Generation PMCA commentary for the fourth quarter ended December 31, 2024, titled, "Too Great Expectations."
You know there’s too much speculation when stock market participants, who’ve become obsessed with rapid trading, including zero-day options (highly speculative leveraged instruments with same-day expirations), are having to attend Gamblers Anonymous meetings.
Market return expectations are at a high and borrowing to invest has surged, which is unusual when borrowing rates are unfavourable. A similar phenomenon occurred during the '99/00 tech bubble and near the markets’ peak in 2007. Strategists are also sanguine, expecting above-average double-digit stock market returns again in 2025.
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The expectation for U.S. tech stocks earnings growth for this year is way above the actual trailing 5-year growth rate of 11%, whereas historically there’s little deviation. Either IT earnings are about to take off or expectations are clearly out of whack. At 27x forward earnings, the tech market is expensive historically, but assuming 11% earnings growth, more in line with history, the resulting multiple—above 30x forward earnings—is sky high—a level only previously achieved in the dot-com bubble. Yet the amount flowing into tech-sector ETFs is at an all-time high market share compared to all ETFs.
S&P 500 earnings are expected to grow in the teens this year. While earnings growth could exceed the historic annual 6% average rate, already high profit margins suggest a possible reversion to the mean, which would compress growth. And a recession would likely cause negative earnings growth, at least in the short term.
The North American stock markets are trading at a premium to our estimate of underlying Fair Market Value (FMV); however, most appear complacent, believing a bull market will persist.
Everything’s Expensive
Long-term U.S. interest rates have been rising, because of heightened inflationary expectations and additional issuance of bonds while demand wanes. Mortgage rates have ticked back up too.
While inflation rates have declined, prices remain high. As an analogy, the running joke is, you’re put in a room and told it’s 100 degrees but not to worry because it won’t rise any further.
Prices for most shares leave us with similar discomfort. Both public and private market valuations have risen too high. Though valuations could become even more extreme if animal spirits heighten further and liquidity expands. If sources of liquidity eventually wane, look out.
Elevated expectations have resulted in elevated share prices. We prefer getting in on the ground floor—there’s less room to fall with more obvious upside. Most may soon be disappointed by stock returns that are unlikely to meet such great expectations.
The Bigger They Are
U.S. stocks now represent about 70% of the Morgan Stanley World index, despite the U.S. being 4% of the global population, 26% of global GDP, and 38% of global markets’ corporate profits.
Within the U.S. indexes, the level of concentration has eclipsed that observed at previous market peaks in 1973 and 2000. The top 10 S&P 500 companies represented 40% of the index as of year end, the highest concentration ever. Interestingly, over the last nearly 70 years, the top 10 S&P 500 companies have underperformed the rest by 2.4% per year.
Furthermore, when the S&P 500 reached its current valuation level historically, though it’s rarely traded so high, all subsequent 5-year returns were negative.
Typically, in any given year, about 48% of stocks in the S&P 500 outperform the index itself. Previously, in years when markets were highly concentrated, the underperformance was even more pronounced. And when more than two-thirds of stocks lagged the index, it marked the end of market concentration for such periods. In the last couple of years, just over 70% of stocks lagged the index, an unusual occurrence, and once again likely setting the market up for an end to its over-concentrations.
The top 10 companies are remarkable businesses. They’ve experienced clear growth in an environment when growth is hard to come by. These highly profitable juggernauts have grown by significant rates, especially in relation to their sizes. But the expectations built into their share prices may be unachievable. These have been capital light businesses; however, the AI race has most spending daunting amounts compared to their historical capital expenditures and current cash flows. Each is currently trading at or above our FMV estimates and each has its own issues.
Apple’s growth is slowing, and iPhone growth should slow to low single digits. While still growing its revenues by low double digits, Microsoft could experience cost pressures from cloud competition and its AI buildout. Nvidia is growing dramatically but it’s so dominant that competition is gunning for the company’s market share, and the AI race may have front-loaded demand. Amazon’s revenue grew by 12% but it was shy of 13-15% expectations and costs were generally higher than expected. Alphabet guided to low double-digit revenue growth but its search business is susceptible to AI and ad-based business vulnerable to a lower rates and volumes. Meta Platforms, like the others, is also spending significant amounts of capital to achieve market share in the AI space, which should materially lower free cash flow. Neither Tesla’s revenues nor its costs met expectations, and it remains the most overvalued of the mega caps, while it loses market share to BYD. The cars better drive themselves because the stock price already appears to be. While Broadcom exceeded expectations, its business is also vulnerable to AI competition. Berkshire Hathaway and JPMorgan Chase continue to meet expectations but both trade at full valuations.
