As we begin a new year I’m struck by the level of pessimism that pervades the outlook for stocks, bonds, commodities, etc. It is important to note that “market feeling” and $5 might buy you a cup of coffee at Starbucks, but nothing more. It is highly irrelevant in predicting market returns and if anything, sentiment is more of a contrarian indicator. With that said, the reasoning behind the pessimism is very rational. The general stock market is very expensive at about 26 times inflation-adjusted earnings, known as the CAPE index. Most stock markets were negative in 2015 and bonds performed poorly too, especially junk bonds, which were down about 10%. The 10-year Treasury is only yielding about 2.21%, so achieving reasonable returns through fixed income is still a very difficult thing to do. The percentage of stocks down 25-50% was the highest that we have seen since the Great Recession, with the best performing stocks being the most expensive such as Facebook, Amazon, and Netflix. Commodities were the worst performers in 2015 as oversupply and a slowdown in China has many sectors in the overall commodity complex in a depression. The United States is gripped by political gridlock and the geopolitical environment is not promising to say the least.
Still there are some reasons for optimism. The global economy is still growing, with the U.S. still chugging along at around a 2% growth rate. Unemployment is low, but we must acknowledge that workplace participation is still low. Housing and automobiles continue to be strong markets, while credit quality remains higher than we have seen in some time. The animalistic forces that created the housing and credit bubble that led to the Great Recession are nowhere to be seen. While this expansion has been the longest since the 1990s, and one of the longest in U.S. history, it has been very weak, which is good and bad. The good part is that it means that any downturn would likely be quite mild, and it also means that there is pent up growth potential that could be released if we saw a more conducive regulatory and economic climate. The bad part is that many Americans are not materially better off than they were 5 or 10 years ago, particularly if they have not benefited from the increase in asset prices.
It is important to understand that investing is, by definition, a long-term endeavor. When you need to take money out in the next 12 months for instance, the best thing to do is invest in cash or Treasuries. By taking a long-term approach, one is able to take advantage of the short-termism that dominates most stock market activity. Value investing is one of the few financial pursuits that if executed with good acumen, should result in significant profits without considerable risks being taken; with risks being defined as the permanent loss of capital. This is achieved by investing in financially strong companies at prices materially less than the value of the underlying business. Value investing does not assure outperformance every quarter or year by any means, but over the long-term the most successful investors have been value investors such as Warren Buffett, Carl Icahn, Bill Ackman etc. 2015 was a very bad year for most investors, including value investors. All three of these giants posted negative returns. It has some parallels to the late 1990s, in that speculators were rewarded for paying exorbitant prices for stocks, while obviously undervalued stocks by just about any metric, lagged behind. Nothing is abnormal about this, which is why Benjamin Graham famously stated that “in the short run, the market is a voting machine but in the long run, it is a weighing machine.”
While the outlook for the overall market might not be very strong, the outlook for our individual companies is, and the outlooks for our individual investments are even better. You might be asking, how can this be if the market is too expensive and growth is so limited? Let me explain. At T&T Capital Management (TTCM) we invest in individual companies, not the overall market. We make absolutely no attempt to be a “closet” index fund. This will cause our results to be quite different than the indices, but over the long-term we believe it creates the opportunity for significant outperformance. Many indexes or mutual funds are obligated to buy stocks that any rational analyst would view as overvalued, but because they are part of the weighting of an index, it must be part of the portfolio. This avoids embarrassment for some due to the comfort of following the crowd, but it adds no value and can only lead to below average results when you factor in fees. At TTCM we only invest in companies that are deeply undervalued and that are in a reasonably strong financial condition. This doesn’t mean that we will avoid all problems, as owning any energy stocks in 2015 was a disaster that we certainly did not avoid, but over the long-term it has served us incredibly well. It allows us to find those pockets of opportunity where prices are distorted because of some short-term issue, but the value continues to grow. In fact, I believe that our individual investments increased in value in 2015 by far more than was exhibited in our portfolios and I’ll show you what I mean later.
Financial stocks are a great example of this phenomenon of individual companies being incredibly cheap despite an expensive market overhang. While the regulatory environment is absolutely terrible adding significant costs and complexity to the industry, these headwinds are widely known and acknowledged and have prevented many market participants from owning these companies. This void has kept valuations abnormally low, despite improving actual business conditions. Mortgages, autos, and credit cards are all performing extremely well, which is great for banks. The major lawsuits that have taken hundreds of billions of dollars in lost profits from the big banks are mostly over, which will assist in even greater profits and capital returns. The Federal Reserve raised interest rates in December and, barring a significant decline in the U.S. economy, seems poised to continue to do so. This will bolster net interest margins and investment incomes for financial stocks, leading to higher returns on equity. Due to the regulatory changes, the big banks and insurance companies have had to hoard capital to reach higher capital requirements.This process is mostly over too, so increased dividends and stock buybacks should be expected. Most importantly, these companies are incredibly cheap! All of our major financial investments trade at material discounts to book value, which is a very important measure of net worth for financial stocks. All of our financial stock investments have the capacity to grow their book value or net worth by a minimum of 10% adjusted for dividends over a full economic cycle, and higher rates are hugely positive in this regard.
The table below shows our largest financial stock positions and highlights their discounts to book value. As you can see, 6 of the 9 companies increased their book values over the last 3 quarters, and this doesn’t even include any dividends paid. The 3 exceptions have short-term issues that are now largely resolved and should resume growth in 2016. I expect all of these companies to ultimately trade at book value once again and tangible book value at the absolute minimum. 8 of the 9 stocks trade at a greater than 20% discount to their growing book values, despite improving business conditions. Please note that these book value numbers are as of 9/30/15 and will mostly be higher once they report their 4th quarter numbers. It is impossible for any financial analyst to argue that these stocks are expensive. One might say that they are out of favor or not exciting, but private market transactions and the history of these industries point to prices far exceeding current levels. Just about any bank acquisition takes place above book value and the same can be said for just about any insurance companies that aren’t highly distressed. None of our positions in this table are significantly distressed. Deutsche Bank has the most hair on it, but as you can see the valuation more than makes up for it with the stock trading at a 50% discount to book value, by far and away the cheapest of the major banks.
At some point, the tables will turn. The government will not treat financial companies like pariahs as they are absolutely integral to global economic growth. Business conditions are improving each year and the major costs and considerations are in the past. We have a future of higher dividends and stock buybacks, which at current prices, would be the greatest source of growth to intrinsic value. It seems very reasonable that these 9 financial stocks could average returns of 12-15% conservatively over the next 5 years. Sure if there is a major recession, many of these companies will be impacted as would everything else, but they have never been stronger than they are right now financially. The valuations basically discount a very severe recession in most cases already. This is the exact opposite of most stocks, which is why I believe we are very likely to outperform considerably over the long-term. I’m going to be writing in more detail about individual names and other sectors, which we are invested in over these next few weeks and months. I believe as earnings come in and as market developments occur, the values of these businesses and the stock prices will really begin to converge. Just as importantly, focusing on deep value will keep us away from the tremendously overvalued areas of the market, which are likely to lead to significant permanent losses of capital.