For printable version which includes all graphs and tables, click here.
We Live in a Bizarro World
Introduced in the early 1960s, The Bizarro World is a fictional planet appearing in American comic books published by DC Comics. It was made even more famous 30 years later in a renowned Seinfeld episode (watch here ). The primary reason for the Bizarro World in finance today is negative interest rates. For 4,000 years of world history, to our knowledge, there has never been a negative sign in front of an interest rate until now. Below is a chart created in late August color coding negative (red) and positive (green) interest rates for developed world sovereign government bonds across various maturities.
Prior to now, the concept of discounting has universally been the authority when it comes to investing. Discounting functions on the principle that “a bird in the hand is worth two in the bush.” It involves calculating the value of future cash flows by applying to it a discount rate, normally related to the prevailing (positive) interest rate, which reduces the cash flow to its present value. Put more simply, it is the concept of being rewarded for delayed gratification. Until now, investors have only been willing to provide capital today in order to receive a greater sum tomorrow. Negative interest rates throw that concept of investing out the window. It is as if gravity were proven to not exist or the sun rises in the west and sets in the east, or the higher price you pay, the better investment result you receive. We are reminded of a recent quote from Claudio Borio, the head of the monetary and economic department at the Bank for International Settlements: “A growing number of investors are paying for the privilege of parting with their money. Even at the height of the Great Financial Crisis, this would have been unthinkable. There is something vaguely troubling when the unthinkable becomes routine.”
Another “Bizarro” fact today is that gold, which has never been an income paying investment, is now yielding more at zero than approximately $16 trillion of negative-yielding government bonds. Central Bankers, by their recent announcements of lowering interest rates further, are set to deliver even more of what has not been working to enhance stronger economic growth and higher inflation. As Stephen Schwarzman of Blackstone has said, “If you push down interest rates too much, you create the problem you are trying to solve.” This fact has not been lost on investors as the chart below reflects. One of the main arguments for not investing in gold no longer exists thus, stimulating investor interest in gold. This has put upward pressure on gold prices benefiting our gold producer holdings. We believe gold provides a unique immunity to both default and debasement risk, two forces that are very real and could harm both stock and bond prices in the future.
Why We Believe in Value
Looking at this chart reminds us why we are so enthusiastic about utilizing a value approach to investment management. Despite Value’s underperformance over the last few years, history demonstrates that for most 10-year periods in the last 90+ years, value has outperformed growth. There are 998 trailing 10-year periods from June 1936 to today. (Monthly data.) Value stocks have outperformed growth stocks in 823 of those trailing 10-year periods or 82.5% of the time and generally by a wider margin. This is why FRM employs a value discipline to long-term investing. It is not easy. It is not always popular.
We do it simply because it works over time.
When we look at a chart like this, we are reminded of the odds that “The House” in a casino possesses to their advantage over gamblers. How often does “The House” actually win? This is proprietary information that is very difficult to know. In other words, don’t bother to ask the casinos. Such information, while determinable, is a closely-guarded secret. Internet gambling has made the data more available, and the Wall Street Journal conducted an analysis of thousands of internet gamblers. On any given day, “The House” wins approximately 70% of the time. But as the duration of gambling for gamblers stretched out to at least two years and longer, “The House” won 89% of the time. This and the chart below are the primary reason we are investors, not gamblers.
Does the Emperor Have Clothes?
We believe the reason for the previously mentioned outperformance of value over growth is that ultimately, the stock market comes to value businesses based on their proven earnings and assets, not their forecasted revenue growth. However, during speculative economic environments when optimism about the future abounds, this optimism can, for a time, push the valuations of high growth companies up and beyond a fair valuation given their realistic prospects for full-cycle profits from those businesses. We believe this phenomenon is happening today.
If you buy the S&P 500 today, you have 16% of your investment in the five companies with the highest market values: Microsoft, Apple, Amazon.com, Alphabet and Facebook. As the nearby chart shows, these five companies trade at a weighted average price to earnings ratio of 33x last year’s earnings. The current “consensus” weighted growth expectation for these businesses is for an earnings growth rate over the next three years of 18% per year. In time, we will know whether all of these companies can sustain this type of growth going forward. The future will eventually arrive – and these businesses will grow at the expected rates or they won’t. The emperor will have clothes or he won’t.
