Generation PMCA’s letter for the fourth quarter ended December 31, 2023, titled, “Value Or Vile.”
A factor-based quant fund which uses various selection criteria recently dropped its value factor. That’s a real head-scratcher. Market studies of longer-term historical returns clearly show that value as a criterion is a leading factor. Though memories are short, and if value isn’t working then perhaps pressures to perform and emotional responses call for its elimination.
Q4 2023 hedge fund letters, conferences and more
To paraphrase renowned investor, and professor, Joel Greenblatt, value investing works, but it doesn’t work all the time which is the reason it works.
None of us is inherently patient. We hate waiting. Who doesn’t get agitated by airport security lineups, waiting for a table at a restaurant (especially when you have a reservation), or for a doctor to call you from the ‘waiting room’? With mispriced securities, whether they’re under- or over-valued, one usually must wait many months for Fair Market Value (FMV) to be reflected. Disparities in valuation are generally caused by overreactions to news, macroeconomic events which move entire sectors or markets, pressure from short sellers (incremental supply) or short covering (incremental demand), indiscriminate buying (e.g., entry into an index) or selling (e.g., fund redemptions), or often simple misconceptions from rumours or poorly disseminated information. All of these cause gyrations in prices away from FMVs.
Though short-term fluctuations in prices away from FMVs can be caused by many circumstances, markets have an incredible ability to filter through noise, over time, reverting prices to equilibrium—to intrinsic or fair market value. Profit motives drive investor buying or selling, such that demand overwhelms supply, or vice versa, until equilibrium is reestablished. Clearly, if one is finding truly undervalued securities, that are constantly being marked back up toward FMV, then market outperformance would be achieved. Though easier said than done.
Where’s the Value?
The U.S. and Canada are not value investments currently. Primarily because they’re pricey but substandard quality too. The balance sheets are poor—government debts at all levels are too high. Spending is way too high relative to tax receipts, exacerbating debt levels. Economic growth is slowing. Canada has already ground to a halt. Unemployment is rising, albeit from ultra-low levels. And central banks, fearing inflation, are keeping interest rates relatively high. All of this while market valuations are high—too high relative to near-term prospects.
The next-twelve-months earnings multiple for the S&P 500 is 21x. This compares to the 30-year average of 16x, when inflation averaged 2.5% and 10-year bonds 3.6%. The XLK, the ETF which represents technology stocks, is even higher, at 28x earnings. Not quite the lofty levels of the 2000 bubble but still historically high. Furthermore, Cypress Capital has run a model for decades which uses various market valuation multiples to forecast U.S. stock market returns for the next 7-10 years. It’s been quite accurate and today forecasts only a 1.4% annualized return. Markets should adjust to these disparities. Value works and markets should again return to equilibrium.
It’s Lonely at the Top
Market tops tend to take place over longer periods whereas bottoms end with a spike down—a capitulation as investors simultaneously give up. Tops are usually prolonged, because of extended positive economic news—a rising tide—and euphoric investor behaviour—a bandwagon effect. FOMO should be the 8th deadly sin.
We have two main concerns. First, as noted, the markets are too highly priced and susceptible to declines. Other than energy and real estate, essentially all sectors are above their average price-to-earnings valuations of the last 30 years. Using aggressively optimistic assumptions about growth and interest rates, one might argue that stocks generally are fair value. But growth has been waning. GDP for most developed economies has stalled. And except for the leading technology stocks, corporate earnings are also flat, and have been so for a couple of years. Passive index investing has now surpassed active investing. And U.S. stocks make up about 70% of the world’s market capitalization, despite its GDP at only18% of the global total. Stocks should revert to the TRAC™ floor they just lifted from rather than ascending nearly 30% to the next ceiling.
Second, unlike most today, we are still expecting a recession. Even the negative yield curve (when 10-year rates are below 90-day T-bills), which has a remarkable track record for calling recessions, and the core component of our Economic Composite, is being ignored since its lead time is so lengthy. Our TEC™, which has signaled the last 9 recessions, without a false alert, began calling for a Canadian recession in July 2022 while the U.S. signal occurred in October 2022. The average lead time from signal to a business cycle peak was 10 months historically. The U.S. is now at month 16 since our alert. Likely taking longer to reach a peak this time because the level of government fiscal and monetary stimulus was so high and unemployment has been so low, both acting as economic shock absorbers.
The U.S. Conference Board’s Leading Economic Index remains in negative territory as well and has remained there for 21 months. While weak manufacturing figures continue (in contraction since the fall of 2022), the service side of the economy has remained buoyant, though there are signs of waning there too (the services employment index has begun contracting). And half the U.S. states experienced a decline in GDP last quarter. It doesn’t help that other regions have softened too. The Eurozone entered a recession late in 2022, which arrived in a timelier fashion from our model’s alerts in those countries. European growth was flat in the latest quarter. China, the world’s growth engine at the margin, has also experienced slower growth. And the recently reported drop in global trade was a magnitude that hasn’t previously occurred without an accompanying recession.
