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Haves versus Have Nots
Much has been said about the historically high level of concentration today in the most frequently quoted, supposedly “broad” market barometers such as the S&P 500. Our focus today will not be on rehashing this widely observed point. We aim to emphasize, instead, the opportunity being created by the artificial intelligence frenzy directing so much attention and money to a small number of companies in the market. This tunnel vision has “left behind” other businesses currently being overlooked by the market today and offering very inexpensive entry points for long-term investors.
Ken French is a well-known professor of finance at Dartmouth who has had a long career studying asset prices. He maintains a data library with broad market valuation statistics dating back, in some cases, 100 years. We quote his data frequently for long-term context about market conditions today. His data library includes the average cash flow multiples of different segments of the market by valuation level. From this, we can compare over time the average cash flow multiple of the most expensive quarter of stocks in the market and the least expensive quarter of stocks in the market. Chart 1 illustrates why we see so much opportunity available in these segments of the market that are being “left behind” in the wake of speculative fervor surrounding stocks that are considered artificial intelligence beneficiaries. The hype around artificial intelligence has driven valuations in this narrow segment of the market to extreme levels. As you can see from Ken French’s data summarized in Chart 1 (see page 1), the most expensive quartile of the stocks in the market today trades for 40x cash flow, which is double the long-term average of 20x cash flow for the most expensive segment of the market. In contrast, the cheapest quartile trades for 5.6x cash flow or about 20% above the long-term average for the cheapest quartile since French’s data begins in 1951. For reference, our FRM equity composite portfolio trades at 8.6x cash flow.
We believe we have assembled for our clients a portfolio of businesses trading at very reasonable valuation levels, which gives us a margin of safety for the future. These low valuations give us more ways to win – not only could we win with the compounding results of owning a business generating high cash returns on capital, but the valuation discount also means that even the slightest outperformance versus low expectations could send the valuation levels higher. This is in contrast to the speculative sectors of the market where only perfection – perfect growth and perfect execution and perfect adherence to speculative valuation levels – could possibly achieve superior future investment returns. Hopefully this demonstrates how we could be optimistic today about the portfolios we have assembled while being cautious about the market in general, especially highly valued stocks that appear priced for conditions approaching perfection.
We want to emphasize how patient, long-term investors should be optimistic today! There are plenty of businesses available to own today at very reasonable valuation levels, which we believe increases the odds of strong future performance as stockholders. These businesses have dominant market shares in their industries, stable and in some cases growing cash flows and trade at very low valuation levels, indicating they are being overlooked despite the high overall market valuation levels. These companies are clearly thought to be “have nots” though we believe a contrarian view will reward patient, long-term investors. We want to highlight a few of these “left behind” companies and industries in our clients’ portfolios.
Chart 2: Energy Sector of the S&P 500 vs. Nvidia (NVDA)
Our first example is the energy sector broadly. Most will know that energy is one of the largest sectors in our portfolios today. There is no better example of the valuation “haves” versus the “have nots” than the energy sector. Chart 2 shows the valuation of Nvidia versus the entire energy sector of the S&P 500. As of this writing the energy sector of the S&P 500 trades for a weighted average 12.75x last twelve month (LTM) net income. Nvidia trades for 62x LTM net income. For Nvidia to grow its earnings to match those of the energy sector by 2034, you have to assume they can sustain 9% annual earnings growth for the next decade. Of the five largest stocks at the peak of the technology bubble (Microsoft, Intel, Cisco, IBM and AOL/Time Warner), only two (Cisco and AOL/Time Warner) experienced earnings growth this high over the subsequent decade. (Cisco grew their earnings at 20% annually from 1999-2009 while AOL grew theirs at 14% annualized.) Cisco’s stock was down a cumulative -39% over this period, while AOL Time Warner’s stock was down -87% over the period. An investor in each stock had a poor result despite the tremendous business success, simply because their stock began the period too highly valued. We recognize that Nvidia’s chip business might grow further over the next decade. But the assumptions you need to get a positive return in the stock are truly extraordinary. If Nvidia has earnings growth over the next decade as strong as Cisco’s 20% annualized from 1999-2009 and the stock trades in 2034 at a mature-industry level such as the 12.75x LTM price to earnings of the energy industry today, a stock investor would have a 2.4% annualized return over the next decade in Nvidia’s stock. Our “have not” energy sector investments today already pay us a 3.1% dividend yield! Additionally, the energy sector is making disciplined investments in growth opportunities and increasing our ownership with buybacks at the reduced valuations.
