Finding Value in an “Overpriced” Market
As Kingwest embarks on its 36th year of investing on behalf of clients, we continue to find it remarkable how quickly market sentiment can change.
Last year opened with the worst start for equities in history, and volatility continued with the surprising Brexit result and then the election of Trump. In November, sentiment turned and public markets became optimistic that pro-growth policy changes such as tax reform, lower tax rates, deregulation, infrastructure investment, and a more business friendly climate would lead to improved economic growth. That pushed the S&P 500 to all-time highs, and the Canadian market followed along.
In this environment, we have been doing well. We are outperforming in both Canada and the US by over 4% in each market before fees. Overall, a pretty good start to the year.
This showing is even better when you consider that in the US five stocks have carried almost half of the market return — Facebook, Amazon, Netflix, and Alphabet (Google) — the FANGs, and Apple.
We own none of them. We believe they are much too expensive and therefore are much too risky. They may be great companies but they can still have a hiccough. And a hiccough in the company will be pneumonia for the share price. We do not take that kind of risk.
“There’s no such thing as a good investment idea, until you’ve discussed price. Investing well is not a matter of buying good things, it’s about buying things well. And people have to understand the difference. And if you don’t understand the difference you are in big trouble.” — Howard Marks
The impact of these companies becomes very apparent when you look at the performance of the sub indices of the market. In the first six months of this year, the Russell 1000 value index (what we do) is up 3.7%; the Russell growth stock index (which includes those FANGs) is up 13.7%. We are fishing in the former pond with the returns of the latter. That is not an anomaly. It is consistent with our past experience. Value investing done right, does work.
We invest with an ‘owners’ perspective. We aim to generate superior investment returns by following a patient and disciplined long term, value added approach. We employ high quality people. We pursue the highest standards of excellence. We also align our interests with yours, our investment partners.
Why does value investing work? And can it continue?
Research in experimental psychology finds that “most people tend to ‘overreact’ to unexpected and dramatic news events.” That opens opportunities to earn substantial profits that can be unlocked through independent thinking, fact based analysis, and a longer perspective.
We take advantage of these opportunities by looking for undervalued companies — companies whose stock price has overreacted to some unexpected news — where, upon study, we conclude that those developments are both temporary and fixable. We are looking for companies where positive developments in the company’s affairs are designed to drive long term recurring cash flow. We have no interest in exchanging $1 for $1 of value.
In the short term, change causes agitation and confusion and stock prices may suffer. But longer term the underlying economics will dominate, reason will rule, and market prices will trend to reflect economic value.
Let us give you a couple of recent examples of moves we made in the portfolio that highlight how we apply this.
We owned Equitable Group until late 2016. We had purchased it at $26 per share about three years ago and sold it at $61, generating a very good return. Last month with the fiasco at Home Capital, the Equitable share price was hit in sympathy, although Equitable had absolutely no involvement in the problem facing Home Capital. In addition, the large Canadian banks showed confidence in Equitable by providing a $2 billion loan facility on normal market terms. Home Capital had to accept extraordinarily expensive terms from the only firm willing to lend it money quickly to shore up its eroding base.
In the face of this overreaction, we purchased our position in Equitable back at a price in the mid $40’s. It is now trading at just under $60.
Another noteworthy example of our strategy is Air Canada. The company is in the midst of a dramatic transformation. Today it may surprise you to know Air Canada is a preferred airline for Americans going to and from Europe. The airline has one of the most modern fleets of the North American carriers. It is improving service continually. Toronto’s Pearson airport is an easier, more comfortable airport to fly through than almost any of the big US airports. This has resulted in rising earnings power for the airline. Meanwhile the stock, when we bought it, was one of the cheapest of any of the North American carriers. The share price has moved up in the past months so that gap is narrowing.
These are but two clear examples of how we act as stewards of your money, as well as our own which is invested in the same portfolios as you. It is a strategy that is sensible, it is proven to work, and we have applying this strategy successfully for years.
1. Why are we optimistic about future growth opportunities?
We believe we have substantial opportunities in the decades ahead to drive attractive returns in our portfolios.
Most importantly, we have confidence in the underlying growth in the Canadian, US, and Global economies which will fuel the growth in companies globally.
The companies we invest in generally have an ‘edge’ — they do something that their customer’s value and rivals cannot match. This advantage allows them to grow their business, while keeping prices at levels that give them strong profitability. We try to hold onto these while this period of out-performance lasts and sell when rivals start to catch up. One company we owned that is a good example of this is Whole Foods. The company was the preferred organic grocer. As other food retailers increased their assortments of organics, pricing pressure came into the business harming Whole Foods profits. That drove us to close out our investment in the company at about $58. (Amazon recently made an offer to buy the company at $42.)
2. Where do we stand in the economic cycle and is there a recession on the horizon?
This economic expansion began in 2009, eight years ago. This is the longest lasting expansion since 1950. Nonetheless, we think it still has legs.
Economic recessions come about because supply constraints cause a number of sectors to overheat and push inflation to unsustainable levels. Then Central Banks step in to raise interest rates to abnormally high levels to try to restrain the inflation. That process generally slows the economy and frequently results in a recession.
This time, the expansion has been characterized by very slow growth relative to other expansions (2% as opposed to the normal 3% growth rate). Slower growth has meant that there are virtually no supply constraints visible anywhere in the economy. Operating rates in manufacturing are well below levels where historically companies began to invest, and labour constraints which are now said to be appearing in some sectors, are nowhere near to pushing wages to unreasonable levels.
For now, there appears no reason to believe that the economy is heading towards a recession in the near term. It is probably still a couple of years out. In baseball parlance, we are probably in the top half of the seventh inning. This means there is still ample room for continued stock market gains.
3. Is the US stock market overpriced?
We mentioned above the impact of the FANGs on the performance of the US market indices. Their impact on the apparent valuation of the market is also dramatic. The market is trading at a forward price-earnings ratio of 18.8 times, a little above the average of the past 60 years. However, the FANGs trade at exorbitantly high multiples — both Netflix and Amazon at 180 times earnings, Facebook and Alphabet over 30 times. If you extract those companies, the market multiple is actually about 14.5 times, below the historic average. So we do not believe that market as a whole is overpriced.
We only buy a few companies a year. Therefore we are not dependent on the whole market being undervalued to produce excellent investment ideas. There are always companies that for one reason or another falter and become substantially underpriced, it is our job to invest in those.
In conclusion, we still feel that the outlook for the equity markets in the near term is favourable. Markets are not overvalued, and economic growth should continue for a few years yet. There are plenty of opportunities in this kind of environment to find exceptional investment. We expect the next year to be a strong one.