There have been a few good articles lately on market valuations. We are in an extremely odd investment environment with hundreds of billions dollars’ worth of government bonds across the globe trading at negative interest rates. Basically, they are guaranteeing themselves a loss unless they can pick up a few pennies before a bigger sucker buys them in the hopes of picking up a few more before getting creamed by the steamroller. When interest rates are this low, it causes market participants to do perverse things such as this. Another corollary event is that stocks that are perceived as being “safe” such as companies like Procter & Gamble (PG), Coca Cola (KO), and Pepsi (PEP) trade at valuations far higher than historical averages. This is despite the fact that these companies are not growing and have actually seen earnings stagnate or even decline.
For example, Coca Cola trades at more than 23 times estimated 2016 earnings, which is the highest in more than a decade. The company is supposed to report a 7.7% drop in first quarter earnings per share. As a whole, the consumer staples sector, trades at almost 21 times earnings, the most since the late 1990s bubble. Market participants are attracted to stable dividends and once again the perception of safety. While this idea seems sensible, all bubbles start with a reasonable premise but then are exasperated by a combination of greed and ignorance. Price is what you pay and value is what you get. If you are paying too much for an asset, you are likely to sustain permanent losses of capital.
It is in the context of this investment environment, where the strategy employed by TTCM should be understood. While most of the market is overvalued, the highest quality financials trade at the lowest valuations in their history by many measures. Financials are one of the few industries that will benefit when interest rates do finally rise, while most other sectors would see a contraction in their earnings multiples. Bonds of course would face a much worse fate in most cases. All of our large positions trade at considerable discounts to book value and in most cases tangible book value. All of our large positions are likely to see major dividend and stock buyback increases over the next 2-3 years even if rates do not rise. Just about all of our large positions have the strongest balance sheets’ that they have had in decades.
Now the detriment of having a concentrated portfolio is that when markets move against you like they did for financials in the first quarter of 2016, we really feel the heat. The benefit however far exceeds that, as we are able to avoid the many areas of the market where investors are likely to see negative returns over the next 3-5 years. I believe index funds and most mutual funds will likely see returns of less than 3% per annum over the next 3-5 years, barring major fiscal policy changes, which enhance growth prospects. I couldn’t in good faith recommend investing in an index fund when I believe that 3% returns are the best case scenario and losses are a very realistic probability. Of course we aren’t trying to predict any 1 quarter or year even, but instead are focusing on the long-term as full investment cycles play out. In addition to this value investment philosophy, we have a great deal of covered calls and cash-secured puts that are working for us. Basically this manufactures a dividend or cash yield of between 3-7% on our big positions, while still providing ample upside potential in the case of covered calls. You will see the full benefit of these calls when most of your options expire in January of next year, but even in a flat market, the dividends should be considerable.
The big banks have reported earnings that have greatly exceeded dismal expectations, which isn’t a surprise to me or to any of those that have been reading our commentary. The bearish case against them which was promulgated throughout the media in the 1st quarter has been proven wrong and I believe the situation will improve considerably over the next 12 months to our benefit. I’ll be releasing a slew of research reports on these companies over the next few days. Thank you very much and I hope that you enjoy the article.