One energy sector portfolio company our clients own that may be less familiar to most but is a very extreme example of undervaluation in the sector is Greece-based shipping company Tsakos Energy Navigation (NSYE: TEN). Tsakos owns a diversified fleet of 74 double-hull vessels including crude oil tankers, product tankers and liquid natural gas (LNG) carriers. Tsakos is the shipper of choice for major oil companies including Exxon, Norway’s Equinor, BP, Total, Chevron and Shell. Tsakos leases out their vessels on long-term charters with profit sharing provisions above specified minimum rates or on spot-based charters. Though time charter rates have been volatile over the last five years, Tsakos has maintained an average utilization of 94.8% over this period, reflecting the reliance of global oil companies on their assets and expertise. Though the stock is up around 20% this year, the company trades for a mere 5.3x LTM earnings per share and only 2.5x cash flow per share. Tsakos has just passed their 30th year as a public company. They have paid a dividend every single year since their initial listing, including during the worst markets for day rates on seaborne carriers. Additionally, they just raised their dividend for 2024 by 50% to yield over 5.7% on today’s price. The stock trades for less than half of the book value per share, contrasting with the S&P 500 which trades for 5.1x book value on average. We believe Tsakos has a unique set of relationships with shippers and a fleet that is hard to replicate and will be needed for years to come. Tsakos is yet another stock in our portfolio that we believe is being overlooked.
Our next example of a “left behind” stock from your portfolio is Verizon Communications (NYSE: VZ), the largest postpaid wireless telecom provider in the country. Verizon holds a roughly 40% share of the postpaid phone market in the US, which surpasses AT&T and T-Mobile who each control close to 30% of the postpaid market. Verizon’s network has the broadest coverage in the country, serving about 93 million postpaid and 21 million prepaid phone customers. They also own extensive fiber assets, particularly in the Northeast where they serve 8 million customers among the 29 million homes and businesses to which they offer broadband access via their Fios network. We initially added Verizon to portfolios in March of 2022 at $51. We increased our position first in July of 2022 at $45 and again at $34. Our average basis today is right around the current share price of $44, which we believe to be very inexpensive. Verizon’s business is solid and they generate a substantial amount of free cash flow from operations. They pay a handsome dividend, yielding 6.14% currently, which has grown for 18 years in a row. The stock currently trades for 9.9x LTM earnings per share and only 5.2x cash flow or 9.7x free cash flow per share, after total capital expenditures (capex). Verizon is just finishing a substantial capex cycle where they acquired new spectrum (licensed network capacity) and significantly invested in upgrading their network to 5G which further improved its quality. Now that their capex has come back down to long-term averages, they have been using this excess cash flow to reduce debt and return capital to shareholders through the generous and growing dividend. We believe with Verizon we own a market leading company with high quality assets and a proven track record of providing a critical resource to its customers. Verizon is a very inexpensive and stable business that we are pleased to have an opportunity to own, which is why it is a top 10 holding across our portfolios.
Another entire industry that we believe to be significantly undervalued is precious metals mining, particularly gold miners. The last time we devoted a section of this commentary to the subject of gold in the 4th Quarter of 2019, you could purchase an ounce of gold for around $1,500. After an eventful five years, gold closed out the third quarter at a price of $2,636 per ounce. The price of gold is up almost 28% so far in 2024. Much of the rising price over the last several years has resulted from the demand of central banks increasing their gold reserves (see Chart 3.) This has mostly been driven by a desire to shift their reserves away from the U.S. Dollar, and gold represents an attractive alternative. Central banks now account for about a quarter of total global gold demand, which is double what it was before 2022. According to the World Gold Council, central bank gold buying reached a new record high of 483 tonnes in the first half of the year, a 5% increase over the same period in 2023.
