Generation PMCA commentary for the second quarter ended June 30, 2024, title, "steering clear of the dear."
As value investors we gravitate to undervalued securities—those that are inexpensive relative to our fair market value (FMV) assessments, because they are out of favour or underestimated. Similarly, we steer clear of those that are popular and dear.
We get nervous once a stock’s price rises to FMV because it’s then we fear a reversal. Stock prices tend to revert rather quickly to a discount once FMV is achieved. When a company is at a discount, we are generally optimistic and relaxed awaiting its rise to FMV, though clearly its discount is dependent on our FMV estimate—our analysis of the company’s future—which is not an easy task albeit made easier when our subjects are high-quality large companies.
High-quality large-cap stocks tend to fluctuate in price between fair value and approximately a 20% discount (about one TRAC™ band down from FMV). Sometimes, though rarely, if investors become overzealous, enthralled by outstanding fundamentals, a stock’s price can run up about 30% above fair market value (FMV)—a TRAC™ band higher. More often, in overall market swoons, or if uncertainty is particularly high for a company, its price may fall to around a 35% discount (2 TRAC™ bands below FMV) or even a 50% discount (3 TRAC™ bands down).
By way of example, Microsoft has run up to its FMV 7 times in the last 10 years. Inverting this, after rising to its FMV, the stock price fell by about 15% or more on 7 occasions in 10 years. And, of those 7 occasions, Microsoft fell 28% and 38% from FMV in 2020 and 2022. Unpacking this: there are many opportunities to invest in well-known, high-quality companies; and FMV acts as a magnet, both attracting prices higher as demand for shares overwhelms supply and repelling prices once FMV is achieved when oversupply, excess selling, pushes prices back down.
When articulated this way, why would one invest in any other way than moving in and out of high-quality companies—those less risky than average, whose share prices rise over longer periods of time driven by ever-rising earnings, yet whose fluctuating prices over shorter time frames provide compelling opportunities to buy and sell along the way. That doesn't mean it’s sure proof, just that the odds are favourable. Investors are still susceptible to having selections underperform if fundamentals disappoint (altering FMVs) or purchases and sales are mistimed.
Crowded Trades
While a buy and hold philosophy can certainly work over longer periods, it’s susceptible to big downdrafts when prices inflect down from FMVs. Buying companies that are big and steady (such as banks and utilities) still leads to periods of short-term price dislocations since prices fluctuate materially from: normal swings as shares rise to FMV and revert; interest rate changes; company specific issues; and overall market gyrations. Currently, prices of most stocks are trading dear—at or above their FMVs. Therefore, we remain nervous about the outlook for the overall market indexes.
Priced for Perfection
Valuations for the North American stock markets remain high. When valuations are this high, returns over the next few years aren’t. In fact, valuation tools that have been used to project returns are estimating nil returns for the S&P 500 over the next few years.
Over the last 50 years, the percentage of S&P 500 stocks outperforming the index has averaged just below 50% with a high of around 67% (2001) and a low of about 27% (1998). So far, 2024 is the worst year on record with only about 20% of the stocks outperforming. The Magnificent 7 stocks collectively accounted for 64% of the S&P 500’s return in the first half of this year.
The S&P 500 (which is cap weighted—skewed by the market values of each company) has grossly outperformed the S&P 500 equal-weighted index. Such pronounced outperformance has just preceded or coincided with all 4 recessions in the last 40 years. When the outperformance has been so relatively high, subsequent 3 and 5 year returns for the equal-weighted index (i.e., the average stock) have materially outperformed the S&P 500. And during those reversals, returns are even more pronounced for value stocks—those stocks trading at the lowest multiples of earnings. Chant it with us, “Buy Low, Sell High!”
Based on 12-month forward earnings, the equal-weighted S&P 500 trades at a 23% discount to the S&P 500, and even the equal-weighted index trades above its long-term average earnings multiple. The yield on T-bills remains higher than the earnings’ yield (earnings/price) of the S&P 500, which is rare and only took place in recent history just before the recession in 1980 and 2001.
When trading at or above FMV, stock prices become highly susceptible to the slightest negative changes. What if interest rates rise because demand for U.S. bonds wanes, unemployment worsens, office buildings endure even more defaults, oil prices rise impacting input costs and pocketbooks, consumer spending softens further because demand for goods is satiated, tax rates rise to reduce deficits, or geopolitical issues are exacerbated? Some of this is bound to occur.
