Templeton and Phillips Capital Management's commentary for the month of October 2023, titled, "the joy of uncertainty."
In today’s tsunami of financial media rushing through the internet, television, and podcasts, we find no shortage of uncertainty. Market uncertainty surrounds Federal Reserve policy (and inflation), the War in Ukraine, artificial intelligence, recession, real estate values, GLP-1s (weight loss drugs), and now, we must add the terrorist attacks in Israel. To be sure, that list represents an intimidating array of uncertain matters. One might be tempted to conclude that today’s uncertainty creates too many challenges for investors, but in reality, we believe the opposite is true.
As investors, uncertainty is our most important raw material. Uncertainty shakes the confidence of near-term speculators that proliferate the markets, and as speculators sell, share price volatility increases, and bargains may appear. Our experience has been, and we continue to believe that bargain share prices create the foundation for attractive investment returns.
If uncertainty is our most important raw material, interest rates are a close second. For that matter, we believe the level of uncertainty today and the rise in interest rates over the past year are related in many ways. Nevertheless, we believe today’s interest rate levels create a luxurious backdrop for investment decision-making that has not been seen in almost twenty years. Luxury, in this case, comes from a real rate of return in risk-free assets and the accompanying patience to do nothing.
Before we delve further into the discussion, we should share our premise that all securities, including stocks, bonds, derivatives, and the investment products and portfolios built around them, are actively engaged in a ferocious competition for investor capital. The luxury we alluded to above comes with the sudden re-emergence of an asset class within this framework, that had been uncompetitive dating back to the 2008 financial crisis, in our opinion.
As we argued in our 2022 year-end letter, the previous ten years of ultra-low, zero-bound interest rates were an anomaly that had profound, and lasting effects on the positioning of investor capital during that period. In sum, the coupons on bonds offered no competition versus other destinations for investor capital, and to be frank the only investors that frequented bonds during that period were either compelled to do so by restrictions in their mandate (e.g., pensions, insurers, banks, etc.) or by contrast were speculating on capital gains through the view that rates would move even lower. You may recall the height of this insanity when global interest rate policies were set at negative rates in regions such as Europe (2014-2022) and savers had to pay banks to hold their capital. By 2019, research from Deutsche Bank suggested that as much as 25% of the global bond market traded with negative interest rates. Similarly, investors in the equity space crowded into three specific areas: growth stocks, passive ETFs (dominated by growth stocks), and private equity. Growth stocks offered the promise of distant, but “certain” earnings in the future and market cap-weighted passive ETFs whose returns were dominated by the same surging growth stocks represented a cheaper (and admittedly wiser) analog. Perhaps least surprising, when governments destroy the incentive to save, the other side of the coin is a wild incentive to borrow. For institutional and high-net-worth capital allocators, this led to a long decade-and-a-half period of employing borrowed money into investment schemes and products.
Most notably, a combination of cheap borrowing, lavish fees, and infrequently reported values in the private equity space culminated in an investment bonanza for all involved. Put differently, allocators looked brilliant generating large paper-based returns and private equity managers minted fortunes through handsome fees. For early practitioners and allocators, private equity strategies worked out well. Conversely, latecomers and those who overstayed their welcome face an uncertain, and perhaps sketchy sequel (e.g., potential losses, unsure capital raising/refinancing, and trapped capital due to tightening financial conditions). The paradigm begs for a reprise of the timeless market truism, “A wise man does in the beginning what a fool does in the end.”
To say that the previous environment has vanished today is an understatement. In its place is a normal and much healthier backdrop offering flexibility, in our opinion. So, let us now return to our previous comments on interest rates providing patience. To see this, we will begin with an illustration of the competitiveness between stocks and bonds for investor capital in today’s market, and to do this we will compare the current earnings yield on stocks with Treasury yields. For anyone unfamiliar, an earnings yield is the reciprocal of the P/E ratio and standardizes the return comparison between stocks and bonds through yield measures. The important difference is that current earnings yields should reflect a yield that moves higher in future years, assuming the earnings stream is growing over time. Similarly, just like a high dividend yield, an unusually high earnings yield may reflect a market view that current earning levels will not be sustained in the future. The earnings yield is a familiar tool for Ben Graham descendants since it reflects Graham’s time when stock investments were not necessarily the de facto destination for investor capital. In sum, during periods of higher (or simply normal) interest rates, stocks had to provide superior value versus bonds to be considered attractive and worth the additional risk. Simply put, the two categories competed for investor capital.
When we update these yield comparisons for today’s market, we obtain a clear measuring stick that may be used to judge a given investment’s competitiveness. As we scan across the markets in the illustration that follows, we see that some categories of stocks simply cannot compete with Treasuries today, while others may present attractive bargains and much higher prospective returns.