It appears that investors in developed Western markets have started to slowly wake up to what is happening with the price of gold. One of the most common ways for western investors to own gold is by purchasing an exchange traded fund (ETF) that owns physical gold and gold futures. ETF holdings of gold had been declining for the past several years and only began to grow slowly halfway through 2024. This increased demand by western investors could drive gold prices even higher.
We believe there are many reasons to own gold as a long-term store of value. This is particularly true when the United States federal government debt is expected to continue its unprecedented growth, regardless of which party wins the election this fall. While we do not own physical gold in our clients’ portfolios, we do own several gold miners which are undervalued relative to physical gold. We continue to own Newmont Corporation (NYSE: NEM), Agnico Eagle Mines Limited (NYSE: AEM), Barrick Gold Corporation (NYSE: GOLD), and Alamos Gold Incorporated (NYSE: AGI). We also continue to purchase shares in these miners for new clients. As Chart 5 shows, our gold mining companies have significantly reduced their debt levels over the past decade and have recently produced attractive cash flows at these record gold prices. Ownership in these well-run miners represents an important part of our portfolio.
Finally, one other example of a company that has been “left behind” in terms of valuation is HP, Inc. (NYSE: HPQ.) HP, formerly Hewlett-Packard Company, provides printers, printing supplies, personal computers (PCs), workstations, mobile devices, and related products, services, and software to consumers and businesses. HP Inc.’s history coincides with the development of home computing and the rise of Silicon Valley from its founding in Palo Alto, California in 1939. We discussed the potential demand and pricing impact from AI-driven PCs on the company’s prospects in last quarter’s commentary. However, we did not highlight HP’s current businesses, the strong position of those businesses in the market and the free cash flow generated by the company.
The PC segment of HP is called the personal systems segment by the company and accounted for 68% of 2023 revenue. The Printing segment contributed 32% of revenue but with higher margins and so contributed 57% of operating profit (see Chart 6). HP has the second largest market share in the global PC market with ~22%, second only to Lenovo’s ~25% share. The PC market has the potential to grow globally as only 36% of households in developing markets have a computer at home compared to 79% of households in developed markets. HP has the highest share of the global printer market at 21%. The closest competitor is Canon with a 17% share. The printer market is not growing unit volume globally, but HP has managed this business effectively through disciplined execution and cost management. While both of these markets are competitive, they do not appear to be attracting new competition. HP has an advantaged position to keep operating profitably in both.
HP has committed to returning 100% of free cash flow to shareholders through dividends and buybacks. Over the last five years, the company’s dividend has grown by 11% annually and outstanding share count has been reduced by 34%, increasing our ownership in the company by more than 50%. HP is expected to generate $3.75 per share of free cash flow in 2024. The company’s shares are trading at an attractive 8.8x cash flow or 10.3x free cash flow, after capital expenditures.
Hopefully these examples, all companies and industries owned in our clients’ portfolios, give you a sense of the optimism we feel for the future! This quarter we also initiated a new initial position in a consumer discretionary company we believe to be significantly undervalued. We like the portfolio we have assembled today and believe patience, a long-term perspective and a willingness to think differently about these “left behind” stocks will reward our clients in the future.
Milestones
This quarter marks 34 years since the inception of our equity composite track record on September 30, 1990. We would posit that there are very few firms with a GIPS-compliant track record of this duration where the same portfolio managers have been making the portfolio decisions for the entire history. We recently came across a list of the 30 best performing stocks in the S&P 500 over the last 30 years, from September 1994 to August 2024 . We calculated these stocks’ performance over our 34-year composite track record since September 30, 1990 (or since their IPO date, whichever is later.) The top 30 companies in the S&P over this period have annualized returns between 39.6% (chip maker Nvidia since 1/21/1999 IPO) and 12.4% (biopharma company Regeneron Pharmaceuticals since 4/2/1991 IPO.) On average, these 30 stocks had annualized performance of 22.7% over the 34-year period. During the same period, the S&P 500 has returned 11.24% annually while, even after a decade of the value approach underperforming, FRM’s gross-of-fee composite results are a hair better.
What was remarkable to us is that FRM did not own one single stock from the list of the 30 best performing stocks in the S&P 500 over that period. Our firm’s composite, gross of fee returns managed to outpace the S&P 500 returns over our 34-year history without owning any of the best performing S&P 500 stocks. It was a reminder to us that there are many ways to succeed in investing. And importantly, you do not have to own every single stock that has strong returns. There are many ways to have good performance. Avoiding the losers can be just as important as owning the winners.
