Don’t need a weatherman to know which way the wind blows
November 9, 2018
Market Summary – 3rd Quarter, 2018
“Why did God create economists? To make the weatherman look good.”
Things are not always as they seem. Case in point – a video clip of the Weather Channel’s coverage during Hurricane Florence that has gone viral on the Internet. In it, the network’s on-scene reporter is trying to steel himself against what he is describing as fierce winds (http://digg.com/video/weather-channel-reporter-hurricaneflorence-wind). The poor man looks as if he is just about to be blown away like Dorothy in The Wizard of Oz. Then the camera zooms out, and in the background are two pedestrians walking casually as if nothing is out of the ordinary. In this case, the Weather Channel’s own cameraperson played the role of Toto exposing the man behind the curtain.
Investors would be wise to look “behind the curtain” of today’s stock market as well. Based on much of the commentary that we see in the media these days, there appears to be a great deal of anxiety among investors about what to do in the almost inconceivable 10<sup>th</sup> year of a bull market. Does the run-up in the major U.S. stock indexes seem excessive? Are October’s declines the beginning of further losses? Is there any way to invest money today that doesn’t take on too much risk?
Today’s tale of two markets
The real question investors should ask themselves today is not “should I be invested in the stock market?” Instead it is, “in which stock market should I invest?” A handful of headline-grabbing momentum stocks has sucked most of the oxygen out of the market. A large chunk of the Standard & Poor’s 500 Index return in 2018 can be attributed to a single digit number of technology-oriented stocks . . . the so-called FAANG stocks. FAANG stocks are defined as Facebook, Amazon, Apple, Netflix and Google (traded through its parent company, Alphabet).
Overlooked is the rest of the stock market, what can be considered the second stock market. It is made up of less glamorous businesses where a number of compelling opportunities exist that don’t reside at the top of the capitalization-weighted S&P 500.
The FAANG moniker is, in effect, a marketing tool. More than an acronym for five companies, it actually serves to help make these stocks popular. FAANG appears to be another in a long-line of cleverly named stock groupings that represent an investment trend, but ultimately proved to be a disappointment for investors. As in previous cases, Wall Street, the media, and many investors are captivated with FAANG stocks. As a result, they’ve become dismissive of traditional valuation methods, convincing themselves that “this time it’s different.”
Today’s FAANG-craze has upended the market once again. For purposes of our discussion, we would add Microsoft as a deserving sixth member of the FAANG contingent. Five of these six stocks are among the eight largest in the S&P 500. In total, this group of six stocks, barely more than 1% of the 500 stocks in the index, represents more than 16% of the S&P 500’s market capitalization (the dollar value of all stocks in the index) of approximately $26 trillion1. Through the first half of 2018, these six stocks accounted for 98% of the S&P 500’s return.2
While there are always individual businesses or industries that drive bull markets, the degree of concentration, with so few stocks responsible for nearly all of the market’s performance, is unusual. Looking forward, there is a notable investment risk for stocks that have generated such outsized returns. Quite simply, we feel that they’ve reached dangerous valuation levels.
As shown here, the FAANG + Microsoft “supergroup,” even based on projected earnings for the year ahead, appears to have become expensive on both a relative and absolute basis.
If they should fail to live up to their lofty growth expectations, the downside risk is significant. In the meantime, there are a number of overlooked stocks in what we refer to as the second market, where MPMG chooses to invest on behalf of our clients. We believe that these value stocks offer more attractive investment opportunities, with significantly less risk.
Just as the economy doesn’t begin and end with the FAANG stocks, neither does the stock market. Like the fads that preceded it, we believe that the FAANG craze will ultimately subside. Not the companies themselves, but the popularity of their stocks. There are many reasons to believe that the time is approaching.
The risk of over-popularity has played out before Investors in stocks that live by momentum, where valuation becomes an afterthought, ultimately succumb to the reality that economics matter. The trading of stocks takes place through a stock exchange, where shares of stocks are awarded to the highest bidder. It is essentially an auction process. The sometimes overlooked downside to this system is that the highest bidder oftentimes accepts the lowest expected return and bears the greatest amount of risk.
A prime example of how this happened in this past was with Cisco Systems, one of the darlings of the dot-com boom of the 1990s. This key provider of internet infrastructure saw its stock top $80/share in 2000 just before the dot-com bubble burst. At that level, Cisco was valued at 19 times sales and more than 100 times trailing 12 months earnings. It was not just priced to perfection, but to euphoria. No matter how well the company performed, it just couldn’t live up to that standard. It continues to be an exceptional, thriving business. Yet the price of its stock back in 2000 greatly overstated reasonable expectations.
An interesting epilogue to the cautionary tale of a vastly overvalued Cisco of the dot-com era is that in 2011, we added the stock to the MPMG All Cap Value portfolio. It remains there today. By then, its price had fallen by about 80% even though its sales, earnings and cash flow had at least tripled since 1999. Cisco’s status as a great company with a solid future was unaltered. What changed was that Cisco’s stock was priced as a bargain. It may be that at some point in the future, one or more of the FAANG stocks will present a more reasonable valuation opportunity tied to a favorable outlook for continued growth and be a fit for our portfolio . . . but certainly not today.
Change in the weather
For the past several years, we have been outspoken (both in previous newsletters and conversations with clients) about the implications of interest rates rising from historically low levels. We’ve witnessed an extended period of historically low rates, brought about by accommodative central banks from around the world in response to the financial crisis and Great Recession of a decade ago. The actions of the world’s central banks were, in our opinion, appropriate, given the need to combat deflation and encourage economic growth.
