Over the last month, we have begun to see financial stocks outperform the overall market.
If one was to ask why, most market participants would say that the perception that interest rate hikes are more likely to be forthcoming in 2016 is driving the stocks. In a market where short-termism is the status quo, these types of stories certainly drive stocks but over the long-term it is the combination between business fundamentals and valuation, which drive stock performance. This really is why 2016 has been such a bizarre year. The year began with the biggest selloff to start the year since the Great Depression. The market saw a recovery, which was then ended by the dramatic Brexit vote, which created another massive panic. We are now in the midst of a continued recovery from those depressed levels.
Every single year there are stories and mini-panics in the markets. Most are meaningless in the long-term scheme of things. The average stock can move 30-50% in a given year, but we know that business fundamentals change much more slowly. If you look at the big banks and insurance companies, business performance has actually been extremely sound. Each quarter book values are going up and earnings have generally exceeded depressed expectations. Capital and liquidity ratios continue to improve. Efficiency ratios are improving and dividends and accretive stock buybacks are enhancing intrinsic value. These metrics are what give us at TTCM the confidence to continue to buy when the market is overly depressed. Whether the Fed raises or doesn’t raise in September or December, I still believe that most of our stocks are in a position to continue growing intrinsic value by in excess of 10% per annum. Over the long-term, stock prices will follow intrinsic value, but of course that can be lumpy.
We have seen this before. In 2011, the European Crisis caused a panic in equity markets and most noticeably on financial stocks. The U.S. economy was much weaker then, as we were still dealing with the aftermath of the Great Recession. Despite the “Crisis,” financial stocks continued to increase intrinsic value and as it became clear that fears were overblown, we saw massive gains in our portfolios’ over the next several years. This experience is not unique, as it really is the history of how value investing has worked. It is just when it is most out of favor, that it leads to the best performance. By buying stocks at massive discounts to intrinsic value, we are creating a strong margin of safety. This doesn’t mean we can’t take short-term mark to market losses, but being long-term investors, it does protect us from taking permanent losses of capital unless we make a material mistake in our analysis. There are times when we will lock in a loss either for tax reasons, or we find a better opportunity. The only time we sell stocks as a result of a short-term decline is when the fundamentals have changed to where our investment thesis is no longer valid.
Today the S&P 500 trades at approximately 27.1 times inflation-adjusted earnings. This is 62.3% higher than the historical mean of 16.7. The 10-year Treasury yield is about 1.57%. Mathematically, it is virtually impossible for bonds to continue to perform at anything close to the levels we have seen over the last 30 years. It would really require rates going deeply negative, which seems highly unlikely in the United States. Much more likely, increases in rates or a loss of appetite for U.S. bonds will lead to massive losses for many investors. For equities, either earnings have to grow dramatically, which pretty much nobody expects, or valuations have to expand to levels that exceed just about any bubble we have ever seen for returns to continue at the pace we have seen over the last 7 years. This seems highly unlikely, but it doesn’t stop the media and most market pundits from pushing market participants into index funds and “closet index” mutual funds. To be clear, most of these funds are just like being 100% long the market, whether that is bonds or stocks. Doing that when valuations are so obviously overvalued is using the same type of logic that pushed people to keep buying real estate at increasingly higher prices, when signs of a bubble and irrational exuberance were very clear. It may be comfortable because “everyone” is doing it, but it is not conducive to protecting and growing your hard-earned capital.
T&T Capital Management
At TTCM we can invest in pretty much any asset class or product. In fact, just pushing people into funds would make my job a lot easier. The reality is I’d never do that with my money and this firm was established to offer the best product at a reasonable price to investors.
We invest your money the same way that we invest our own money.
We feel gains and losses just like you do. We never say that we’ll outperform each quarter or year, but we do believe that we can exceed the market over the long-term, which we have a record of doing. I believe the market is set up for us to outperform by a significant margin of several years.
The stocks that we own trade at about 1/4th of the price to book value of the S&P 500.
That is a 75% discount! These are stocks that are already at trough or recession-like valuations, despite improving fundamentals. We own many of the stocks that will actually see enhanced earnings when interest rates finally do go up, which they inevitably will. In addition to taking concentrated and contrarian positions, we also are employing conservative income-generating strategies such as covered calls and cash-secured puts to generate income and reduce risk. In a world where junk bonds yield 6%, we are able to sell puts on deeply undervalued stocks at double-digit annualized returns, with our worst case scenario being that we will end up owning the security we want to own at cheaper prices than what are currently available.
Once these value stocks come into favor and due to the low valuations, we could easily see 3-5 years of 15-20% annualized returns without them being overly expensive.
This is how value investing works. We buy things when they are grossly out of favor and unpopular. It is surprising that there is still so much hysteria about banks, 8 years away from the Financial Crisis, but this emotion has created the opportunities. Time is our friend as it allows the investment thesis to play out. Friday’s jobs report will likely have a big impact on whether the Fed raises in September or not. It may cause prices to fluctuate dramatically over the short-term, but ultimately with rates flat or higher, these companies are positioned to grow earnings, dividends and book values. The stocks will follow these metrics, as will our portfolios.