Similar concentration and aggressive growth expectations were dominant in the S&P 500 during the technology craze of the late 1990s found in the second table on this page. In 1999, the five largest technology companies accounted for around 11% of the market capitalization of the S&P 500. During 1999, the belief was that there was no price too high to pay for the technology-related “darlings” of the day. Quoting an article published in April 1999 in Kiplinger’s entitled “Big Stocks That Keep Getting Bigger,” "[Lehman Brothers strategist Jeffrey] Applegate argues that you shouldn't be intimidated by the high price-earnings ratios. The dandy double of low inflation and low interest rates permits higher absolute valuations because a dollar's worth of future earnings is more highly prized than it would be if inflation and rates were higher. Plus, notes Applegate, the combination of “globalization and advances in technology has put us in a world that has never existed before.”
Sound familiar? Investor memories are surprisingly short. The chorus in 1999 was the same as today: “This time is different, the price you pay shouldn’t matter today because low inflation and low interest rates are here to stay.”
Unfortunately for anyone who took this article’s advice, the returns over the following 10 years prove it could hardly have been more wrong. The ironic thing is that most of these businesses did end up growing much faster than the broader US economy. Annualized nominal US GDP growth from 1999 through 2008 was 4.61%. As the chart shows, most of these businesses grew their earnings at much higher rates. However, because they didn’t grow nearly as fast as the market had assumed in justifying their aggressive PE ratios, their stocks ended up being poor investments despite their fantastic business results. As Research Affiliates has pointed out, even to date, Microsoft has been the only top ten technology stock as of year-end 1999 to beat the S&P 500 Index over the following 20 years through Sept 2019.
It is curious to us that today’s largest five companies in the S&P 500 are all expected to experience well above-average growth rates despite the fact that they all compete with one another. This was not the case for the largest five technology related stocks back in the technology bubble, and those companies still couldn’t grow fast enough to match the market’s expectations.
Why Do We Like What We Own?
We are excited to own a portfolio of companies at valuations that are reasonable based on their actual earnings, cash flows, and assets today. We believe we have purchased these companies at attractive enough valuations to have a good chance of earning a satisfying, risk-adjusted future return on our clients’ capital. The left chart below reflects our calculation of our composite equity portfolio’s Price/Value ratio over recent history. This chart reflects the market price divided by our assessment of the companies’ fair values. The right chart below calculates the implied return potential of the portfolio based on the Price/Value ratio. Remember that these calculations include all of our equity holdings, not just stocks that we are currently buying. Accordingly, there are stocks in your portfolio that are near harvesting, stocks that are only beginning to reach potential, and then stocks that we have just planted and are deeply discounted to our intrinsic value estimates. Our clients’ equity portfolios offer today, in our opinion, a much more attractive investment opportunity with better downside protection than the much more richly-valued broad market.
In today’s “Bizarro” world, revenue growth expectations in the future are considered, by most investors, more valuable than actual realized profits in the present, but we firmly believe this will not last forever. In fact, at the end of this past quarter, we began to observe change afoot regarding the extremely popular Initial Public Offering (IPO) market, typically the highest risk segment of the public stock market. Companies like Uber, Lyft, Slack, Peloton, and others have gone public this year at very high valuations, but many of their stocks have disappointed as the market has begun to require, at the very least, the prospects of profitability in the intermediate future. Up until very recently, the market has not been concerned whether a fast-growing company even had the prospects of ever being profitable. WeWork, which we wrote about a year ago, announced that they will be postponing their IPO as they continue to bleed cash at a rapid pace. Ultimately, we expect the market to once again value growth that is profitable, businesses that earn returns for their shareholders, and healthy balance sheets. We believe our exposures play an important role in hedging our clients’ portfolios against today’s lofty market environment and the possibility of challenging times in the future since challenging times tend to favor value investors.
World Events for Oil
We could not fail to mention the significant, at least to us, events that happened in world oil markets recently. Since May, the world has witnessed the bombing and hijacking of six different oil tankers in the Straits of Hormuz in the Persian Gulf, the bombing by drones of critical pipelines in Saudi Arabia, and finally on September 14th, the coordinated bombing by seven Cruise Missiles and 18 drones of critical production, refining, and storage facilities. The assets targeted represented roughly 5% of the world’s daily oil production in Saudi Arabia. Iran is suspected to have been involved with all of these events, either directly or at least indirectly through Houthi rebels in Yemen. The price of crude oil immediately spiked 15% in mid-September. However, oil prices subsequently dropped back below the price immediately before these events, ending the quarter with an overall 7% decline, although still up 17% year-to- date. We believe these events should cause investors to place a premium on the security of the world’s oil reserves. This is why we are pleased to own secure reserves in safe territories that should be prized by investors as the market begins to recognize that worldwide oil reserves are not as secure as once thought. We believe that oil markets are much tighter than is generally thought and that oil prices should be trending higher.
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. A copy of FRM’s current disclosure Brochure (Form ADV Part 2A) discussing our advisory services and fees is available upon request.