Is Value Investing Dead?

By Aline Wealth Management on October 30, 2017

David Einhorn of Greenlight Capital has come out recently and suggested that investors are focusing on valuation metrics that don’t make sense—to wit:

“What if equity value has nothing to do with current or future profits and instead is derived from a company’s ability to be disruptive, to provide social change, or to advance new beneficial technologies, even when doing so results in current and future economic loss?”

“Perhaps, there really is a new paradigm for valuing equities and the joke is on us. Time will tell,” Einhorn wrote.

Clearly value investors like Einhorn (and many others including Buffett) are having a difficult time in 2017—what does that tell us about the future of value investing?  Can it be that a school of investment research – one focused on the tenets of fundamental research can no longer be valid?  Unlikely in my eyes—but at this current juncture value investors have been feeling the pain to such a degree (capitulation phase perhaps) that I suspect the tide is about to turn (as it has done in the past;  one thing I know for sure—this time is NOT different).   I took a look at several of storied, long-time value investors—the likes of Buffett, Gabelli, Fairholme, Longleaf Partners and others—and while these funds have under-performed in this Go-Go market their long term returns are impressive.   In the graph below please note that the 10-year relative out-performance of growth over value starting in 2009 is now 2 standard deviations above its mean –typically that bodes well for a shift—a reversion to the mean (notice the same thing happened with value commanding a lead over growth from the late 90’s to 2009).

GMO is a well-respected money management firm—their claim to fame (at least one of them) is that during the late 90’s run-up in tech stocks, they held to their conviction that markets were indeed irrational only to have a field day picking up opportunities in the aftermath.  Courage of one’s convictions—not bowing at the altar of the consensus- these may not be easy to do but it is what separates the professional investor from the trader/speculator.   A recent  GMO report highlighted the four components of stock returns:  Earnings Growth;  Dividends;  Price-earnings Ratios (and the expansion or contraction of these multiples); and Profit Margins.

It notes that price-earnings ratios and profit margins tend to return to average levels after they deviate appreciably  (mean reversion), while earnings growth and dividends tend to track economic growth and account for nearly all long-term returns.    Expanded margins and price-earnings multiples are responsible for more than half of the advance of the present Bull run, the report shows. They are all but certain to snap back, probably before long, it warns.  That leads GMO to forecast a decline of 3.9 percent a year for the next seven years for stocks of large American companies, with smaller companies and developed foreign markets doing better, but still losing ground. The only stock markets that GMO expects to produce gains, of 2.9 percent a year, are in emerging economies. Most bonds are expected to lose money, too, with emerging markets again doing best.

Jim Reid, a strategist at Deutsche Bank, echoed the belief that investors had few places to hide. He examined valuations of 15 stock markets and 15 bond markets since 1800 and concluded that “at an aggregate level, an equally weighted bond/equity portfolio has never been more expensive.” Bonds alone have never had such rich valuations, meaning low yields, since 1800, he said, and stocks have been more expensive just over 10 percent of the time.  Mr. Reid said the high valuations come at a particularly fraught time, because of “the incredibly unique size of central bank balance sheets, debt levels, multi-century all-time lows in interest rates and even the level of potentially game-changing populist political support around the globe.”

Rich valuations were among the factors that prompted warnings in the third quarter of an imminent correction in stocks. In September, Citi Research put the odds that one would begin in the succeeding three months at 45 percent. Citi cited the flattening yield curve and soft growth in earnings, along with the high valuations, in explaining its estimate.  Other firms used snippets of data to argue that a decline was anything but imminent.  Leuthold Group noted that on the 15 previous occasions since 1928 when the S.&P. 500 closed at a 12-month high on any day in September — the worst month for stocks historically — and the advance-decline line, a measure of market breadth, also reached a 12-month high, the S.&P rose 5.9 percent on average during the fourth quarter.

The stock market seldom falls just because it is overvalued; there usually is another catalyst. A more aggressive Fed is one obvious candidate, but not the only one. Wall Street has been largely unperturbed by North Korea’s missile tests, but that would almost certainly change if a war ensues. Efforts to change the federal health care and tax laws remain works in progress — without much progress — potentially testing investors’ patience. Ramifications of a stronger than expected showing by the far right in Germany’s elections and a violent crackdown by the authorities in Spain as Catalonians voted overwhelmingly for independence in a referendum could unnerve the markets, too.  If overvaluation does not cause declines, it exacerbates them once they start. Some investment advisers are gravitating toward foreign markets because they are cheaper and, especially in Europe and Japan, have central banks that continue to flood the economies with cash.  (Source Barron’s 10/16/17)

Observations:

• The S&P has posted 6 weekly record closings in a row; seven monthly record closings in a row and now 7 daily records in a row—this has never happened before.  Art Cashin has stated that the market, on a technical basis, is the most over-bought market in 62 years.  (Source: Gluskin Scheff)