It is fun to think about the winners (“If only I had put every dollar I had into Nvidia or Amazon!”), but that ignores the reality that most people investing in these index “winners” also owned the index “losers” that dragged the performance of the index from the best performers in the ~23% annualized range to the S&P 500 index overall return of ~11% annually. An investor who owned the S&P 500 over our firm’s inception period would have also owned one of the worst value destruction stories in history: telecommunications behemoth Worldcom Inc. Worldcom was an S&P 500 index member from 3/29/1996 to 5/14/2002, during which time its shareholders suffered a cumulative -98% loss (-33% annualized) after the company entered the index at $14.74 with a market cap of $8.8bn, peaked at $61.99 with a market cap of $179.6bn and exited at $1.24 per share with a market cap of $3.6bn (following a 1 for 25 reverse stock split a year prior.) An S&P 500 index investor would have also owned Qwest Communications and Nortel Networks, losing -88% and -54% cumulatively during their tenures as members of the benchmark S&P 500 index. It is these losses and many other subpar returns which bring the 22.7% annualized gain of the 30 best performing S&P 500 stocks over the 34-year period down to the 11.2% annualized gain of the overall S&P 500 since 9/30/1990.
Protecting our clients’ capital during prolonged down markets has been key to FRM’s long-term results. We have analyzed our performance in three types of markets: “normal” markets where the S&P 500 has annualized between 0% and 15% for the trailing five years, “bullish” markets where the S&P 500 has annualized more than 15% for the trailing five years and “down” markets where the S&P 500 has had a negative annualized return for the trailing five years. The results in Chart 7 illustrate that FRM’s added value over our 34-year history has mostly come by protecting our clients during “down” markets. Additionally, our variation in annualized returns during various market environments is much lower than that of the S&P 500. FRM’s average annual gross return in different market environments ranges from +9% annually to +14% annually. The S&P’s average annual return in different market environments ranges from -2% to +19%. We believe that both of these attributes, protecting in a down market and low variability of medium-term returns, are a direct result of our remaining true to a value-oriented approach to investing your capital. Every client knows that we do not bat 1.000 at stock selection. Our track record includes our fair share of poor investments. However, we are proud that our track record, demonstrating the results of our security selection for our clients, now spans 34 years. We have consistently utilized a disciplined approach to security selection that has been practiced and honed for that entire period. This discipline was passed down to us from mentors spanning back into the 1950s. Our approach to assessing the value of companies emphasizes the proven and historical instead of the projected and hopeful. We will not own every stock that has strong performance. However, we continue to believe that avoiding the speculation-driven overvalued segments of the market in favor of owning time-tested, cash-flowing businesses increases our odds of future success.
Expanding our Team
We are very excited to announce the first hiring of a third-generation member of FRM’s investment team. George Sellers joined us in September as an investment analyst. In 2019 George concurrently received a B.S. in Industrial and Systems Engineering and an M.B.A. from the University of Oklahoma. He also received a scholarship to study at the London School of Economics in the summer of 2018. George originally hails from Montgomery, Alabama. In the spring of 2023, George over-married to the former Savannah Murphree of Camden, Arkansas. Stay tuned for more news on the Sellers family in our end-of-year edition of this commentary. George joins us from Stephens, Inc., where he was a vice president and equity research analyst, initially covering the transportation industry and later covering healthcare. George is also a CFA Level III candidate. We look forward to your meeting George, another reason to come by for a visit to our offices if you have not yet done so.
Disclosure
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 amckelvy@frmlr.com.
Compliance Statement: Foundation Resource Management (FRM) claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards. FRM has been independently verified for the periods January 1, 2000 through December 31, 2019. The verification report is available upon request. A firm that claims compliance with the GIPS standards must establish policies and procedures for complying with all the applicable requirements of the GIPS standards. Verification provides assurance on whether the firm's policies and procedures related to composite and pooled fund maintenance, as well as the calculation, presentation, and distribution of performance, have been designed in compliance with the GIPS standards and have been implemented on a firm-wide basis. Verification does not provide assurance on the accuracy of any specific performance report. 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.
