Today, the Wall Street Journal had an interesting article on the weak performance of “blue chip” stocks such as Coca Cola, IBM, AT&T and Wal-Mart this year. “Blue chips” is a term that has no relevance to me but has been and still is a popular term for much of the investment community. A “blue chip” can best be described by a strong brand, large size and as a company that has been around for a while. The problem with the term is that dead companies such as Kodak, Polaroid and the AIG prior to 2008, were as “blue chip” as they come. Businesses are living and breathing organizations consisting of people, assets and liabilities. Circumstances change, relying on the perception of a business instead of basing an investment rationale on the fundamentals is a fool’s game.
The most defining element of a successful investment is the price paid versus the value received. During the 1960’s the “nifty fifty,” which were the blue chips of the era, soared to extraordinary valuations. The rhetoric was that no price was too great to pay for these stable and growing businesses. Not unlike the euphoria for tech stocks in the late 90’s, the strategy worked for a while until it didn’t. As Benjamin Graham said, “in the short-term the market is a voting machine, but in the long-term it is a weighing machine.” Record low interest rates and financial media have pressured market participants into buying “blue chips” at 20-25% premiums to historical averages. The rationale is that because the dividend yield might be higher than the 10-year treasury yield, the strategy offers the potential for upside and more income. I would agree with that assertion, but when you are paying a premium for slow-growing or non-growing businesses, there is also the risk of permanent losses of capital.
At T&T Capital Management (TTCM), our primary goals are avoiding permanent losses of capital and maximizing risk-adjusted returns. Short-term mark to market volatility is not something that we attempt to mitigate, as we believe any strategy to do so would increase the chances of permanent losses of capital and diminish returns. The weak performance and relative overvaluation of “blue chips” is by no means the biggest concern that I have for most market participants. A lot of people have piled into technology investments that have worked wonderfully over the last few years, but that trade at stratospheric valuations. All of them have compelling stories but very few will be the next Google or Apple. 3-D Systems is an example of a company that I’ve written about many times http://seekingalpha.com/article/1879061-3d-vision-is-not-necessary-to-see-3d-systems-is-overvalued, as an absurdly valued company, that was also extremely promotional, usually a big warning sign in my eyes when it comes to investing. The stock has come down to earth, as the business has underperformed in relation to expectations, but this is just one of many companies that I believe will prove to be quite painful for market participants. Buying great and immensely profitable companies such as Microsoft and Cisco in the late 90’s or early 2000’s, the “nifty fifty” of the tech era, resulted in hundreds of billions of dollars in losses for investors. These losses occurred, as a result of declining share prices from their lofty peaks, despite these companies posting huge revenue and earnings growth in the following decade.
While we are truly in an innovational era in regards to technology and biotech, their stock prices tend to reflect this optimism. Any disappointments set the stage for dramatic weakness in the stocks. Conversely, we are in a period of financial repression for financial stocks. The government and administration are unabashedly using them as a piñata of sorts, likely to offset blame for other challenges or short-falls. Banks are quite similar to utilities in that they are heavily regulated enterprises, with very little pricing power, or ability to engage in true free enterprise. This will lead to fewer large mergers and lower returns on equity, unless something changes. In addition, many market participants remember the huge losses that banks caused shareholders during the Financial Crisis, so there is a perception that they are “risky.” Just like with the term “blue chip,” one must look at the characteristics of the companies before generalizing with a term like that.
Now, most of the big banks have more capital than they have ever had, in addition to more conservative balance sheets and risk profiles. Just as importantly, the stocks trade at discounts to their liquidation values and at fractions of intrinsic value. This means that stocks that the general market constituency would deem as “risky,” actually have the least chance of permanent losses of capital, and the best risk/reward ratios. These factors are basically insignificant in predicting short-term market movements so temporary underperformance can occur anytime, but it is this rationale that gives me extreme confidence in long-term outperformance. At some point perceptions will change and these banks newfound “safety” will lead to higher dividends and valuations. I’ve been continuing to add money to my accounts during this volatility so that I can increase my positions into these stocks. I’d highly recommend clients set up regular reinvestment programs into their accounts, as that type of dollar-cost averaging program is extremely beneficial for long-term returns. Thank you very much and please let me know if you have any questions or need anything at all!