Yet, allocation to stocks by households is at an all-time high of 35%. It was 29 at the '68 market top, 30% when the bubble formed in 2000, and 34% at the peak prior to the pandemic. Even worse, investors’ allocation to leveraged ETFs is at near-record levels.
Nvidia is the talk of the town. Its last 12-month revenues have tripled from the prior 12 months. But it trades at 50x book value, just under 40x sales (the highest price/sales multiple in the S&P 500). Its AI growth has surely been astounding; however, investors appear to be ignoring that Nvidia’s business has been highly cyclical historically, resulting in 6 share-price drawdowns of over 50% during the last 25 years. Artificial intelligence or real ignorance? Time will tell.
Concentration in tech stocks persists. In the Russell 1000 Growth Index, a bit of a misnomer since just 440 stocks constitute this index, only 6 stocks represent half the index. Periods such as these, with extreme concentration, have not ended well historically.
Buffett even just sold half of Berkshire Hathaway’s mammoth Apple position, likely because its share price simply ran up too high. He’s amassed Berkshire’s greatest cash position ever relative to its assets. Buffett’s Berkshire Hathaway itself is fairly valued, on sell in our TRAC™ work, and likely to fall to a floor before moving back to its FMV.
Far from Perfect
It’s not just overall valuations that have kept our posture defensive. Our Economic Composite, TEC™, is still calling for a U.S. recession. Other developed markets have either entered recessions (as predicted by TEC™) or their growth has flatlined. While a U.S. recession has taken much longer to occur than we expected, the economy has certainly weakened.
After being below 4% for 27 months, the U.S. unemployment rate has lifted to 4.3%, well above the 3.4% cycle low, the rate now above levels off-the-bottom that have always coincided with the onset of recessions. Full-time employment was down 1.2% year-over-year in June—each time it’s been negative in the last 60 years has also coincided with a recession. U.S. job openings have fallen and the rate of wage gains diminished too. Small business hiring plans, which normally are a leading indicator of the unemployment rate, imply much higher unemployment in the months ahead. In Canada, the unemployment rate has lifted to 6.4%, and the economy lost jobs in the last couple of months.
U.S. credit-card delinquencies have reached double digits. U.S. corporate bankruptcies have jumped dramatically from last year and are at the highest level in over 10 years.
The fact that Walmart is experiencing growth from wealthier families doesn’t bode well. We’re seeing evidence of trading down from many businesses. Comments regarding a struggling consumer have come from McDonald’s, Starbucks, Whirlpool, Diageo, and even LVMH—at the high end—where demand for champagne has substantially weakened. Is everyone celebrating with just cake?
Corporate insiders, normally value buyers themselves, appear to realize that the economy is slowing and that stocks are fully valued. There are now more than 5 insider sellers for every buyer of U.S. stocks.
Over the Top
While our undervalued stocks don’t keep us awake at night, we are concerned about geopolitical ramifications from the behaviour of Russia, Iran, North Korea, and other nations with similar regimes.
While it’s unrealistic that the leaders of these nations will alter their behaviour, we still hope that clearer heads prevail. And closer to home, we can hopefully alter some of the misguided policies that have us on the wrong course. For example, debt levels must be reduced by reigning in spending otherwise economic growth will lag considerably, currencies will lose material relative value, and significant inflation could result if governments are forced to ultimately aggressively print money to meet obligations.
The federal budget deficit in the U.S. is expected to be over $2 trillion this year as spending continues to be well ahead of receipts. This forces the government to finance the deficit with additional bond sales. Such high debt levels suppress economic growth as the law of diminishing returns typically sets in when debt reaches 80-90% of GDP; currently the U.S. ratio is around 100%.
Thankfully, while price levels remain high, the inflation rate has diminished. Even with core U.S. inflation still at 3.2%, above the Fed’s 2% target, there continue to be secular forces such as lower population growth, technological advances, and debt-suppressed growth rates which should maintain disinflationary pressures.
Our Strategy
The market often overreacts, causing stock prices to fall below FMVs. We are constantly evaluating companies to determine whether we should buy, sell, or hold. The companies we do hold have competitive advantages, high returns on invested capital, strong free cash flows, and healthy balance sheets.
Since we believe the U.S. market is fully valued and we still expect a U.S. recession, we continue to hold a partial hedge against market declines by shorting an S&P 500 ETF (or holding an inverse long ETF) and/or the Vanguard Total World Stock ETF.