Firm Definition: Foundation Resource Management (FRM) is an independent investment adviser registered under the Investment Advisers Act of 1940, founded in 1992, headquartered in Little Rock, Arkansas, that manages equity, fixed-income, and balanced portfolios.
Composite Description: The FRM Equity Composite includes all discretionary non-wrap equity accounts following the FRM Value Equity strategy. An investor in this offering should have a long-term investment horizon. FRM’s Equity Composite is an all-capitalization, value-focused, long-only stock offering. It invests predominately in mid- and large- capitalization companies, yet it has no restrictions on what size company in which it can invest. The portfolio managers use bottom-up fundamental analysis based on value investing principles to identify potential investments trading below the portfolio managers’ view of the stock’s intrinsic value. The offering focuses on capital appreciation while seeking to minimize the permanent loss of capital. Because of the size and value-driven characteristics of the portfolio’s holdings, performance can vary from the broader stock market. Prior to January 2002, the composite consists of all equity portfolios managed by the portfolio manager, Greg Hartz, which included portfolios that were managed by Mr. Hartz under a different organization. The composite inception date is October 1990. The composite creation date is June 2020.
Composite Benchmark & Description: The composite benchmark is the Standard and Poor’s 500 Total Return Index (“S&P 500 Index”). The S&P 500 Index is a capitalization weighted index of 500 stocks, and it is designed to measure performance of the broad economy through changes in the aggregate market value of stocks representing all major industries. The securities included within each client account that is included in the composite differ significantly from the securities that comprise the S&P 500 Index. For example, client accounts are significantly more concentrated. The S&P 500 Index is presented as a broad-based measure of the equity market. The index returns reflect no deduction of fees, expenses, transaction costs or taxes that actual client accounts are subject to. The results of the composite may be materially more volatile than the indices. The indices returns have been taken from published sources. Investors cannot invest directly in an index.
Calculation Methods: Performance is expressed in U.S. dollars. Clients do not participate in an automatic dividend reinvestment program; however, dividends and other earnings are reflected in composite performance. The measure of composite dispersion presented is the asset-weighted standard deviation of annual gross-of-fees portfolio returns for portfolios included in the composite for the full year. Asset-weighted standard deviation is not presented for periods when the composite contained five or fewer accounts for the entire period as it is not statistically meaningful. The three-year annualized standard deviation is a measure of the variability of the gross-of-fees composite returns and benchmark returns over time. Policies for valuing investments, calculating performance, and preparing GIPS Reports are available upon request. The firm’s list of composite descriptions are available upon request.
Past performance is no guarantee of future results. For reasons including variances in portfolio account holdings, variances in the investment management fee incurred, market fluctuation, the date on which a client engaged FRM’s investment management services, and any account contributions or withdrawals, the performance of a specific client’s account may have varied substantially from the indicated FRM composite results. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by Foundation Resource Management, Inc. (“FRM”), will be profitable, equal any historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Please remember that it remains your responsibility to advise FRM, in writing, 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 to modify any reasonable restrictions to our investment advisory services. Information pertaining to FRM’s advisory operations, services and fees is set forth in FRM’s current disclosure statement on Part 2A of Form ADV, a copy of which is available from FRM upon request. FRM’s Chief Compliance Officer, Abby McKelvy, remains available to address any questions regarding these results, fees and compensation, policies for valuing portfolios, or any other part of this presentation. Please email info@frmlr.com or call 501.604.3190.
Treatment of Fees: Gross performance results have been reduced by trading expenses but are before management fees. Net performance results have been further reduced by a model management fee of 1.00%. Model fees are deducted at a rate of 1/12th per month from the gross-of-fees composite returns. Actual investment advisory fees incurred by clients may vary, depending on portfolio structure or timing of investment. The following is an example illustrating the effect an investment advisory fee could have on a client’s portfolio: For a $1,000,000 initial equity investment, the total investment management fees for an account that experiences a 6% annual compound return are: One Year: $10,320 Five Years: $53,400
Composite Fee Schedule: 1.00% up to $5 million and 0.85% for assets over $5 million. Fees are negotiable for assets over $10 million.
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