Sources: Bloomberg, Templeton and Phillips Capital Management, LLC, data as of 10-19-23
Our interpretation of the data above is that the two categories of stocks found in the NASDAQ and MSCI World Growth Index, are simply not competitive with Treasuries today, when compared to either the 10-year Treasury or the 6-month T-bill. The counter arguments to that view are likely that the Federal Reserve will soon be cutting interest rates, which will restore the attractiveness of low earnings yields, and/or that the promise of artificial intelligence is so profound that we are underestimating its likely effect on future earnings growth. For some healthy perspective on the current level of interest rates, consider that the long-term average for the 10-year Treasury is 4.5%, dating back to 1871 (based on Robert Shiller’s data). From our vantage point, we are skeptical that the Federal Reserve will be cutting interest rates either soon, or sharply enough (for a host of reasons) to justify the low earnings yield on tech and growth.
Turning to AI, we see profound changes coming, but not necessarily translating into the profound earnings growth needed to justify current valuations. In sum, we believe the promise of AI is likely real in economic terms, but it is not likely to save the day for over-valued stocks any more than the unimaginable (and actual) growth of the internet did for tech stocks during the dotcom mania. We often cite the case of Microsoft, a remarkable company that needed 16 years to climb out of its dotcom share price decline.
Conversely, the categories of stocks with earnings yields above the Treasury benchmarks range from acceptable at the low end to (potentially) very attractive at the high end. In this segment, we see the passive S&P 500 as generally acceptable but flag the value stocks within it as notably better, in our opinion. Then, finally, share prices outside of the U.S. show the most potential, but with the necessity for more careful judgment on a bottom-up basis, inclusive of top-down filters and caveats (e.g., geopolitics, property rights, etc.). As a final note, we included both the 10 Year Treasury and the 6-month T-bill as measuring sticks given that in the investment world, the 10 Year Treasury is a standard input for judging the value of an equity in financial models, but the 6-month T-bill is the real-life bogey for most investors (in our opinion). On that matter, both measures currently offer a real yield after inflation (approximately 1.8% and 2.5% for the 6-month and 10 Year, respectively), but we consider the T-bill safer since it escapes current debates around the economic cycle (probability of recession) and the term premium (future inflation), either of which could affect investor outcomes in a positive or negative manner (due to bond duration). In the most basic sense, investors today should be requiring equity returns well north of 5.5% to get coaxed out of collecting 5.5% annualized returns in a T-bill. We believe these returns are available in the equity markets but are not likely to be found in the same assets that produced the best returns over the past ten years (e.g., tech, growth, passive S&P 500, and private equity). In fact, we believe there is a substantial risk that many of those assets underperform T-bills over the near-to-medium term.
“Successful investing is not an easy job. It requires an open mind, continuous study, and critical judgment. Changes of trend occur when least expected. Policies profitable for the last ten years will not be best in the next ten.”
Sir John Templeton
We believe the quote above from Sir John represents timeless advice, and in this case, may also be prescient, based on the analysis we shared. This brings us now to our final remarks on the luxury of patience that comes with today’s environment.
To begin, we will start with further sage advice, this time from Warren Buffett,
“The stock market is a no-called strike game. You don’t have to swing at everything – you can wait for your pitch.”
As we pointed out above, the 6-month T-bill offers a real yield approaching 2.0%, which should significantly calm any sense of urgency or impulse to chase wild pitches (e.g., “buying the dip” on NVDA) in the current market. Instead, investors willing to exercise patience can simply wait for their pitch, and in the current environment of uncertainty, they are increasingly likely to be rewarded for their patience.
One recent example from our portfolio may be seen in our purchase of UnitedHealth Group (NYSE:UNH). A few months ago, shares of UNH surfaced on our quantitative screens ranking potential ideas on the basis of free cash flow yield (as an improved proxy for earnings yield measures). Incidentally, UNH, a generally well-regarded and high-quality healthcare firm, had a free cash flow yield measuring 8.9% which stood out on three perspectives: 1. above its previous high set during the panic of COVID, 2. two standard deviations from its long-term mean, and 3. more than twice the free cash flow yield of 3.8% found on the S&P 500 Index. A valuation at that level begs rather simple questions and decision points, for instance, is UNH’s outlook worse today than in the depths of COVID, or is the S&P 500 two times more attractive as an investment than one of the best-operated healthcare enterprises in the industry? Based on our research, the answers were no to both.
