Archive for June, 2017

Bizarro (Investment) World

Friday, June 16th, 2017

In analyzing the current state of the financial markets/investment world, my mind settled onto some major issues that should be impacting the stock markets but currently are not:  (1) Rising Interest Rates; (2) Increased Risk Assumed by Investors; and (3) Equity Valuations.

Rising Interest Rates

  • The Federal Reserve raised the fed funds rate Wednesday by 25bps to 1.25% –  the stock and bond market mostly shrugged it off since it was highly anticipated
  • The Fed also announced that there will likely be another rate hike “relatively soon” and that they were going to start reducing the size of their balance sheet by the end of this year by $50 billion per month
  • Coincidently, all of the other Central Banks around the world are also starting to tighten their monetary policy

Normally, this would spook the stock and bond markets, sending both stock and bond prices lower.  Higher interest rates impact corporate earnings in a negative way, and lower earnings lead to lower stock prices.   However, we are not in a normal market any longer.

Increase Risk Assumed by Investors

There was a study that I read earlier this week that showed only 10% of the trading volume in the stock market is currently being transacted by money managers actively managing money:

  • 90% of the trading happening in the stock market is now through hedge fund program trading, index funds, and etf’s
  • Additionally, we have record levels of margin debt outstanding

Given that so many investors are now locked into passive investment strategies, there is no one actively employing Risk Management techniques like we and other active investment managers do.  Passive strategies do not raise cash as valuations and risks rise.  Passive strategies do not sell high beta stocks when they have had significant runs higher to protect the gains.  Passive investment strategies do not re-position portfolios to emphasize defensive or undervalued sectors when economic conditions that negatively impact the earnings of companies present themselves.

Record high levels of margin debt have historically shown that investors are too enthusiastic and not paying attention to the fundamentals.  When the market goes south, the margin debt can wipe out their investments and they then have no assets to ride the recovery higher.

Equity Valuations

Given the relentless upward movement in stock prices, and in an effort to find companies that are undervalued to add to client portfolios, I recently valued all of the holdings in the S&P 1500 using my discounted cash flow model (using Free Cash Flow as the input) and compared the resulting intrinsic value to current prices. The findings were quite instructive:

  • Taken as a group, the companies are collectively 40% over-valued
  • 310 of the companies were undervalued
  • Of these, the predominant number were Financial Services, Energy and Retail
  • One company’s DCF value and price were exactly the same
  • 1,189 companies were overvalued
  • Of these, the predominant number were Technology, Aerospace/Defense, Heavy Construction, and Biotech  (one caveat about a strict DCF using FCF, many growth companies in the tech and biotech industries do not have free cash flow as they are constantly reinvesting for growth – this can negatively impact the calculation of their intrinsic value and likely has skewed the results  – meaning the 40% over-valued result is somewhat less – when I have time I plan to repeat the exercise with EBITDA instead of FCF to check the results)
  • Not surprisingly, when I calculated the Forward Rate of Return for each company, the undervalued companies’ FRR were predominantly in the double digits
  • The overvalued companies’ FRR were predominantly in the single digits or negative
  • When I made the comparison of the 1500 companies’ Price-to-Earnings, Price-to-Book-Value, and Price-to-Sales Ratios to their 10-year median values for each ratio, I was surprised by the extent of the companies that were overvalued on these metrics
  • Only about 350 companies have ratios less than their 10-year median values, and only about 100 of them were showing undervalued on all three ratios
  • Those most consistently overvalued based upon the ratio analysis were also overvalued on the DCF analysis; those most consistently undervalued based upon the ratio analysis were also undervalued on the DCF analysis
  • When I compared the companies’ PEG Ratios to our benchmarks (1.2 preferred and 2.0 tops) I was pleasantly surprised by the number of companies that passed these benchmarks.
  • Even though P/E’s were predominantly higher than their 10-year median levels, earnings growth had to have also been higher, making the higher P/E’s more palatable

With rising interest rates on a global basis, the macro economic picture is deteriorating. Combine this with investors’ assuming more risk than is warranted for the current stage of the cycle, and equity valuations on average well above fair value, now is the time for caution and prudent risk management – NOT aggressive buying of equities or of trusting your investments to a passive strategy with no one working on your behalf.

  • Statistically, the portfolio that is cautious when the markets are overvalued and aggressive when they are undervalued significantly outperforms other styles of management including passive index styles and buy-high-sell-low
  • It can be difficult for an investor, professional or otherwise, to maintain prudent risk management standards in the face of the hype over index funds and etf’s and the hype of the high flying stocks in hot but overvalued market
  • Investing is a marathon and not a sprint – what really matters is that our clients have the largest pot of money possible when they need it (retirement is a big one) and not following the latest fad that wins in the short-term but causes the client to lose in the long-term
  • Stock market returns do not come in a straight line.  Stock market returns are not like receiving interest on a CD or a bond.  Active investment managers can book profits and raise cash when valuations get too high then use that cash to buy back shares when corrections happen.  Passive investment strategies ensure that you lose money in the correction and wait for the recovery only to get back to where you started.

I do not know when this market will roll over and correct.  There is no way to know what the catalyst for the pullback will be.  However, when it happens, I and other active investment managers who have cash on hand to purchase stock in great companies at a significantly reduced valuation will be almost as happy as our/their clients when the correction subsides and stock prices resume their march higher.

When that happens and we turn the page on this investment cycle, this Bizarro (Investment) World where prices continue higher in spite of materially negative issues will revert to an Investment World where earnings, cash flow, and valuations matter.  And I will be happy to see that happen.

Investment management is risky business and it is always best to trust a professional to deal with the complexities of generating and protecting wealth.

Here is something from this century for those of you reading this who weren’t alive in the early 80’s and may have never seen Risky Business:

And for those of you that wanted a full Bob Seger video, here is my favorite:

 

–Mark