Fears of the Coronavirus have caused bonds to rally, resulting in lower interest rates once again. The Tech Bubble has continued to grow, while value stocks have been left in the dust the last few months. While this can be frustrating over the short-term, over the long-term, it creates compelling opportunities to create substantial wealth.
Right now we have multiple opportunities to buy companies with improving business fundamentals at a discount to a conservative estimate of liquidation value, despite strong growth potential. These stocks all pay a dividend yield that is considerably higher than the 10-year Treasury yield, which is a lowly 1.55%. We will use a staggered strategy of buying the stocks outright and selling puts to dollar-cost average/or earn an attractive return assuming the options expire out of the money.
This is a strange market in my estimation, in that in very large areas of China, the economy is virtually on lock-down. Small businesses are struggling to make payroll and indicators such as coal utilization, are down by 40%. Stocks have held steady overall, but there has been a huge bifurcation between value and growth. One possible explanation is that, as interest rates go lower, the desirability of stocks becomes more compelling relative to fixed income. Once again, this pushes market participants to take more risk than they generally would during a more normal interest rate environment.
The excessive valuations are certainly not only centered in technology. Companies such as Wal-Mart trade at 23 times forward earnings, which is dramatically higher than historical averages, given a slowing growth rate. However, once again, the dividend yield of 1.82% looks better than a no-growth 10-year Treasury yield of 1.55%. The danger arises if Mr. Market decides to revert Wal-Mart’s valuation multiples to historical averages. This could result in a loss of roughly 33% from current levels, which would then put the stock at what we would deem to be fairly valued. Another potential catalyst towards mean reversion would be inflation perking up, causing bond yields to rise.
One of our favorite investments currently trades at about a 12.5% discount to tangible book value per share. Earnings per share have been growing by 10-15% per annum, which is expected to continue. The dividend yield is 2.07% and the payout is likely to grow. The stock trades at a forward earnings multiple of 6.8 times, meaning the earnings yield is 14.7%. The stock recently came down due to short-term concerns regarding an acquisition, but the acquisition will substantially increase its product lines, and will lead to higher returns on equity. By focusing on these types of highly attractive investments and eschewing the glamorous, yet highly overvalued investments that most people are talking about, I’m optimistic we should be able to do quite well over the next 3-5 years, even if the market pulls back.
Dividend yields are a major theme in the investments that we have been making. Many of the stocks we own yield between 2-7%, and we believe the dividends should grow. When you combine that with covered calls and upside potential, the attractiveness relative to bonds or alternative investments is obvious. The key is to not get caught up in short-term market movements and instead we must let fundamentals play out. Those that treat the stock market like a casino have historically generated terrible investment returns.
Lastly, two basic financial planning recommendations. It is that time of year when most people make their IRA/401K/403B contributions, assuming they don’t do it monthly. If you are able to, definitely take advantage of these as they are hugely beneficial tools. Secondly, with interest rates coming down again, there is another refinancing window for mortgages. It is prudent financially to keep your cost of capital as low as is possible. If you have credit card debt (which we don’t recommend), it is always a good idea to explore reducing that as much as is possible. If you have home equity, it is a much cheaper form of capital than credit card debt, and with the appreciation in the real estate market, that might be an opportunity to explore.