For printable version which includes all graphs and tables, click here.
Are We Nearing a “Minsky Moment?”
Hyman Minsky was an economist who created a hypothesis for the boom-and bust cycles of markets back in the 1960s. His “financial-instability hypothesis” posited that it was the very stability of boom times that caused investors to take excessive risks and therefore sowed the seeds for instability or a bust. During the Russian Debt Crisis of 1998, Paul McCulley, who was then PIMCO’s economist, coined the term “Minsky Moment” to describe that moment when some destabilizing event takes place that sparks a crash of highly-indebted markets and economies and moves the markets along Minsky’s identified stages. Former Treasury Secretary Larry Summers has recently suggested that markets could face a “Wile E. Coyote” cliff moment in coming months as the Federal Reserve attempts to tame inflation through higher interest rates. You may recall in the classic Looney Tunes cartoon that Wile E. Coyote would run off the cliff but remain suspended in mid-air, not yet recognizing his doomed predicament to fall off the cliff.
We will not start making prognostications for the market’s short-term direction in this quarterly commentary (you should stop reading if we ever resort to that), and only time will tell whether Mr. Summers is right that we will hit an air pocket in valuations as interest rates increase. What we do know (and have been reiterating to you in our annual client meetings) is that broad stock market valuation levels remain highly elevated. We believe that the recent mid-sized bank portfolio impacts from higher interest rates will not be the last problem exposed by a return to normalized (i.e. higher) interest rates. Our economy remains heavily indebted, and every company that refinances will likely have to double their interest expense on the same amount of debt. On the bright side, for every company paying double the interest expense there is a bond investor who receives double the interest income! Many of our clients are among those benefiting in their bond and short-term cash investments. We are only just beginning to see the reverberations of the end of the era of easy money.
We have long warned that we expected the end of radical monetary policy to be volatile. However, upon review it seems it has been nearly a decade since we reminded our clients in these pages about our different view of volatility compared to what is commonly accepted understanding in financial markets today. Any student of finance and markets today would be taught the Modern Portfolio Theory definition of ‘risk’ as the volatility of an asset’s return. We respectfully disagree. To us, and we believe to most of our clients, ‘risk’ is the potential for a permanent loss of capital. For those who have a disciplined process of using fundamental metrics to ascertain the value of a public security and who remain committed to only purchasing those securities at a discount to that estimate of value, volatility provides opportunity.
The banking crisis earlier this year caused what was termed by the financial press as a “flight to quality” in the unusual form of highly priced growth stocks. We see it differently. We would say that the first quarter brought a “flight to risk” as many of the highly valued stocks that underperformed the most in 2022 had very strong bounce backs during the first quarter of 2023. The high-multiple and tech-heavy Nasdaq Composite Index had its strongest January since 2001. It was up nearly 20% during the first quarter. (Our most tenured readers might recall that after peaking in March of 2000, the Nasdaq entered a 30-month bear market that declined 78% at its October 2002 trough. During that 30-month bear market, the Nasdaq had seven 20% rallies and was positive nearly a third of the months, averaging +10% across the rally months.) For the first quarter, Tesla was up 68% with an ending valuation of 54x earnings, Nvidia increased 90% to end at 118x earnings, Microsoft was up 20% to end at 32x earnings and Apple was up 27% to end at 28x earnings. Despite this recent outperformance by what is arguably the riskiest segment of the market, we continue to believe that the tide has turned in favor of value investing’s future prospects.
Why can we say this you ask? One reason is valuation. Your portfolios remain as attractively valued as we have seen in years. We discuss our valuation metrics with clients ad nauseum – but only because we believe valuations at any point are the single best indicator of future expected returns. You cannot pay high prices and expect to have strong future results. On the contrary, we believe that paying low prices today is the best way to maximize the odds of strong future performance. Many clients have noticed that we are the most fully invested (having the least amount of cash) in equity portfolios that we have been in years. This is because we have continued to find opportunities to add new, attractively valued stocks to the portfolio despite broad market valuations remaining stretched. Our composite portfolio today trades for only 9.5x trailing one-year earnings. Said another way, this is an earnings yield of over 10%, which is a true rarity. And this is despite a highly-valued broad stock market. Our dividend yield is 3.63% versus a yield on the S&P 500 of 2.05%. Our portfolio companies have much less debt than the average company in the broad market, which we expect will be a source of strength in a higher interest rate environment. We purposefully focus our communications with clients on the businesses you own in part to refocus your attention on the stability of owning actual enterprises and less on the stock market’s day-to-day volatility.
