Steering Clear of the Dear

This article has been excerpted and edited from our quarterly newsletter to clients dated August 21, 2024.

As value investors we gravitate to undervalued securities—those that are inexpensive relative to our fair market value (FMV) assessments, because they are out of favour or underestimated. Similarly, we steer clear of those that are popular and dear.

We get nervous once a stock’s price rises to FMV because it’s then we fear a reversal. Stock prices tend to revert rather quickly to a discount once FMV is achieved. When a company is at a discount, we are generally optimistic and relaxed awaiting its rise to FMV, though clearly its discount is dependent on our FMV estimate—our analysis of the company’s future—which is not an easy task albeit made easier when our subjects are high-quality large companies.

High-quality large-cap stocks tend to fluctuate in price between fair value and approximately a 20% discount (about one TRAC^TM band down from FMV). Sometimes, though rarely, if investors become overzealous, enthralled by outstanding fundamentals, a stock’s price can run up about 30% above fair market value (FMV)—a TRAC™ band higher. More often, in overall market swoons, or if uncertainty is particularly high for a company, its price may fall to around a 35% discount (2 TRAC^TM bands below FMV) or even a 50% discount (3 TRAC^TM bands down).

By way of example, Microsoft has run up to its FMV 7 times in the last 10 years. Inverting this, after rising to its FMV, the stock price fell by about 15% or more on 7 occasions in 10 years. And, of those 7 occasions, Microsoft fell 28% and 38% from FMV in 2020 and 2022. Unpacking this: there are many opportunities to invest in well-known, high-quality companies; and FMV acts as a magnet, both attracting prices higher as demand for shares overwhelms supply and repelling prices once FMV is achieved when oversupply, excess selling, pushes prices back down.

When articulated this way, why would one invest in any other way than moving in and out of high-quality companies—those less risky than average, whose share prices rise over longer periods of time driven by ever-rising earnings, yet whose fluctuating prices over shorter time frames provide compelling opportunities to buy and sell along the way. That doesn’t mean it’s sure proof, just that the odds are favourable. Investors are still susceptible to having selections underperform if fundamentals disappoint (altering FMVs) or purchases and sales are mistimed.

CROWDED TRADES

While a buy and hold philosophy can certainly work over longer periods, it’s susceptible to big downdrafts when prices inflect down from FMVs. Buying companies that are big and steady (such as banks and utilities) still leads to periods of short-term price dislocations since prices fluctuate materially from: normal swings as shares rise to FMV and revert; interest rate changes; company specific issues; and overall market gyrations. Currently, prices of most stocks are trading dear—at or above their FMVs. Therefore, we remain nervous about the outlook for the overall market indexes.

PRICED FOR PERFECTION

Valuations for the North American stock markets remain high. When valuations are this high, returns over the next few years aren’t. In fact, valuation tools that have been used to project returns are estimating nil returns for the S&P 500 over the next few years.

Over the last 50 years, the percentage of S&P 500 stocks outperforming the index has averaged just below 50% with a high of around 67% (2001) and a low of about 27% (1998). So far, 2024 is the worst year on record with only about 20% of the stocks outperforming. The Magnificent 7 stocks collectively accounted for 64% of the S&P 500’s return in the first half of this year.

The S&P 500 (which is cap weighted—skewed by the market values of each company) has grossly outperformed the S&P 500 equal-weighted index. Such pronounced outperformance has just preceded or coincided with all 4 recessions in the last 40 years. When the outperformance has been so relatively high, subsequent 3 and 5 year returns for the equal-weighted index (i.e., the average stock) have materially outperformed the S&P 500. And during those reversals, returns are even more pronounced for value stocks—those stocks trading at the lowest multiples of earnings. Chant it with us, “Buy Low, Sell High!”

Based on 12-month forward earnings, the equal-weighted S&P 500 trades at a 23% discount to the S&P 500, and even the equal-weighted index trades above its long-term average earnings multiple. The yield on T-bills remains higher than the earnings’ yield (earnings/price) of the S&P 500, which is rare and only took place in recent history just before the recession in 1980 and 2001.

When trading at or above FMV, stock prices become highly susceptible to the slightest negative changes. What if interest rates rise because demand for U.S. bonds wanes, unemployment worsens, office buildings endure even more defaults, oil prices rise impacting input costs and pocketbooks, consumer spending softens further because demand for goods is satiated, tax rates rise to reduce deficits, or geopolitical issues are exacerbated? Some of this is bound to occur.

Yet, allocation to stocks by households is at an all-time high of 35%. It was 29 at the ’68 market top, 30% when the bubble formed in 2000, and 34% at the peak prior to the pandemic. Even worse, investors’ allocation to leveraged ETFs is at near-record levels.

Nvidia is the talk of the town. Its last 12-month revenues have tripled from the prior 12 months. But it trades at 50x book value, just under 40x sales (the highest price/sales multiple in the S&P 500). Its AI growth has surely been astounding; however, investors appear to be ignoring that Nvidia’s business has been highly cyclical historically, resulting in 6 share-price drawdowns of over 50% during the last 25 years. Artificial intelligence or real ignorance? Time will tell.

