Be wary when everyone is on the same side of the boat
July 25, 2019
Market Summary – 2nd Quarter, 2019
“In calm water, every ship has a good captain.”
~Grover Cleveland (22nd and 24th President of the United States)
Anyone who spends time on the water knows that the situation can get perilous when all of the passengers suddenly run to the same side of the boat. A vessel that seemed to be on a smooth course is rapidly at risk of overturning.
It’s not unlike the current state of the S&P 500 Index. The most compelling development in the index today is what professionals call a “crowded trade.” In other words, a lot of money is flowing into only a few stocks. Booming demand for this small segment of large capitalization stocks, some of the biggest in the market today, is driving indices like the S&P 500 to record levels.
The chosen few
It was recently reported that only four mammoth stocks – Microsoft, Apple, Amazon and Facebook – have generated nearly one-quarter of the S&P 500’s return in 20191. Such top-heavy performance distorts the S&P 500’s return. The other 496 stocks had to share the remaining 75% of the index performance. Microsoft, Apple, Amazon and Facebook also happen to be four of the five largest components in the index2. The success of these four stocks and a handful of other mostly technology stocks has had a disproportionate influence on the index. It bears an unsettling resemblance to the technology boom of the late 1990s, when a small group of stocks drove the market to new highs. While a small number of popular stocks continue to thrive in today’s market, the vast majority of the S&P 500 has been, relatively speaking, neglected. Many of these neglected stocks, upon closer inspection, offer compelling value.
Is today’s example of investors crowding onto one side of the boat unique? Sadly, it is not. Such behavior has been prevalent in human civilization throughout its existence. It is as much an anthropological phenomenon as it is an economic one. It is referred to as “FOMO” – the fear of missing out – and it is a common human bias. In today’s investment environment, it applies equally to individuals and sophisticated professional money managers who don’t want to be left behind the crowd by failing to own the popular stocks. The problem may be even more acute with the professional managers, who are obsessed with short-term performance for fear of losing assets under management. These factors contribute to a feeding frenzy that pushes the prices of strong-performing stocks even higher…until it stops and reverses. And it always does.
That’s not to say the four dominant stocks in the S&P 500 aren’t great companies. We believe, however, that their greatness is more than factored into their stock prices given their ongoing popularity and rapidly rising valuations. Investors need to be asking themselves, “At what point do their valuations become unsustainable?”. Anyone throwing money at the popular stocks driving the S&P 500 today is seemingly convinced that these companies can match or beat what have become sky-high expectations for ongoing growth and financial success. But just as trees don’t grow to the sky, valuations, even of great businesses, cannot rise indefinitely.
We’ve seen this before
Such dramatic price run-ups that lead to massive overvaluation are nothing new. Countless instances of this occurred in the technology bubble of the late 1990s and early 2000. A prime example we’ve cited before (because this stock was added to our portfolio when valuations became attractive) was Cisco, which peaked at $80 in March 2000. It became such an “it” stock that even income fund managers owned it, despite the fact that at the time Cisco paid no dividend! But that side of the boat became overcrowded as the “FOMO” principal made it too enticing for most investors to stay out of the stock. For a period of time, investors reaped rewards by simply riding the momentum of Cisco’s skyrocketing stock price while ignoring fundamental valuation. But ultimately, reality set in and the stock price took a dive. Cisco’s stock would fall from $80 in 2000 to less than $9 in 20023, and it would not be able to sustain a price above $20 until 2014. Cisco was then, and remains now, a great company with a growing business. Since its stock price peaked nearly two decades ago, the company’s sales and cash flow have more than tripled. Net income is almost five times higher. But nearly 20 years after topping out, the stock today is priced at less than $55, still more than 30% below its peak4.
“Bull Markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”
~ Sir John Templeton, legendary investor
Where the market stands today
Many market pundits would have you believe that 10+ years into a bull market, we should be close to the euphoria stage of Sir John Templeton’s market cycle5. Yet the data appears to tell a different story. According to a recent survey, global fund managers are very pessimistic. It shows that 50% expect global growth to weaken over the next year, a record high. 87% believe the market is close to the end of its bull cycle. By Templeton’s standards, this data suggests that this bull market may well have more room to run.
A closer look is more revealing – significant value can still be uncovered in a market where so many quality stocks are being neglected by investors. Consider that the forward-looking price-to-earnings (P/E) ratio of the broader S&P 500 is 16.7 times projected earnings. That’s only slightly higher than the 15.5 times earnings multiple of five years ago. Yet as of the end of June, there were 67 stocks in the S&P 500 with a forward P/E ratio of under 10. That is more than three times as many stocks with a P/E of under 10 as was the case five years ago, when we were only halfway through the current bull market6. It illustrates how not all stocks have participated in the current market run-up. In light of that fact, it is still possible to find select stocks that offer real value and solid upside opportunity.
Seeking out stocks like these is clearly the road less traveled, given current trends in the market. Yet it offers more appealing, long-term opportunity for favorable outcomes than chasing returns of certain stocks that, while performing well at the present time, are also taking on outsized risk from a valuation perspective.
The ever-increasing value of value stocks
Viewed in isolation, value stocks have generated impressive performance, averaging double-digit returns per year over the past decade7. Their track record in that time significantly outpaces the long-term historic average for stocks. However, value stocks have lagged growth stocks over the past 10 years, and the contrast between growth and value is even more pronounced when looking at the past five years.
