It has been quite a bizarre 2016 thus far in the equity markets. We’ve seen a dramatic selloff and global bear market. Then we saw a reasonable recovery in March. Some of the worst performing economies such as Brazil have had the best stock market returns, while many others are still deeply in the red. Many of the best hedge funds such as Carl Icahn, Bill Ackman, Bruce Berkowitz and Tiger Global are down considerably. The U.S. market itself is not cheap on an absolute basis but is reasonable compared to bonds. The trailing twelve month P/E for the S&P 500 is 22.8. This is considerably above historical averages. The inverse of P/E is the earnings yield, which indicates what yield would be paid out if the S&P 500 paid out 100% of its earnings as a cash dividend, and that yield is 4.4%. That is very low for taking equity risk, but looks decent only in comparison to 10-year Treasuries which are yielding 1.75%.
It has been an interesting year because we have seen incredible divergence between business performance and stock prices. While some sectors have recovered from the beginning of the year bear market, others such as financials and health care have continued to lag. The best performing sectors such as utilities, telecom and consumer staples trade at massive premiums to historical averages, despite lackluster growth prospects. This is in stark contrast to financials, which trade at some of their lowest levels from a valuation perspective in history. This sets the stage for what I believe to be one of the best investment opportunities in the last 10 years, as a simple reversion to the mean should lead to 50-75% upside for some of our key financial decisions. We do not need a buoyant U.S. economy, dramatically higher interest rates, or a better regulatory environment to achieve these gains. All we need is to let the fundamentals play out; and as short-term investor sentiment changes, the financials should once again come into favor as current prices could only be justified if we were to face a massive recession, which is not in the near-term cards.
At T&T Capital Management, we are not a mutual fund or an index fund. We don’t try to mirror their performance. Instead, we focus on maximizing long-term risk-adjusted returns. In an expensive market like we have now, this requires being contrarian. Is it safe to buy Procter & Gamble at 29.19 earnings, when the historical average is closer to 20 and the company is not growing? No it is not. Conversely, is it safe to buy AGO at 50% of a conservative estimate of liquidation value? Absolutely. This doesn’t prevent us from taking short-term mark to market losses. The negative of a concentrated portfolio is that it can be more volatile, but the benefit is that we can really focus on the best investment opportunities that we can find. A few dollars of upside in our key names will have a dramatic impact on our returns. We don’t need them to get back to book value, but if they did, we are talking about in excess of 50% upside from current levels. Historically, financials have traded at a premium to book value, and keep in mind that our key investments are growing in book value with stronger balance sheets than they have had in their respective histories.
Let’s start with AGO. The company trades at $24.16, down about $5.50 from its 52-week high of $29.75 based on concerns about Puerto Rico. AGO has an operating book value of $43.11 and an adjusted book value of $61.18. The stock should trade at a minimum of $35 to $40, and likely higher than that over the next 3-5 years. The company has a massive reserve already in place for Puerto Rico. Liquidity is absolutely not going to be an issue and as Puerto Rico gets restructured, the removal of uncertainty should lift the stock much higher. Here is my most recent article on AGO: Assured Guaranty – The Puerto Rican Circus Obscures This Gem Of An Investment.
This being our biggest position, a simple return to the 52-week high would make us a great deal of money. The stock pays a dividend of about 2.15%, while we are waiting. In addition, we have sold a great deal of covered calls at $30 or above. For example, if we collected $1.15 on a $32 call, we are manufacturing an additional 4.76% dividend in addition to the 2.15% that the company already pays out in dividends. It also means that we have all of the upside up to $32. If AGO were to get to $32 from current levels, the returns would be 32.4% plus the 6.91% of income from the dividend and sold calls, for a total of 39.31%. At $32, the stock would still be undervalued by at least 50% to conservative estimates of intrinsic value. Obviously, we’d be willing to reduce some exposure as prices get higher, but there is very little risk in my opinion, as defined by the possibility of taking permanent losses of capital.