Meanwhile, despite our concerns, the American economy has remained resilient. Industrial production is up and consumers are still spending at higher rates than expected. Despite higher interest rates, house prices are back to all-time highs. And this could encourage a further market rise in a final blowoff—a swift 10-15% upswing to the next TRAC™ ceiling.
Our Portfolios
The following descriptions of the holdings in our managed accounts are intended only to explain the reasons that we have made, and continue to hold, these investments in the accounts we manage for you and are not intended as advice or recommendations with respect to purchasing, selling or holding the securities described. Below, we discuss each of our new holdings and updates on key holdings if there have been material developments.
All Cap Portfolios—Recent Developments for Key Holdings
All Cap portfolios combine selections from our large cap strategy (Global Insight) with our small and medium cap ideas. We generally prefer large cap companies for their superior liquidity and lower volatility. The smaller cap positions tend to be less liquid holdings which are more volatile; however, we may hold these positions where they are cheaper, trading at relatively greater discounts to our FMV estimates, making their risk/reward profiles favourable. There were no material changes in our smaller cap holdings recently.
All Cap Portfolios—Changes
We made changes among our large cap positions summarized in the Global Insight section below.
Global Insight (Large Cap) Portfolios—Recent Developments for Key Holdings
Global Insight represents our large cap model (typically with market caps over $5 billion at the time of purchase but may include those in the $2-5 billion range) where portfolios are managed Long/Short or Long only. At an average of about 75 cents-on-the-dollar versus our FMV estimates, our Global Insight holdings appear much cheaper, in aggregate, than the overall market.
Global Insight (Large Cap) Portfolios—Changes
In the last few months, we have made several changes in our large-cap positions. We bought Becton, Dickinson and Company, Arkema, Cooper Companies, Walt Disney, lululemon athletica, Elevance Health, and Occidental Petroleum. We sold Sirius XM Holdings (after buying it recently), American Tower, and Unilever after each lifted to a TRAC™ ceiling in line with our FMV estimates. We sold Empire Co. and Telus when both fell through TRAC™ floors providing sell signals.
Becton, Dickinson and Company produces medical devices, laboratory equipment, and diagnostic products. Its share price essentially flatlined over the last 5 years because it was overvalued, was digesting an expensive acquisition and faced a major recall. Now, we see several catalysts emerging that should reignite investor enthusiasm. Efficiency gains should translate to an operating margin in the next fiscal year of 25%, up over 1% from this year. Efforts to improve cash flow conversion should lead to rapid acceleration of free cash flow, which we expect to be near $4.5 billion by fiscal 2026, double that achieved in 2023. After several recalls effectively took its Alaris infusion pumps off the market, shipments have since returned to an all-time high, providing a boost to revenue growth. Our FMV estimate is $272.
Arkema SA manufactures adhesive solutions and advanced materials. End markets include automobiles, semiconductors, sports, and packaging. We are impressed with how the company has managed through a challenging macro environment. Momentum in sports and adhesives led to volume growth of 5% in the most recent quarter. Strict cost controls translated to an EBITDA margin of 18%. Looking ahead, we see the expansion of Pebax (foam used in high-end athletic equipment), the ramp up of its new polyamide plant in Singapore, and the acquisition of Dow’s flexible packaging laminating adhesives business as being significant revenue and earnings drivers. Our estimate of FMV is €124.
Cooper Companies, the contact lens maker, is illustrative of our investment approach. We purchased Cooper in 2023 after shares fell nearly 20% between July and September. Our analysis concluded that Cooper was gaining market share thanks to its cutting-edge portfolio of vision solutions. After our purchase, the stock ascended to our FMV estimate over the next few months. What changed? Not Cooper’s business. It was routine market volatility—volatility that provided the opportunity to buy a high-quality business below fair value. Cooper’s shares again just experienced a 20% correction, providing another buying opportunity. Meanwhile, industry data continues to show strong performance for contact lenses, even as the economy weakens. We expect Cooper to grow its vision sales by nearly 10% in the second half of the year and cross $1 billion of free cash flow by 2027. We see few risks other than from ongoing competition with Johnson & Johnson. Our estimate of FMV is $110.