• Debt (remember that 4-letter word?):  The US Treasury is likely to come up against a government shutdown in the first week of December—will Congress just kick the can down the road again –or will leadership emerge with respect to our growing debt problem?  Currently the CBO estimates we will hit a $1 trillion deficit in 2021 and $1.5 trillion in 2027.  We have $107 trillion of unfunded pension liabilities and without substantive entitlement reform this will eventually become the next generation’s problem.  Our current $20 trillion in debt multiplied by say a 5% interest rate (hence the benefit of low interest rates—if they stay low) would cost us $1 trillion a year in debt service and on top of that we have entitlements and defense spending.   Taking a look at the debt levels globally one will see that the G20 nonfinancial debt-to-GDP ratio is now at a record 240%, having taken out the peak of the last cycle in 2007 at 212% (each nation has a different component of this debt—in the US it is auto loans, credit cards, student debt and a corporate debt binge that was used to buy back shares).   James Grant, founder of Grant’s Interest Rate Observer claims that “markets are merely as efficient as the people who operate in them, and fake perceptions caused by artificially-determined interest rates distort investment decisions.   The consequences of manipulated and suppressed interest rates will (someday) lead to a great shake out in finance.” See the graph below for an illustration of this massive debt buildup since the Great Financial Crisis of 2008—investors certainly have short memories.

• Valuations:  looking at the Shiller CAPE model, the current 26x figure puts the S&P at the most expensive in the world –but more disturbing is the fact that we are 99% higher than we have been at any other time since 2005.   Take a look at the 3-D graph below (cool, right?) –here we have 3 factors or axis’s—the current CAPE multiple, the corporate profit margin or “embedded margin” and the resulting long term return on the S&P.  Other valuation models include looking at the market from a lens of Free Cash Flow – on that score we are trading at 24x—the highest since 2006, according to Factset.  There is also the market capitalization vs. the total GDP-a favorite indicator of Warren Buffett, which is now showing heights not seen since the 1929 era and suggests to Scott Minerd of Guggenheim Investments that returns for the next decade in the S&P will be less than 1% per year.   There is also the Fed Model is another method of valuation—here we look at the “earnings yield” (earnings divided by price) of the S&P and compare that with the 10 treasury bond yield –currently that spread is 1600 basis points we are the most expensive in the world and has only traded more expensively 25% of the time since 2005. (Source: Gluskin Scheff)

• The Fed:  clearly the Fed is unwinding their stimulus and raising rates.  But consider the impact of fiscal stimulus (lower tax rates) at a time in the cycle where unemployment is 4% and we are in the 8^th year of an expansion—what happens (as Reagan found out in 1981) is a more aggressive Fed and a flatter yield curve—fiscal policies are always trumped by the more powerful  monetary policy.

• Is the Economy that strong (or is it perception—“animal spirits”)?  Taking a look at companies and their commentary from their earnings releases—P&G, for example, stated that US shoppers continue to cut back on paper towels and diapers—that global sales are running at a 2% growth rate but in the US they are flat.  GE, a proxy for the US economy (at least it was a proxy), has shown disappointments in organic revenue growth, reduced guidance, falling industrial cash flows, and shrinking margins—bringing down their shares to 2-year lows despite a market for large cap stocks that has been on a tear.  What is the disconnect here?  Is GE broken (possibly to some degree) or have investors been focused on Go-Go stocks without a care for the risks associated with such valuations?  The Conference Board’s Leading Economic Index (LEI) unexpectedly contracted in September—the first set back in a year.  Looking at the growth over the last 12 months we find decreasing growth rates and in fact the recent readings for 3-month growth is the lowest since October 2016.    (Source: Gluskin Scheff)

• China has created, as per a recent report from the IMF, 3x more credit in 2016 versus 2008 to achieve the same level of economic growth.  It suggests a lower asset and income base to cover the larger amount of debt.  China has a debt level 2.7x larger than their economy (as measured by GDP) with over half of the debt on corporate balance sheets.  Consumer debt is starting to accelerate as well, with faster growth in short term loans which increases instability.  The accelerated growth in debt has been achieved through the shadow banking system—funded by individuals investing in “wealth management products” which in its simplest form are loans between companies—and there has been huge growth in these products.  Can these WMPs be the catalyst to a larger reconciliation of these excesses?  (Source: Auour Investments).

• Sentiment:  The Investors Intelligence Poll shows 60% bulls and 15% bears and other polls or sentiment indicators are showing a similar lack of fear.  Margin debt is climbing fast—a telltale indicator that things are getting frothy (you think?!) and the foreign investor, the classic lagging indicator, has plowed $40 billion into the US stock market YTD August.  (Source: Gluskin Scheff)

Where to position assets today?

If I were to answer this question glibly I would say something akin to “carefully—very, very carefully”.  Sort of the opposite answer that I would have given in late January of 2016 when during that 6 week slide we were finding plenty of opportunities.  Our thematic portfolios (water, infrastructure, bio-pharma, IoT, cyber-security) continue to perform and as are our “Steady-Eddie” portfolio of uncorrelated investments.  But clearly, in the face of this Go-Go market we are pulling in our risk reins a bit and raising some, dare I say it, cash levels.

Ending this missive on a high-note, I am convinced that the huge influx of capital to index strategies where the only decision is to BUY provides an opportunity to find forgotten and misunderstood companies, those often outside the index with compelling fundamentals, prospects and insider ownership.  You can rest assured that we are doing just that—searching for opportunities to grow wealth but do so in a risk sensitive fashion.

Thank you for your continued vote-of-confidence and please let us know if you have any questions or comments.

PS Check out this video: http://mediahub.financialpicture.com/view/8775/2516