Disconcerting Signs
U.S. employment has been outstanding, but last year 25% of job growth was generated by the government, disproportionate with the fact that government represents 19% of the workforce. The growth in overall hours worked has nearly halted and appears to be headed into negative territory, another precursor to a recession.
Credit availability has been shrinking for a year-and-a-half as banks tighten standards. Business loans fell in 2023 in the U.S., even with an expanding economy. It’s no wonder with high interest rates and the central bank shrinking the money supply—down 4% last year. We should begin to see the lagged negative implications—higher delinquencies and bankruptcies—from this shortly.
Deficit spending is out of control. If a U.S. recession is imminent, the onset would be accompanied by the highest budget deficit on record, as a percent of GDP, just prior to a recession. Which is troublesome at this stage in the cycle when governments should be preparing to ramp up for rainy days. Debt loads, as high as they are now, are problematic. They inhibit growth. And their repayment imposes other real vulnerabilities—inflation, devaluation, or default.
Other risks remain too. The political climate is disheartening. In North America, and elsewhere, we’ve been presented with candidates for whom most prefer not to vote. Geopolitical events have left us with wars between Ukraine and Russia as well as Israel and Hamas. Not to mention the economic implications from disruptions to energy and food supplies, safe passage of goods in the Red Sea, or funding of war efforts, refugee aid, and ultimately, rebuilding.
While inflation appears to be under control now—the 6-month annualized core PCE in the U.S. now just under 2%—a strain on pocketbooks remains for consumers from high prices for many items such as groceries, dining out, rent, car insurance, and travel costs. The pressures of the pandemic induced bottlenecks have passed. While used car prices were above new car prices briefly, the Manheim Used Vehicle Value Index is showing a 22% drop from its high 2 years ago. Commodity prices have been dropping, perhaps another leading indicator of slowing growth. The CRB RIND (raw industrial commodity prices of economically sensitive commodities) has been falling since early 2022 and continues to make recent lows.
We believe secular forces from high debt and lower population growth, which stifles growth, along with globalization and technological productivity, should keep inflation in check for the foreseeable future. China is now experiencing outright price deflation. Importantly, lowered long-term U.S. inflation expectations imply lower 10-year interest rates. Although interest rate cuts are likely, the S&P 500 has declined 21% on average to its lows following the Fed’s first cut.
To-ing and Fro-ing
Stocks and overall markets tend to vacillate between fair values and appropriate discounts. In fact, FMV generally acts as a barrier, or ceiling, for price. It’s normal course for large-cap securities to move between FMV and 15-25% discounts. Sometimes, though not often, they’ll trade up through FMV, to a higher level, but those instances are not typical. And it’s rare that overall markets trade above FMV. That’s the reason we believe markets are now vulnerable. We expect a normal course reversion down to a discount to FMV. A recession would merely expedite this.
Meanwhile, investors continue to purchase leveraged ETFs—close to recent-high levels—betting on even higher prices. Household allocations to stocks remain unusually high. We are not contrarian just to be so, but because common sense dictates it when others are being extreme in the face of evidence that suggests being contrary. This is also exhibited in the cost of hedging where put options prices are near all-time lows (i.e., the cost of insurance is relatively cheap).
Insider transactions of U.S. and Canadian stocks embolden our stance too since it’s showing nearly 4 sellers for each buyer.
Though stock markets are at all-time highs, they are essentially flat over the last couple of years, having reverted to the same TRAC™ ceilings which resisted further ascent in late 2021. Another decline should be forthcoming. Still, crystal balls can be murky. And even when visions of the future appear clear, the timing of events often remains uncertain.
Our Strategy
Our intention, because studies show it works over the long term, and since it’s intuitive to us, is to invest in undervalued companies—preferring those with competitive advantages, high returns on invested capital, strong free cash flows, and healthy balance sheets. Over shorter time frames, if businesses endure disappointing results, take longer to be appreciated by the market, or are offset by a defensive posture (shorting in the face of rising markets), underperformance results. That part isn’t our strategy but our recent outcome.
That said, we continue to add positions we believe are undervalued, despite having to review many more companies than usual to find candidates for the portfolio which also speaks to the markets’ overvaluations.
Since we remain cautious, we hold a short position as a partial hedge against market declines. Though there are reasons to believe that any recession we may have may be relatively shallow.
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 made several changes in our large-cap positions. We bought Telus Corp (NYSE:TU), Cenovus Energy Inc (NYSE:CVE), Amazon.com Inc (NASDAQ:AMZN), Charter Communications Inc (NASDAQ:CHTR), and US Bancorp (NYSE:USB). We sold Capgemini SE (EPA:CAP) after it lifted to a TRAC™ ceiling in line with our FMV estimate and sold Humana Inc (NYSE:HUM) and Cigna Group (NYSE:CI) (after buying both recently)—the former had disappointing earnings and the latter reached our FMV estimate.
