Focusing on Valuations

Terrence Craig
Chief Investment Officer

B Bus Sc (Hons), CA (SA), CFA

SA Equities have shown abysmal returns for investors

South African Equity markets delivered abysmal returns for investors over the last three years as is highlighted in the table of returns below. For the 1, 2 and 3 year periods ending 30 June 2017, neither of the primary SA Equity benchmarks, the All Share Index [ALSI] and the Shareholder Weighted Index [SWIX], were able to beat either cash or inflation over any of the periods in the last 3 years. As is highlighted below – an investor would have been better off with “money in the bank” (i.e. cash) than being invested in the SA Equity market as returns went backwards in real terms.

Performance p.a. to 30 June 2017

Corporate takeovers confirm Element’s Investment Philosophy

At Element we are focused on selecting shares, based on our research, that are trading at discounts to our estimates of long-term intrinsic value. In addition, these shares should offer an appropriate “margin of safety” – a large enough discount to fair value – to allow for forecast risk and changing dynamics.

One can view our investment philosophy as researching for companies that are trading at a share price below what a rational business person (or entity) would be prepared to pay for the company in an arm’s length transaction. A takeover of a company we hold, at a premium to the price we paid, is confirmation that our investment philosophy, research process, fair value and margin of safety estimates are working correctly. A rational business person (or entity) that is prepared to pay more than Element paid to take over a company is as good a confirmation as any that our investment philosophy and process is working.

Source: Element Investment Managers

In addition, all these shares were either small or mid-cap in terms of size – an example of Element’s competitive advantage of our smaller size as an active boutique investment manager. No large active manager could have taken a material portfolio position in these shares across its client base as the small size of the companies would determine that the resulting final portfolio positions for the large active manager’s clients would be immaterial (even if a maximum of 35% of the entire company had been bought). Using Astrapak as an example with R500m as its market cap - pre being bought out – buying 35% of the company (the maximum that could be bought before an offer would need to be made for 100% of the company) would cost R175m. For any large active manager that had R100bn or more in equities, R175m would equate to a 0.175% equity position across its portfolios. A meaningless position, with immaterial impact on overall equity performance, even if the company were to be taken out for double the manager’s entry price. It is also worth highlighting that any passive investment strategy would not have taken the overweight positions in these companies that Element did for our clients as it would invest in line with the equity benchmark weights dominated by the Top 40 shares in the ALSI or SWIX.

Expensive Global Equity Valuations warrant investor caution

Globally investors appear overly complacent given expensive asset valuation levels, deteriorating global political instability and changing central bank action with respect to interest rates, amongst many other material issues. Mikihiro Matsuoka, the chief economist at Deutsche, cautions that while global markets benefited from a “long period of post-global financial crisis accommodation,” that’s changing as central banks move to tighten by raising interest rates. This central bank action “raises the returns on safe assets and lowers the valuation of risk assets”. Nine years of central banks keeping rates low and driving up asset prices appears to be changing – investors should take note.

On 10 July 2007 former Citigroup CEO Chuck Prince famously said what might be termed the “speculator’s creed” for the era of Bubble Finance:

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing”.

Prince was fired within four months of making that statement. Investors should remember that the music will stop – it always does.

We have highlighted in previous Element commentaries, the below four valuation indicators of US Equities – using the S&P 500 index. The graph shows an average of the four indicators and highlights long-term valuation levels as opposed to giving any short-term signal of market direction. As we have experienced before, periods of over- and under-valuation can last for many years, but valuation levels do play a role in framing longer-term expectations of investment returns. At the end of June 2017, the chart highlights that US Equities are the second most overvalued since 1900, now higher than the 1929 valuation peak and over 2 standard deviations from the mean, with only the Tech bubble valuation levels of 1999/2000 having been higher than today.

US Equity market overvaluation continues to suggest investors should maintain a very cautious long-term outlook and guarded expectations. This is not a starting point where investors make good investment returns over the long-term – if anything investors should expect poor returns from US equities, at best, over the next decade.

As US economist David Stockman highlighted in an article on 21 July 2017:

  • The US stock market has narrowed drastically during the last thirty months, as is typical of a speculative mania. This narrowing means that the price-earnings ratios (PE), among the handful of big winners, have soared.
  • The US “FAANG+M” shares (Facebook, Apple, Amazon, Netflix, Google and Microsoft) as a group has seen its weighted average PE multiple increase by 50% in the last few years. That’s caused the market cap of these six super-momentum stocks to soar from $1.7 trillion to $3.1 trillion during the period or by 82%. 75% of this huge gain in market cap is attributable to PE multiple expansion, not underlying operating performance.
  • We have seen this movie before: The Four Horseman of Tech (Microsoft, Dell, Cisco and Intel) at the turn of the century saw their market cap soar from $850 billion to $1.65 trillion or by 94% during the manic months before the dotcom peak.
  • At the March 2000 peak, Microsoft’s PE multiple was 60 times, Intel’s was 50 times and Cisco’s hit 200 times. Those nosebleed valuations are not much different than Facebook today at 43, Amazon at 192 and Netflix at 222 times PE.
  • Even great companies do not escape drastic over-valuation during the blow-off stage of bubble peaks. This in turn leads to abysmal returns for investors buying these companies at peak levels.
  • Only the daredevils and Wall Street dancing machines would dare buy the S&P 500 at 25 times PE, the Russell 2000 (small and mid-cap index) at 88 times PE and Amazon at 192 times PE.