Another reason we believe the tide has turned towards value is the cloudy outlook for the very technology shares that have led the broad market’s advance in 2023 and continue to trade for multiples well above long-term averages. We believe there are cracks beginning to appear in the two most cited justifications for high technology company valuations: a return to low interest rates and the higher growth rates of technology businesses. First, fear of a banking contagion sparked optimism that the Federal Reserve would have to cease their interest rate increases or even lower interest rates, which would further boost the multiples of the fastest growing segment of the market. But with its recent continuation of further interest rate hikes, the Federal Reserve has restated its commitment to dampening inflation. Second, data from Bloomberg Intelligence reveals that technology sector earnings are now expected to fall 7.7% in 2023 compared with growth of 5.2% expected only six months ago . What is the justification for paying higher multiples for technology companies if they are not actually growing their businesses at higher rates?
While growth companies not meeting growth expectations may surprise the market in 2023, it should not be a shock to those paying attention. There was a seminal study published in the Journal of Finance back in 2001 analyzing growth rates of various businesses across the market from 1951 to 1997. This study demonstrated that valuation ratios have limited ability to predict future growth. Thus “growth” stocks do not actually end up consistently growing more than “value” stocks. The conclusions of this paper had been questioned in recent decades as growth stocks experienced a long stretch of out performance. To answer these questions, the research team at the investment firm Verdad performed their own update of the analysis using data from 1997 to 2022 . Yet again, they found little to no evidence that the high growth firms of today persistently experience long-term earnings growth, beyond chance.
What could happen to the highest valued segment of the market if it becomes known that today’s growth stocks are not actually growing at higher rates? A piece by investment firm GMO answers the very question. (Spoiler alert: it is not favorable news for the future performance of companies trading for high multiples.) GMO analyzed a basket of growth companies that “disappointed” the market’s expectations for sales growth and also lowered future sales estimates. “Value trap” is a commonly used term to describe stocks that appear cheap on financial metrics but the business’ fate deteriorates and they ultimately turn out to not be truly cheap. However, GMO’s piece was the first we had seen the term “growth trap” used to describe a growth company that underperforms their growth expectations. GMO’s research shows that these so-called “growth traps” had worse performance than did a comparable basket of “value traps” over the past 25 years. As GMO states, “When Value disappoints, markets are mad. When Growth disappoints, they are merciless.” We think it is more than the warmer weather that leads us to believe it is finally spring for value investors.
Reflections on Avoiding a Falling Knife
It is tempting to think of investing as a “precision” science where one model of cash flows can spit out an exact figure for a company’s worth. On the contrary, our 30-plus years of investing experience has provided us enough humility to recognize that identifying attractive investment opportunities is as much art as science. Our analysis and estimates of intrinsic value are an attempt to come “close” to a business’ ultimate value, but being cheap on valuation metrics is not the only criteria necessary for our deciding that a stock is worth adding to client portfolios. Because our aim is to buy companies at a discount to their intrinsic value, we must believe that there are factors that will eventually cause the market to recognize the value we see. Thus, there are “soft” factors relating to our confidence level of the odds of success being in our favor. We do not always get this assessment right. (Every client knows that we do not bat a thousand!) However, we thought a discussion of our past analysis of Bed Bath and Beyond (NYSE: BBBY) might shed further light into how and why the appearance of a “cheap” stock in and of itself does not result in our initiation of a position.
Bed Bath and Beyond is a familiar retailer to most and was the subject of much discussion during our research meetings in 2017 and 2018. At the time of our reviews, BBBY appeared to be a very cheap stock by almost any metric. When we first analyzed the company in July of 2017 it traded for a mere 6.7 times trailing 12-month earnings, sported a dividend yield of 2.05%, had a 10-year average return on equity of 24% and traded for only 1.58 times book value, resulting in a return on equity at current market price of 15.2% (=24%/1.58). The company had a very reasonable $1bn of net debt (debt minus cash) and had trailing 12-month free cash flow of $674mm. However, the stock was down over 50% from its $80 peak to $38 over concerns regarding declining market share and disappointing profitability.
We evaluated the company five times from July 2017 through October 2018, but we had several reasons for ultimately passing on this investment despite the cheap financial metrics. First and foremost, we have a general hesitation regarding the retail sector given its fickle nature. You may not be surprised to hear that we do not consider ourselves particularly adept at predicting trends and since retail preferences can change quickly, it is difficult to predict who will consistently adapt to those changes successfully. Secondly, Bed Bath and Beyond in particular was facing stiff competition from online retailers since most of their products were easily purchased online. The average customer needs little input from a knowledgeable sales staff regarding bread-and-butter housewares and the average product BBBY sells is easily shipped directly to the consumer, both attributes suggesting that sales will be particularly likely to shift to online channels where BBBY was not excelling. Thirdly, BBBY’s total assets were over 40% inventory, which is high compared to other retailers with 25-30% inventory exposure. Given the above fickle nature of retail, we were not very comfortable with our knowledge of the quality of this inventory and its worth to consumers. Furthermore, various efforts to cut costs, increase foot traffic and optimize store count failed to stem the rapid decline in Bed Bath and Beyond’s profit margins and same-store-sales, and we did not have ample evidence to be confident that these trends would reverse. Despite various periods of optimism, BBBY stock is down -99% since the day we first analyzed the company. Though like any value investor, we have owned our fair share of “value traps” through the years, it is safe to say that Bed Bath and Beyond was at least one value trap we avoided.