TELUS had a strong fourth quarter which reaffirmed our belief that the company is the best positioned of the 3 major Canadian telecom companies. Its wireless net additions in Q4 exceeded both Rogers and BCE for the first time in 3 years. Furthermore, there are numerous company-specific catalysts on the horizon that should fuel free cash flow, earnings, and dividend growth, which include completion of copper-to-fibre migration, decommissioning of central offices, removal of the DRIP program, cross-selling, and the monetization of real estate and healthcare assets. Our FMV estimate is $30 and its dividend yield is attractive at 6.3%.
Cenovus Energy is Canada’s third-largest integrated oil and gas company. Over the last year, its share price declined and markedly underperformed its large-cap peers because it experienced numerous operational challenges at its U.S. refineries. Lingering rumours of a merger with Suncor also added to investors’ indifference. This left shares trading at a sharp discount to peers and its widest discount to net asset value historically. Refinery margins should improve, and we expect investors to refocus on the high-quality Christina Lake and Foster Creek assets, which account for half of its value. Oil prices have been volatile, but Cenovus’ investment grade balance sheet and its requirement that investments earn returns more than its cost of capital, even at US$45 oil, means the company can withstand even weaker prices. Production should rise in the low-single-digits with free cash flow reaching $6 billion by 2028. Our net asset value estimate is $30.
Amazon.com had recent results which clearly indicated that the company continues to fire on all cylinders. Growth at Amazon Web Services, its cloud business, accelerated to 13%. Advertising revenue rose 26%, driven by sponsored ads. Retail margins reached a record 55%. Trailing twelve-month operating income rose 201% year-over-year to $37 billion. Free cash flow also crossed $35 billion—we expect Amazon to generate over $100 billion of free cash flow by 2026. After a positive stock reaction to these results, shares trade closer to our $190 FMV estimate.
Charter Communications is the largest U.S. cable company. The sector has been undergoing dramatic changes, creating both challenges and opportunities. Consumer and business subscriber trends have been choppy post the lockdown-induced surge. Streaming, cord-cutting, and separation of sports from programming packages have shifted the landscape for content and advertising. Large investments in line upgrades and fibre optics are suppressing free cash flow. Charter’s recent results reflected this turbulence: the company lost 62,000 residential broadband subscribers and guided to higher-than-expected capital expenditures as it continues to roll out its fibre-optic network. We believe these investments will peak in the next 18 months and free cash flow should then surge. Charter’s free cash flow could nearly triple over the next 5 years—excess funds which can be used for debt repayment and share buybacks. Our fair value estimate is $500.
U.S. Bancorp is different than its regional peers. Regional banks have rebounded since the collapse of Signature Bank and others early last year; however, the recent plummet of New York Community Bancorp’s share price serves as a reminder that risks remain. NYCB’s problems appear to be bank-specific and not indicative of systemic issues. Meanwhile, U.S. Bancorp’s capital ratio is well above its minimum regulatory capital requirement. Its loans to office buildings represent only 13% of its commercial real estate loans. Deposit trends are steady. And multiple high-growth businesses (e.g., payments, credit cards) provide income diversification. The company appears to be refocused on nuts-and-bolts banking, along with revenue and cost synergies from its acquisition of Union Bank. Our FMV estimate is $50.
Income Holdings
U.S. high-yield corporate bonds (ICE BofA Index) yield 7.6%. After the U.S. government bond market experienced its longest bear market in history, from rising rates, interest rates may have seen their highs. We expect tighter credit and rising delinquencies to widen credit spreads, leading to a difficult market for high-yield bonds. 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.
We have been prizing cash and have made few purchases for Income portfolios recently. We sold SEGRO REIT because it lifted to a TRAC™ ceiling near our FMV estimate and Atlas Preferred shares because it rose near its par value. We recently bought Freehold Royalties, a royalty trust with revenue-based royalties from Canadian and U.S. major oil and gas producers. We bought it at a significant discount to our estimated $19 FMV and a 7.9% dividend yield. And we bought AvalonBay Communities, the largest U.S. apartment REIT, at a discount to our $210 estimated FMV. It is one of the highest quality U.S. REITs and yields 3.9%.
Valuing Value
You’ll never see us drop value as part of our process. That defies logic. Searching for undervalued securities—trading below our FMV estimates and possessing high-quality features—is the recipe for investment success that resonates most with us. Not simply because it’s backed by long-term studies that shore up its validity. But also because our temperament and tools are designed to take advantage of these strategies.
It clearly requires patience though, and extra patience during periods when value-based strategies are underperforming, whether attributable to growth stocks being preferred, or markets having run up too high. Now, with growth stocks so enamoured relative to value, we believe value investors should fare much better over the next few years.
Even without a recession to drag down earnings and underlying values, we believe that stock markets are susceptible to declines. But contrary to most, we are expecting a recession. Even more of a reason to cling to our value criteria. To hold undervalued, strong, noncyclical companies that can best weather a potential storm. To hedge against possible market reversion. Better safe than sorry. Better value than vile.
Randall Abramson, CFA
Generation PMCA Corp.