Concentration in tech stocks persists. In the Russell 1000 Growth Index, a bit of a misnomer since just 440 stocks constitute this index, only 6 stocks represent half the index. Periods such as these, with extreme concentration, have not ended well historically.

Buffett even just sold half of Berkshire Hathaway’s mammoth Apple position, likely because its share price simply ran up too high. He’s amassed Berkshire’s greatest cash position ever relative to its assets. Buffett’s Berkshire Hathaway itself is fairly valued, on sell in our TRAC^TM work, and likely to fall to a floor before moving back to its FMV.

FAR FROM PERFECT

It’s not just overall valuations that have kept our posture defensive. Our Economic Composite, TEC^TM, is still calling for a U.S. recession. Other developed markets have either entered recessions (as predicted by TEC^TM) or their growth has flatlined. While a U.S. recession has taken much longer to occur than we expected, the economy has certainly weakened.

After being below 4% for 27 months, the U.S. unemployment rate has lifted to 4.3%, well above the 3.4% cycle low, the rate now above levels off-the-bottom that have always coincided with the onset of recessions. Full-time employment was down 1.2% year-over-year in June—each time it’s been negative in the last 60 years has also coincided with a recession. U.S. job openings have fallen and the rate of wage gains diminished too. Small business hiring plans, which normally are a leading indicator of the unemployment rate, imply much higher unemployment in the months ahead. In Canada, the unemployment rate has lifted to 6.4%, and the economy lost jobs in the last couple of months.

U.S. credit-card delinquencies have reached double digits. U.S. corporate bankruptcies have jumped dramatically from last year and are at the highest level in over 10 years.

The fact that Walmart is experiencing growth from wealthier families doesn’t bode well. We’re seeing evidence of trading down from many businesses. Comments regarding a struggling consumer have come from McDonald’s, Starbucks, Whirlpool, Diageo, and even LVMH—at the high end—where demand for champagne has substantially weakened. Is everyone celebrating with just cake?

Corporate insiders, normally value buyers themselves, appear to realize that the economy is slowing and that stocks are fully valued. There are now more than 5 insider sellers for every buyer of U.S. stocks.

OVER THE TOP

While our undervalued stocks don’t keep us awake at night, we are concerned about geopolitical ramifications from the behaviour of Russia, Iran, North Korea, and other nations with similar regimes.

While it’s unrealistic that the leaders of these nations will alter their behaviour, we still hope that clearer heads prevail. And closer to home, we can hopefully alter some of the misguided policies that have us on the wrong course. For example, debt levels must be reduced by reigning in spending otherwise economic growth will lag considerably, currencies will lose material relative value, and significant inflation could result if governments are forced to ultimately aggressively print money to meet obligations.

The federal budget deficit in the U.S. is expected to be over $2 trillion this year as spending continues to be well ahead of receipts. This forces the government to finance the deficit with additional bond sales. Such high debt levels suppress economic growth as the law of diminishing returns typically sets in when debt reaches 80-90% of GDP; currently the U.S. ratio is around 100%.

Thankfully, while price levels remain high, the inflation rate has diminished. Even with core U.S. inflation still at 3.2%, above the Fed’s 2% target, there continue to be secular forces such as lower population growth, technological advances, and debt-suppressed growth rates which should maintain disinflationary pressures.

OUR STRATEGY

The market often overreacts, causing stock prices to fall below FMVs. We are constantly evaluating companies to determine whether we should buy, sell, or hold. The companies we do hold have competitive advantages, high returns on invested capital, strong free cash flows, and healthy balance sheets.

Since we believe the U.S. market is fully valued and we still expect a U.S. recession, we continue to hold a partial hedge against market declines by shorting an S&P 500 ETF (or holding an inverse long ETF) and/or the Vanguard Total World Stock ETF.

Meanwhile, despite our concerns, the American economy has remained resilient. Industrial production is up and consumers are still spending at higher rates than expected. Despite higher interest rates, house prices are back to all-time highs. And this could encourage a further market rise in a final blowoff—a swift 10-15% upswing to the next TRAC^TM ceiling.

STEERING IN THE RIGHT DIRECTION

We are comfortable investing in undervalued, solid, noncyclical businesses while holding hedges that should benefit when the expensive market indexes decline.

We look to avoid overly popular companies that are priced too high, susceptible to decline, and result in misery. We don’t like the adage ‘misery loves company’. We’d rather not be miserable.

Bob Robottii, a well-known U.S. money manager, recently hosted a conference that invited several value investors, calling it the Restoration of The Fallen. And referring to stock pickers, he stated that he’d be shocked if they don’t outperform the indices over the next decade. That might seem like a bold statement to those who’ve suffered underperformance as indexes have risen so smartly. But tried and true value investors realize that markets often get carried away, lifting valuations to lofty valuation levels. We welcome a return to normalcy because we’re always cognizant of valuations, steering toward the bargains and away from the dear.