed by solid fundamentals.
Conversely, I can look at major components of both stock and bond indices and show that they are dramatically overvalued. The thing I cannot tell you is the timing of when these events are likely to unfold. This is where patience comes in to play. As the great Charlies Munger says “the big money is not in the buying or selling, but is instead in the waiting.”
Below is a fantastic article and video where Howard Marks of Oaktree talks about his expectations for low returns on various asset classes and what this means for institutions and individual investors. If you have mutual funds or heavy fixed income and you’d like to explore how TTCM can assist you, please don’t hesitate to give me a call directly at 805-886-8140.
Howard Marks Says Institutional Returns at 5.5% a ‘Big Problem’