The major developed economies of the world have since recovered. Beginning in 2017, for the first time in several years, nearly all of the world’s developed economies are growing simultaneously. The United States economy has been the shining star among developed economies, showing stronger growth facilitated by a favorable new tax law and continued leadership from our companies. It should come as no surprise that interest rates are finally starting to rise. In fact, the yield on the 10-year U.S. Treasury note has been spiking in October. As of October 10th, the yield on the 10-year Treasury was at its highest level in seven years.
In response to these higher interest rates, key indices such as the S&P 500 have been in decline. As we have stated earlier, defining “the market” as only the S&P 500 index, with its concentration in just a few technology companies with what we believe to be bloated, growth-style valuations, is not appropriate. Rising interest rates are, in our estimation, not necessarily problematic for all investors. To the contrary, rising interest rates could be a wonderful development for value investors, those concentrating on the second market.
Why interest rates rise and what it represents
It should go without saying that a strong economy is a good thing, but it is not without its challenges. One of the consequences of strong economic growth is that bond investors may become concerned that the economy is growing too strongly, too quickly. This may lead to an uptick in inflation. Concerns about inflation typically rise when the strong demand for goods and services results in too much money chasing too few goods and services. Excessive demand then drives prices up. The resulting escalation in inflation can be problematic because it represents a loss of one’s purchasing power.
As a practical example, a $1,000 loan made today and repaid 10 years later will, because of inflation, be able to purchase fewer goods and services in 2028 than it could in 2018. The bond market responds by driving up interest rates, as lenders will demand higher interest rates as compensation for the decrease in purchasing power of the money that will be repaid in the future.
Why higher interest rates impact stock investors
The foundation of finance and the valuation of businesses lies in determining the value of future earnings and cash flows in today’s dollars. Inflation makes future earnings streams worth less in today’s dollars. Higher inflation has an even more damaging impact on the future worth of those earnings. As stated earlier, the S&P 500 Index is currently dominated by just a few stocks of companies that, in our opinion, are extremely overvalued. These stocks represent companies that, despite meager-to-non-existent earnings today, are priced with the expectation that they’ll deliver much higher earnings down the road; which is the feature that defines a growth stock. With such a large portion of their expected earnings so far out into the future, their valuations are substantially more negatively affected by rising interest rates.
MPMG’s value style management, on the other hand, are less dependent on distant anticipated earnings to justify their valuations. By definition, these type of investments are already modestly valued. In certain environments (and we are in such an environment today), they are misunderstood and unloved. This means the market has not demonstrated an irrational exuberance for their future earnings power as it does for so many of the technology darlings of today. In addition, value investments are less dependent on future earnings to support their current valuation levels, as short-term and intermediate earnings are already in place. Therefore, they tend to hold up compared to growthstyle investments in a rising interest rate environment.
The purpose of a stock market is to give investors a way to buy and sell stocks based on their perception of the value of each firm whose stock is traded. As interest rates continue to rise, growth-style stocks are likely to lose their appeal. In that event, investors would respond by selling these overvalued businesses and reinvesting the proceeds in more appropriately valued assets. This rotation is highly beneficial to value-style investments, and the increased demand for value stocks should drive that part of the market higher.
Choose your own adventure
One advantage of being an investor in our free market system is that you have choices. The question for investors is simple – which market will drive your portfolio? One option is to continue to ride the wave that has driven the market for the better part of the last decade, with a focus on FAANG-like stocks. In fact, over the past ten years, based on a comparison of the Russell 3000 Growth and Value indices, growth stocks have enjoyed a cumulative 50% advantage. Choosing to go in this direction means you expect that these stocks, which already carry high valuations, still have room to perform. Yet you know that it is inevitable that these stocks will be faced with setbacks (Facebook already has). Will you know when it is time to sell those positions before giving back any gains you might have earned?
The other choice, currently overlooked by most investors, is in the market that features strong businesses that are favorably priced. Many stocks in this second market have yet to materially participate in the market’s recent rallies. They are truly “unloved” stocks that offer tremendous upside potential.
These value stocks aren’t by definition the most popular and will go through periods where they underperform growths stocks. Yet over the long run, the story is dramatically different. Despite underperforming growth stocks over the past decade, the Russell 3000 Value Index enjoys close to a 30% cumulative performance advantage over the Russell 3000 Growth Index dating back to 1979.3 Another key fact, especially in a time when market volatility has returned, is that paying the right price for stocks offers greater protection against periods of fluctuation. Highflying growth stocks that are riding a momentum wave are far more vulnerable to the impact of market volatility.
Those who use the second approach, the approach that MPMG remains steadfastly committed to, are required to, just like Toto, pull back the curtain. That’s how you discover great companies that offer tremendous value and intriguing upside potential. In recent times, those who focused on identifying great businesses at an attractive price had to buttress themselves against the headwinds of hurricane FAANG. But there are signs of change in the air. It may not be long before winds are at the backs of stocks that offer real value and attractive upside potential.
1. www.slickcharts.com/sp500, stock weighting as of 10/2/18.
2. Investing.com, “6 Stocks Accountable for Nearly All the S&P 500s Gains This Year,” July 10, 2018. (https://www.investing.com/analysis/6-stocksresponsible-for-nearly-all-of-the-sp-500s-gains-this-year-200329990)
3. Source: FTSE Russell & Co.
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.
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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.