Energy: A Long-term Shareholder Perspective
The heightened volatility we are seeing as we emerge from over a decade of radically easy monetary policy has affected different parts of your portfolio to varying degrees. It will not surprise us if the greatest volatility moving forward continues to be in the companies that are producers of commodities or in commodity-adjacent businesses. As we have explained in previous commentaries, we believe these owners of real assets are important parts of your investments and remain attractively valued. We see value in their potential to protect your portfolio against what we continue to believe will be an era of higher inflation relative to the first 20 years of the 21st century.
A major part of your exposure to commodity producers is in the oil and gas industry. As President Biden said in his State of the Union speech, “We’re still going to need oil and gas for a while.” According to U.S. Energy Information Administration (EIA)’s projections for 47% growth of global energy demand over the next 30 years (see nearby chart), the consumption of oil and gas will be an important component of the world-wide energy landscape for decades. In November of 2022, the world’s population reached 8 billion and is expected to grow to 8.5 billion by 2030 and 9.7 billion by 2050. Barring a miraculous technological breakthrough, this population growth ensures continued demand for all types of energy.
The EIA projects that renewable energy will be the fastest-growing source of energy through 2050, but petroleum and liquid fuels will remain the most-consumed source of energy. There is also growing acceptance of nuclear power as an important part of lowering our carbon emissions. Energy requirements would likely be even higher if it were not for continuous improvements in energy efficiency. Of course, projections of how the world may look in 30 years are not likely to be 100% correct, so let us shift to the current landscape and near-term future. According to the EIA, global oil demand is set to rise by 1.5 million barrels per day (mb/d) in 2023 to a record of 100.9 mb/d. As the nearby chart shows, most of the growth is being driven outside of the developed world. Nearly half of the gain is expected to come from China following the lifting of its Covid restrictions. India is also growing its demand rapidly as the world’s third largest user of oil. Jet fuel remains the largest source of growth.
Our largest holdings in oil and gas producers are in two major integrated oil companies, Exxon Mobil (NYSE: XOM) and Chevron (NYSE: CVX), and in the largest independent producer ConocoPhillips (NYSE: COP). (ConocoPhillips spun-off its refining business Phillips 66 in 2012.) Owners of these companies with a long-term investing outlook (call it five years or more) should be encouraged by recent developments. The managements of each of these companies (and the others we own) have positioned each to produce attractive returns even at oil prices well below $100. Also, all three companies are much more profitable today than in 2013 when oil prices were even higher. Furthermore, debt levels at each company are also at or approaching the lowest levels of the last decade. Finally, each plans to return a large amount of cash to shareholders via dividends and share repurchases. Last year, each repurchased shares equal to over 3% of the companies’ market capitalization and each have indicated they plan to increase that amount in 2023.
How do we maintain a constructive outlook for these companies after a full year of declining oil prices? One reason is that lower prices encourage consumption and discourages new production (for proof see OPEC and Russia’s April 2 announcement of production cuts), and with global inventories at low levels, this should lead to higher future oil prices. Another reason is that during the first quarter of this year, the lower oil prices and fears of a recession lead to reduced share prices for the oil and gas companies we own. How could that be a positive thing for a long-term shareholder? If the companies have been doing what they said they would do and bought back shares, the remaining shareholders now own a greater share of the company! And the shares were bought back at lower, more attractive prices. A more attractive price means a higher future return for remaining shareholders. All while receiving an attractive dividend. We remain optimistic about our investments in the energy sector.
Mark Millsap Presents at Investment Forum
In early March, one of our principals, Mark Millsap, made a presentation to the Capstone Student Investment Conference at the University of Alabama. The presentation is entitled “Finally Wind in our Sails: Headwinds Turn to Tailwinds for Value Investors.” In case some of our clients may be interested in watching, Mark’s presentation and slides are available at the link below using the password “CSIC2023.”
We recently updated our Form ADV Part 2A and 2B informational brochure and reported no material changes from the previous version. If you would like a copy of this brochure, please contact our Chief Compliance Officer, Abby McKelvy, at (501) 534-2675.
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Foundation Resource Management, Inc. (“FRM”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from FRM. Please remember to contact FRM if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services or if you would like to impose, add, or modify any reasonable restrictions to our investment advisory services. FRM is neither a law firm, nor a certified public accounting firm, and no portion of the commentary content should be construed as legal or accounting advice. FRM claims compliance with the Global Investment Performance Standards (GIPS®). GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein. A copy of FRM’s current disclosure Brochure (Form ADV Part 2A) discussing our advisory services and fees or our GIPS-compliant performance information is available by emailing Abby McKelvy at email@example.com.