Walt Disney has experienced a tumultuous few years. An uninspiring performance by former CEO Bob Chapek led to the return of Bob Iger. A proxy battle was waged against activist investor Nelson Peltz. Once dependable Marvel and Pixar franchises were in box-office and creative funks, and its legacy businesses faced massive technological disruptions. Now, there are also signs that consumers are less inclined to splurge on trips to one of its 12 theme parks. However, we see numerous positives below the surface. Its streaming service, Disney+, is now profitable. With long-term college football and NBA deals in place, ESPN remains the premier digital sports platform. More affordable cruise experiences should help offset theme park softness. And recent hits, Inside Out 2 and Deadpool & Wolverine, both crossed $1 billion at the global box office, signs that Disney has its creative mojo back. Our FMV estimate is $120.
lululemon athletica suffered a 50% correction in its stock price over the last several months despite having strong fundamentals. It has a consistent long-term earnings growth trajectory and earnings doubled over the past 3.5 years. That growth helped lift the stock price above its FMV in late 2023, yet it now trades at a substantial discount to our $385 FMV estimate because sales and earnings growth guidance have been tempered. North American store expansion is expected to be minimal and overall company revenue guidance was lowered to 11% from 19%; however, new store growth in Europe and China is substantial, and same-store-sales growth exceeded 30% recently in China. Even with rising competition in its traditional athleisure lineup, the lululemon brand remains strong. The company has a remarkable 35% return on invested capital and nearly $3 billion of net cash on hand, which could further boost value from share repurchases.
Elevance Health provides health insurance through its Anthem and Wellpoint businesses and pharmacy benefit management (PBM) through CarelonRX. We believe the market is overly focused on the higher utilization rates experienced in its Medicaid business, especially in outpatient radiology and medical equipment. While it could take a quarter or two to see a resolution, its overall health benefits platform is experiencing mid-to-upper single digit earnings growth. Management is executing its plan to boost margins from 4% (2022) to 5.5%-6.5% (2027). Carelon is growing even faster, boosted by services such as behavioural management. Regulation and scrutiny about the power of PBMs are risk factors. Our FMV estimate is $650.
Occidental Petroleum is one of the largest oil and gas companies in the world. Key assets include 1.4 million net acres in the Permian, 0.7 million net acres in the DJ Basin, 9 Gulf of Mexico platforms, and OxyChem—a leading manufacturer of basic chemicals. Ongoing design enhancements and facility upgrades are lowering unconventional well costs and per well facility and construction costs. A highlight of the company’s industry leading operational expertise is its recent 3-mile TX Delaware well which was completed in less than 13 days, 24% faster than the previous record. Occidental’s purchase of CrownRock provides a complimentary asset footprint in the Permian basin and adds sub-$40 breakeven inventory. We expect share buybacks to resume after Occidental de-levers its balance sheet post-acquisition over the next year. Though we expect higher oil prices since global inventories are low and demand remains strong, commodity price volatility is always a factor for any oil and gas company. Our FMV estimate is $75.
Income Holdings
U.S. high-yield corporate bonds (ICE BofA Index) yield 7.2%. Long-term interest rates appear to have peaked and short-term rates are expected to follow, already lower in Canada. However, we remain concerned about tighter credit and rising delinquencies which should negatively impact high-yield bond credit spreads. Lenders have already tightened credit standards and corporate financings have become more difficult.
Our income holdings have an average current annual yield (income we receive as a percent of current market value of income securities held) of about 6%, and most of our income holdings—bonds, preferred shares, REITs, and high-yielding common shares—trade below our FMV estimates. Still prizing cash, we made no new purchases for Income portfolios recently. We sold AMC debentures since its fundamentals softened yet we were afforded a favourable exit price. We also sold AvalonBay Communities REIT after it rose near our FMV estimate.
Steering in the Right Direction
We are comfortable investing in undervalued, solid, noncyclical businesses while holding hedges that should benefit when the expensive market indexes decline.
We look to avoid overly popular companies that are priced too high, susceptible to decline, and result in misery. We don’t like the adage ‘misery loves company’. We’d rather not be miserable.
Bob Robottii, a well-known U.S. money manager, recently hosted a conference that invited several value investors, calling it the Restoration of The Fallen. And referring to stock pickers, he stated that he’d be shocked if they don’t outperform the indices over the next decade. That might seem like a bold statement to those who’ve suffered underperformance as indexes have risen so smartly. But tried and true value investors realize that markets often get carried away, lifting valuations to lofty valuation levels. We welcome a return to normalcy because we’re always cognizant of valuations, steering toward the bargains and away from the dear.
Randall Abramson, CFA
Generation PMCA Corp.
August 21, 2024