For at least a decade now, expensive stocks have been getting more expensive, while cheap stocks have gotten cheaper. The valuation gap between popular stocks and those that are out of favor has never been wider5. This is an anomaly. Historically, cheaper stocks have outperformed more expensive stocks over long periods of time. This tends to be the case because investors underestimate the possibility that struggling companies can right their ship and get back on course. Alternatively, investors also commonly overestimate the staying power of stocks that have enjoyed wild success, but that ultimately can’t live up to the hype.
As value investors, we seek to identify and own quality businesses selling at a significant discount to their true value. We want to own these businesses at such a discount that their low price, as well as their modest debt loads, present significant downside protection. This allows us to limit our risk and still preserve significant upside.
So if you aren’t a value investor, what are you? The alternative to this approach is, in our judgement, nothing more than speculation. Those who choose the crowded trade have decided to participate in a casino-like environment, hoping another roll of the dice will land their way. In our view, such a speculative approach is not a sound way to build wealth.
Patience will persevere
We believe that the rapid ascent of the S&P 500 this year, fueled by the outsized performance of a select few stocks, has surpassed any reasonable justification based on fundamental investment principles. The combination of “FOMO” in an index-obsessed investment universe, augmented by continued artificially low interest rates, has worked to the benefit of a narrow group of stocks. As we mentioned in our last newsletter, the persistence of low interest rates is a key factor. With yields on bonds so low, the discounted present value of future earnings on stocks is higher. That provides extra leeway for already expensive stocks that are overly reliant on the potential of significant (but future) earnings that very well may fail to materialize.
It is our firm belief that current market conditions are an aberration and not the new normal. We’ve seen comparable circumstances in the past, and the key lesson to remember is that markets have always corrected themselves. As the old proverb says, “water seeks its own level,” and that’s as true in the stock market as anywhere else. In today’s market, investors continue to rush to the same side of the boat, investing in what HAS worked but failing to recognize that these stocks are propped up by artificial and temporary market conditions. The risk inherent in this end of the market is rising.
Crowded trades can flip quickly, usually with little or no warning and often in dramatic fashion. We believe in a true, time-tested investment philosophy of identifying quality companies with strong prospects for sustained profitability that have been overlooked by the market. These aren’t stocks that rely on unsustainably low interest rates or the momentum of “FOMO” investors. These are, to borrow a phrase from our old friend, the investment guru Professor Jeremy Siegel, stocks for the long run. That’s a time horizon that is suitable for virtually every investor who is trying to build and protect wealth and get to the finish line.
2019 MPMG Speaker Series
America: A Ten Point Plan For a Return to Civility
MPMG is pleased to welcome political satirist/social commentator Dennis Miller to our 2019 MPMG Speaker Series event. For nearly four decades, Dennis Miller has been entertaining audiences across television, film, and on stages throughout the country with his acerbic wit and trademark “rants” on politics and pop culture. He has been called, “the most cerebral, astute and clever stand-up ever to put mouth to microphone.”
In such polarizing times, his pragmatic take on the world is refreshing. Miller’s next initiative is an inventive and humorous presentation—in his own words—“America: A ten point plan for a return to civility”. Equal parts comedian and social commentator, Dennis’s scathing-yet-playful perspective will be directed towards our current environment and how our political tribalism may negatively impact our society and economy.
You can hear Dennis ranting on his twice-weekly podcast The Dennis Miller Option or his twice-daily syndicated, 60-second radio feature “The Miller Minute.” Miller is a five-time Emmy award winner for his critically acclaimed, half-hour live talk show Dennis Miller Live, which had a nine-year run on HBO. Miller also garnered three Writer’s Guild of America Awards for the series as well as an additional WGA Award for his 1997 HBO special Dennis Miller: Citizen Arcane. He also wrote and starred in the Emmy-nominated cable comedy special Raw Feed. This was followed by Dennis’ eighth special for HBO, Dennis Miller: The Big Speech, in 2010. His most recent stand up special is Fake News, Real Jokes, released by Comedy Dynamics in November 2018.
Dennis has also achieved success in the literary arena with four books, I Rant Therefore I Am, The Rants, Ranting Again, and The Rant Zone—all New York Times bestsellers. For two seasons, Miller called the plays alongside Al Michaels and NFL Hall of Fame quarterback Dan Fouts on ABC’s Monday Night Football. He was also the “Weekend Update” correspondent on Saturday Night Live for six years, before exiting in 1991.
Over the years, Miller has become both a public and critical favorite. The New York Times has said, “Mr. Miller is exquisitely attuned to contemporary foibles…his material can be scathing, his delivery low key…Mr. Miller reaches a bit farther than most comedians for the scorching comment…this smart aleck has an uncommonly sharp eye…” We look forward to celebrating our 14th annual event with one of the country’s most insightful and entertaining figures.
1. CNBC, June 18, 2019.
2. S&P Dow Jones Indices L.L.C, S&P 500 Factsheet, June 28, 2019.
3. $80.06 as of 3/27/2000 close; $8.60 as of 10/8/2002 close.
4. Stock price at close of business on June 28, 2019.
5. Comtois, James, “Managers pessimistic about global growth – BofA survey,” Pensions & Investments, June 18, 2019.
6. Hough, Jack, “11 Cheap Stocks to Buy as the Market Hits New Highs,” Barron’s, July 5, 2019.
7. Source: Russell 3000 Value Index as of 6/28/2019.
Established in 1995, Minneapolis Portfolio Management Group, LLC actively manages separate accounts for individuals, families, trusts, retirement funds, and institutions. Our proven value-oriented investment philosophy has created long-term wealth for our clients.
Visit our website at: www.MPMGLLC.com
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted. Market returns discussed in this letter are total returns (including reinvestment of dividends) unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.