Investors and market participants often get told that the way to get rich is buying quality companies or properties. Firstly, it is important to define quality. For many, quality is conflated with credit risk. For example, U.S. government debt is often seen as having the least chance of a default than any other bonds, mostly due to the government’s ability to print money and raise taxes, more so than any fiscal discipline of course. The flight to “safety/quality” led to tens of trillions of dollars invested in government and similarly “safe” bonds at negative yields. Now the investors that piled into these seemingly conservative investments are sitting on over a trillion dollars of losses because as interest rates rose, the prices of these bonds plummeted. That is basically one of the moronic strategies that doomed SVB Financial, in that they deployed their massively growing deposits in long-term fixed income at way too low of yields, taking on far too much interest rate risk. When that fast money left in a panic, the bank failed. We at TTCM, wrote about the massive risks in these bonds dozens of times, as just the very nature of loaning money and paying interest to do so is so brazenly silly. The reality is markets get silly all the time. People bought them because they had been going up in price and the narrative told them to buy. This is where not conforming to group think can be greatly helpful and profitable.
Another definition of quality is assessing assets capable of producing higher returns on the capital employed in the business than lesser quality assets can produce. Think of some of the class A apartments, offices, warehouses, data centers, malls etc. These assets, often located in prime locations are able to produce higher leasing rates than their peers and could be defined as higher quality. For the last decade, investors have paid incredibly low cap rates (which means high valuations) for these types of assets. They were able to finance them at extremely low rates due to the Federal Reserve’s low interest rate policies and quantitative easing. Now as rates have risen, these asset classes, and many of the top quality assets/buildings, have seen major declines in value. Defaults are starting to emerge for buildings that set the skyline in cities like Los Angeles, San Francisco, New York and Houston. Ultimately, I believe that as the dust settles, there will be extraordinary buys on these same assets, but the key difference will be the prices that we are willing to pay.
For stocks, quality businesses such as Microsoft and Apple are producing immense cash flows and very strong returns on capital, with incredibly durable franchises. They seem almost invulnerable in the current market environment. Investors are valuing these stocks, and other great franchises such as McDonald’s, at roughly double what their historical valuations have been. At first glance, one might ask, why are investors paying double their historical valuations? These businesses have been really great for a while right? Like with those that bought bonds at incredibly low yields, those that paid top dollar for the best assets, many are willing to pay these multiples because it has been working recently. Investors flock to recent performance, which is almost always a terrible long-term strategy, as it gets them buying stocks when they are expensive and selling them when they are cheap. I would argue that the bubbles have shifted away from bonds and commercial real estate, and have now shifted towards some of these large cap high-quality stocks now trading at these historically elevated multiples. Don’t get me wrong, these are great companies that we would love to own at the right price. I don’t think that at current valuations the price is very attractive and there has been some reasonable evidence of insider selling, so maybe some executives are seeing the same thing.
The stock market has been led by a very small group of companies this year, while the majority of stocks, especially cheaper smaller caps have been left behind. I believe this is creating both risks and opportunities. I feel fantastic about the investments that we own, as we are acquiring high quality franchises and assets, at cash flow yields that were unthinkable just a few years ago. We are using a variety of different tactics to capitalize including stocks, bonds, preferred stock, and options. I think we have a nice combination of protection from the overall elevated valuations of the indices, with the ability to profit from individual opportunities and strategies. In the next few weeks I’ll write about some specific investments and strategies. Earnings season start in earnest once again at the end of this week, which I think should be a nice catalyst for many of our key positions.