Instead, we believe the bargain valuation reflected a mix of three factors, including 1. a market avoidance towards dividend growth stocks (due to higher interest rates) that pressured those names to be more competitive with treasuries, 2. near-term earnings concerns over latent demand for surgical services following COVID, and then 3. some uncertainty surrounding the effect of GLP-1s (Ozempic) on many aspects of the U.S. economy including medical device makers, food companies, and in this case, even healthcare payers and providers. In the months since UNH has reported earnings that beat expectations and helped calm fears over its fundamental strengths relating to these market forces.
After further modeling and research, we found a probable outcome for future growth in free cash flows over the next several years of approximately 13%, compared with its historical record of 15.1% in the previous five years. All told, investors at the current valuation would receive 8.9% through UNH’s current free cash flow, and then the potential of 13% annualized growth in those cash flows over the next five years.
From a fundamental perspective, UNH’s ability to continue executing its healthcare payer and provider model seems probable, in our opinion. To start, we believe the company’s aggressive push into technology combined with the scale of its network confers a durable competitive advantage in terms of growing both sides of its business model. Our research suggests that UNH has considerable leverage in its negotiations with providers, supported by its large and expanding data enterprise—employing machine learning and AI techniques. Moreover, we believe UNH has the capital and expertise to continue building out its OptumCare business which includes healthcare professionals and key growth segments including home care. Home care in particular will be a continued focus for UNH and competitors as the current quality or absence of care can be increased in many regards, but also at a much lower cost (given the absence of hospital overhead).
Finally, we believe that the secular demographic drivers related to an aging population in the U.S. provide an important growth tailwind for UNH and others. For example, the U.S. Census reports that the cohort of Americans aged 65 and over are growing at the fastest rate on record, dating back to the late 1800s. In the past ten years, from 2010-2020, the census reports that Americans aged 65 and over increased by 38.6%. Going forward, we look for UNH to continue expanding its free cash flows due to its strategic plan and strengths, as well as reward shareholders through its consistent reward of dividends and share repurchases.
We often highlight recent ideas in our commentaries, but in this commentary, we would also stress that we believe many of our existing holdings have become more attractive in this current environment of higher interest rates. It is important that we highlight certain ways in which we believe higher interest rates are positively impacting the business performance of current holdings in the portfolio.
For the sake of brevity, we will share a few thoughts and examples. Perhaps the simplest example comes from our longstanding holdings in the Property and Casualty Insurance holding companies, Fairfax Financial Holdings, and Berkshire Hathaway. In these cases, it is important to recognize the material impact that higher interest rates have on the short duration investment portfolios of these companies. As a reminder, in both cases, a considerable amount of the earnings streams in these firms is tied to insurance and reinsurance. Within these corporate silos, the firms collect insurance premiums that are generally invested in fixed-income instruments (often referred to as “float’), and the interest-based earnings that these portfolios generate on short-term investments have recently increased 4x-5x led by the rise in T-bill rates during the past year and a half. These increases in interest income represent new financial resources that can be potentially used to generate higher future returns on behalf of shareholders through acquisitions (public equities or private firms) and / or share repurchases.
In addition to our observations on P&C Insurance holding companies, we are also upbeat on what we believe are durable firms, many of which were purchased during the COVID panic of 2020, and their ability to navigate a more difficult funding environment for weaker competitors in their respective industries. While it may not be obvious to many investors today, the rise in interest rates during the past year has presented a challenge to competitively weaker firms ranging from speculative start-ups to old economy zombies, unable to access the cheap borrowing that sustained them during the halcyon days of zero-bound interest rates. For instance, in the first nine months of 2023, S&P Global reports that 516 companies have declared bankruptcy, compared with 263 in the first nine months of 2022. In many cases, the bankruptcies are unsurprising, ranging from Bed, Bath, and Beyond to Rite-Aid. For that matter consumer discretionary firms such as those represent approximately 22% of the classifiable total in 2023. This potential phenomenon was a factor behind our purchase of Amazon during the COVID panic of 2020, based on our perception that it could grow its market share (and possibly earnings) in a challenging environment for its competitors, many of which have accumulated debt trying to either adopt or combat e-commerce trends established by Amazon in the retail market. Now that we appear to be entering this environment, we believe a new fundamental catalyst could be surfacing.
Going forward, we expect to see additional bankruptcies to the extent the current interest rate environment persists, and weaker companies struggle to finance themselves. At the same time, and much like the fact that interest rates today are only in line with their long-term averages, we believe the rise in corporate bankruptcies only reflects a return to a normal economic environment. In any event, we expect to continue to remain opportunistic in this environment and are happy to have the additional returns and flexibility afforded to us through today’s interest rate environment.
Templeton and Phillips Capital Management, LLC
Lauren C. Templeton
Principal
Scott Phillips
Principal