Citigroup trades at $41.86 and has a tangible book value of $60.03. Total book value per share is $69.46. Keep in mind that all of these numbers have been growing and will continue to grow. If Citigroup were to just trade at tangible book value, the returns from current prices would be 43.4%. This is another big position, so your portfolio would really feel the full heft of this. Citigroup’s 52-week high is $60.95 and the company hasn’t been losing any money, so there is no reason to believe it will not get back there. The company has some of the highest capital ratios of all banks in the world. There is a very realistic chance that this can be an $80-$90 stock yielding 3-4% as a dividend within 3-5 years. How many investment opportunities are there like this in today’s market where the average P/E is 22.8? Very few. Citi is projected to make $5.19 per share this year, so the current earnings yield would be 12.4%.
Bank of America trades as $13.27 and has a tangible book value of $15.16 per share. Total book value per share is $22.54. Once again, both numbers should continue to grow. If the stock gets back to tangible book value, we are looking at a 14.2% return; a return to book value would give us a 70% return. Like AGO and Citigroup, Bank of America will be aggressively buying back stock and most likely will be increasing the dividend. Buying back stock at a huge discount to intrinsic value will only increase intrinsic value. We have a good number of calls sold at $17, where we collected sizeable premiums, manufacturing an additional dividend of 5-7% on the stock. This means, we are getting paid for waiting. Bank of America’s 52-week high is $18.48 and it has not been losing money. There isn’t any reason it shouldn’t go back there. Patience is the key.
AIG trades at $54.11 and has a book value of $75.10. The company is planning to return $25 billion of capital to shareholders between 2016 and 2017, mostly through stock buybacks. That is a whopping 40% of current market capitalization. This will be hugely accretive and will dramatically lift both intrinsic value and book value per share. The dividend yield is 1.86% and we have sold a variety of calls at much higher levels to add to that yield. AIG’s 52-week high is $64.93. A return to that 52-week high, which would still be a massive discount to book value would give us a 20% return from current prices. A return to book value would give us a return of 39%.
All of these companies should grow intrinsic value by in excess of 10-13% per annum through earnings and stock buybacks. Unlike the overall stock market, or especially bonds, all of these companies would benefit from higher interest rates. While we may be down a little to start the year due to these positions, the opportunity to make massive gains over the next 3-5 years is a highly probable event unless 1 of 2 things happens. Either these companies will have to lose many tens of billions of dollars, which seems very unlikely. The other thing that could happen would be if valuations which are already at historic lows, just got lower and investor sentiment never improves. That seems incredibly unlikely, especially when you consider that profits, dividends and stock buybacks should all improve meaningfully over the time period.
Investing is about having the expectation of profits, due to rigorous fundamental analysis that tells you that it is a strong likelihood. Sometimes clients will be constantly focused on short-term metrics of performance, which can be deeply misleading, particularly when you have options involved, which often have large spreads between the bid/ask, where you don’t get a full feel for until the options get to expiration. In the short-term the market can do anything. Fundamentals really don’t matter on a day to day basis, but over time they do. If these stocks trade this cheaply for long, you could see spinoffs, privatizations, etc. to close the gaps. That is how capitalism works. I know it can be tough to be patient, especially when every day we receive constant data and prices. The market craves activity, but as Charlie Munger says, “the big money is in the waiting.” That is a powerful statement and is 100% on point. Those of you that have been with me for a long time have seen both strong outperformance and underperformance depending on the respective quarter. That is the same with any money manager. Right now we have the best outlook for future gains that we have had since T&T Capital Management started and I see the least amount of risk, as defined by the risk of taking permanent losses. My belief is that the overall stock and bond markets will do quite poorly over the next 3-5 years, but we will do well based primarily on our holdings in financials and our utilization of options to generate income and reduce risk. As always, if you have any questions please don’t hesitate to contact me directly at 805-886-8140.