Believe it or not, there are now over $13 trillion worth of bonds that are trading at negative interest rates. Money-losing unicorn stocks are able to IPO at valuations worth tens of billions of dollars. Interest rates have plummeted with the 10-year Treasury bond now circling around 2%. Lingering in the background of this environment, is the biggest valuation gap between growth and value stocks that has ever occurred dating back to 1930. These gaps have generally occurred in prior periods of excessive valuations, only to be radically corrected, with value dramatically out performing. Small and mid-cap stocks, are also significantly cheaper than their large-cap peers, despite historically achieving higher returns. International stocks have lagged as well.
One of the hardest skills in investing is the ability to simply be patient. There is so much data out there, that the human brain simply cannot process everything. Many market participants become glued to their trading screen or account snapshots on a daily basis, despite knowing that business values change far more slowly than day to day market prices.
Investment returns can be very lumpy. One day a stock is an undervalued but highly out of favor company that is lagging the market with low expectations over the short-term. Over time, business conditions improve and the company begins to exceed the low expectations and the stock starts building momentum higher. Another way we often see value realized is through mergers and acquisitions. Just this week we saw Allergan (AGN) get bought by Abbvie (ABBV) at a huge premium to its recent share price.
There are a few major themes in our current investment portfolio. Firstly, the stocks are deep value, trading very inexpensively, often at 1/3rd of the valuation of the overall market and/or at a discount to tangible book value where relevant. Secondly, the companies are mostly able to take advantage of the disconnect between price and value, via repurchasing their own stock at these prices. So when AGO sells off from $45 to $41 absent of any material news, over the long-term we will benefit because the company is buying back about 10% of its market capitalization this year at these lower prices. That in turn will enhance the intrinsic and book values per share, as well as the earnings per share. Other examples of this behavior are ALLY, BAC, C, and AAL. For AGO, we had already realized most of our profits on our sold puts on the stock when it traded higher, so now we have actually been able to sell many of the same puts again at very attractive rates of return.
While some people are buying bonds that are assured to have a negative return till expiration, we are able to buy high-quality businesses at 10-20% earnings yields. That won’t payoff in one month or even one year necessarily, but over time that is how you make real money via investing. When you buy stocks this cheap, you don’t need exceptional growth for the investment to play out. The companies can pay their earnings out via dividends, or build value via accretive buybacks. Over time, the stocks tend to get valued at a higher level.
Years ago, we had large investments in the healthcare insurance industry, in companies such as United Health and what was then Wellpoint. At the time, the stocks were trading between 8-13 times earnings. Now the industry trades between 18-21 times earnings, despite arguably peak margins. It isn’t hard to imagine European banks now trading at 60% of tangible book value, once again trading at 1.2 times tbv, which should also grow as they retain earnings. When we invest, we always want to think about what things should look like 3-5 years from now.
The person buying those negative interest rate bonds might make money if someone pays a higher price than they paid for it tomorrow, but in 3-5 years the risks are dramatically skewed against them. Conversely, with our value portfolios’, I can’t tell you if we will be higher or lower in one month or one year necessarily. Over a 3-5 year period though, I’d be shocked if we weren’t materially higher, even though I would not be surprised if the S&P 500 was flat to negative during that period. Value investing is meant to zig when the market zags. That doesn’t mean we can’t make money in a bull market as we most definitely have made a ton. But, when the inevitable downturns occur and mean reversion does its thing, we have the ability to truly deliver superior alpha, and I think that is how we are set up.
In 3-5 years, Puerto Rico’s bankruptcy will be resolved. What does that do for AGO, AMBC, and our bonds? Will we have faced a recession and if so how large? What happens to these glamor stocks trading at stratospheric valuations if growth goals aren’t met? How will the market react when the big banks are solidly profitable throughout the next recession due to their changes in structure and business model after the last recession? Many pundits have criticized Warren Buffett’s Berkshire Hathaway (BRK/B) for its major under-performance over the last 10 years, but we’ve been buying the stock and selling puts, as we think it will outperform over the next 10 years.
Most of our portfolios’ have between 8-14% in unearned option premium, most of which expire in late January from the sale of puts and to a lesser extent covered calls. On average I’d bet that most people would benefit materially by really only checking their account at the end of January, as that is when you see the full fruits of the strategy. We aren’t 100% long stocks like the S&P 500, because we think the S&P 500 is rather expensive and that returns on it will likely be inferior over the next decade. We also don’t have 40% in incredibly low yielding bonds like the traditional 60/40 asset allocation that just about every advisor does nowadays for someone close to retirement. We use tools to create more attractive risk-adjusted opportunities, but the cost of those tools is that you have to let time do its thing. Time decay is a powerful force with options, especially when we get to that last 30-60 days. We almost always see a major January effect as our options expire, which historically has been as big as the double-digits. I’m not making any guarantees of course, but I like where we are positioned.
In a few weeks we will see 2nd quarter earnings come out for many of our investments. If you take an interest in such things, watch how metrics such as earnings per share and book value are progressing. That will give you a better read on how things are going, than any day to day price the stock market gives you. Over time those values will converge, but consistently predicting the timing of it of course is impossible. Take comfort that even when a stock will drop a bit in the short-term, we are invested in companies with CEOs that are smart enough to buy into these dips. We use a strategy to capitalize on these dips, by buying more stock and/or selling puts to either earn income or buy the stock cheaper.