A further sign signalling investor caution - Millennials are not learning from their parents (the baby-boomers) – not that we are surprised.

According to TD Ameritrade (the US online stockbroker), the five stocks most owned by its millennial customers are: Apple, Facebook, Amazon, Tesla and Netflix almost all staples of millennials’ daily diet and the prime beneficiaries of momentum trading.

None of the millennials’ top 10 stocks pay “boring” old dividends according to Steven Quirk, executive vice president of TD Ameritrade’s Trader Group. Quirk said nearly half of the firm’s millennial clients trade on their mobile devices, twice as much as the overall customer base. They “all trade the same” social media stocks, he said, including hip losers Snap and Twitter. The smartphone makes it much easier to trade online; you can do it in your Uber car or while waiting in line for coffee. This ignores the conclusive research that “the more you trade, the worse you’ll do”. These millennials have only superficial knowledge of companies or industries yet think they’re experts and are “buying what they know”. This is the same movie that starred the baby-boomers in the Tech bubble.

Peter Lynch, the superstar fund manager of Fidelity Magellan Fund who popularized that maxim in his best-selling book, “One up on Wall Street: How to Use What You Already Know to Make Money,” warns against misinterpreting his advice.

In 2015, Lynch, who retired from investing 25 years earlier at the top of his game, told The Wall Street Journal: “I’ve never said, ‘If you go to a mall, see a Starbucks and say it’s good coffee, you should call Fidelity brokerage and buy the stock.’” The common wisdom of “buy what you know” ignores the hard fundamental research on companies at which Lynch and his team excelled. “’People buy a stock and they know nothing about it,’” he told the Journal. “’That’s gambling and it’s not good.’”

Credit Suisse has highlighted the inverse correlation (-86%) between the FAANG shares’ relative performance and the US 10 year yield as shown in the chart below.

So if the Fed continues to raise interest rates as planned, those high-flying tech stocks are likely to come under pressure, at least if history is any indicator and that would threaten the torrid streak of gains that has led major US Equity indexes to new highs.

It is worth noting that two of 2017’s highest-profile US Equity initial public offerings, Snap and Blue Apron, are officially loss-making to date for investors. As of 28 July 2017, shares of both stocks were trading below their IPO price — meaning that investors who bought in (and held onto the shares) are now facing losses.

Snap sold its shares for $17 in March. It began trading for $24 and rose to its all-time high a day later. It’s now below the IPO price of $17 at $13.81. Blue Apron – with an IPO price of $10 – barely kept itself above water on its first day of trading before slipping below 24 hours later. It is now much lower at $6.80.

Hussman Strategic Advisors chart (3 July 2017) on the next page uses the ratio of nonfinancial market capitalization to corporate gross value-added (including estimated foreign revenues), which they find better correlated with actual subsequent S&P 500 total returns than any other indicator. Market Cap/GVA is shown in blue on an inverted log scale. The red line shows actual S&P 500 12-year average annual nominal total returns. Presently, Hussman associates current US Equity valuations with prospective S&P 500 12-year returns of roughly zero, coupled with the likelihood of a 50-60% interim market loss.

As per John Hussman:

  • It’s almost impossible to convey how badly investors are likely to regret dismissing valuations and ignoring market internals by the time the current speculative market cycle is completed.
  • The only question is how long it takes for the gap between price and fundamentals to become intolerably wide. As we’ve seen, it can take a long time. But once the bubble psychology breaks, that gap can close with sickeningly great speed.
  • This movie has been re-made many times, always with the same ending.

Andrew Bishop appointed as a Portfolio Manager

Andrew Bishop has been appointed joint portfolio manager with me on our SA Equity funds, effective 1 July 2017. Andrew has been with Element and worked with me for the last 8 years as an investment analyst, initially focusing on equity research and more recently researching other asset classes as well. Andrew has B Bus Sc, B Com (Hons), CA (SA) and CFA as qualifications and has been an integral part of our Investment Team since joining Element in July 2009.

We continue to research for undervalued shares for our clients and will buy these with an appropriate margin of safety when the opportunity arises. Expensive global valuations, a handful of large caps driving indices and nosebleed valuations highlight to us that the movie is playing out the same as before.

Investors should heed the warning signs and act with caution.

 
 

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