On a trailing-12-month basis, these top 10 S&P 500 stocks are trading at a price-to-earnings ratio of about 47, way above the average stock valuation. They trade at 27x forward earnings, versus 17x for the S&P 500 when it is calculated on an equal-weighted basis. The average stock isn’t cheap either though. The median price-to-earnings ratio for the Value Line Index (1700 equal weighted North American stocks) recently hit the top 10% of its historical range.
What to Expect When You’re Expecting (a Recession)
A couple of pages complete and we’ve barely touched on our continued concern about a U.S. recession. Our Economic Composite, TEC™, alerted to one which has yet to occur, though it has alerted to recessions that have recently occurred in other major developed countries.
We monitor the business cycle for peaks because, since 1965, 2-year rolling losses of 20% or more have always been preceded by a peak in the cycle and were also accompanied by additional market volatility.
The U.S. economic cycle has been prolonged, likely by excessive stimulus. Still exceeding 6% of U.S. GDP, the federal government budget deficit remains at unusually high levels. Though this stimulus has buoyed the consumer and assisted in keeping unemployment low. The U.S has now experienced a record 49 consecutive months of job growth.
TEC™ is driven mainly by the inversion of the yield curve. Short-term interest rates were higher than longer-term interest rates for a record 20 months, and only recently did the yield curve un-invert—10-year U.S. Treasury bond yields once again exceed T-bill yields. This un-inversion (a normalization) is also significant because it has typically occurred only a few months prior to every recession.
A recession is precipitated by liquidity drying up because central banks are tightening, which is occurring in the U.S. and elsewhere.
While governments provided reams of excess liquidity over the last few years, another source of short-term liquidity has come from the ability to borrow Japanese Yen (an undervalued currency), at extremely low interest rates, and invest the proceeds in higher yielding instruments (just about anything). This should cease soon, since Japan has begun raising rates. Higher rates should prop up the depressed Yen, hurting borrowers (those short Yen) and forcing these major hedge funds, in this massive carry-trade, to cover borrowings or buy Yen. To do so, they would sell USD, which should constrain liquidity—fewer USD and less overall investment activity.
Don’t be perturbed if you had to reread the previous paragraph—it was rewritten more than once. Please don’t swear off our letters either. Some economic issues are clearly complex and don’t worry, there’s no test at the end.
Even if the DOGE (government efficiency) program is successful at cutting one-quarter of projected expenditures, about 1.5% of GDP, it could initially be detrimental for the economy, assuming most cost cutting would be personnel related.
Tariffs, though hopefully short-lived, are taxes on foreign goods and induce stagflation—slowing trade (even the fear of which could crimp corporate expenditures) while boosting prices.
Realistic Expectations
Over time, most returns from stock indexes come from earnings growth, with a bit from dividends. In the last 50 years, the nominal (including inflation) growth rate of the U.S. economy was about 5% annually. Over the same period, margin expansion enhanced corporate earnings growth to a slightly higher 6.5% per year. And the S&P 500 in the same time frame, ignoring fees, returned about 9% per year with an additional 2.5% from dividends. Since the market was at a low valuation 50 years ago and a high one today, market returns outstripped the combination of earnings growth and dividend yields.
The overwhelming driver of more recent returns has predominantly been much higher valuations. In 2024, market returns exceeded earnings growth in nearly every developed market.
As value investors, we expect most of our returns to come from multiple reversions, as our stocks rise toward our FMV estimates. While we also prize earnings growth and dividends—an integral part of our valuation analysis—they are just part of our return expectations.
Stock indexes today are high and vulnerable to valuation compressions. As valuations revert, it should subtract from stock index returns. Furthermore, the S&P 500 yields only 1.3% today, about half its historical yield. Even if the economy were to continue growing by 5% nominally, and dividends add another 1.3%, that doesn’t leave much room for upside in the short term if overall valuation levels revert from their highs.
For example, the Nasdaq 100, excluding the dot-com bubble, has traded on average at 19x next-12-months earnings. The forward multiple now is 27x. If, however, we use the annual earnings growth rate over the last 5 years of 12%, it implies a forward multiple above 30x (again, compared to 19x normally). Frankly, we’re not sure why others aren’t as concerned. Is it a result of FOMO, complacency, ignorance, or a dramatic upswing in earnings that we’re missing?
When U.S. investors’ allocation to stocks have been this high, it has coincided with a peak in the market. Valuations this high for the U.S. markets imply a flat return over the next several years.
Insider likely agree, as selling in the U.S. remains high with recent data showing 5 insider sales for every buyer. Nearly the most sellers to buyers in 35 years. Meanwhile, market timers (newsletter writers) are exuberant about stocks and gold, while detesting bonds. They’re invariably wrong when they’re so extreme. And their readers, retail investors, are invested in leveraged long-based ETFs way in excess of inverse (short) ETFs.
Secular and Cyclical Trends
The markets remain vulnerable to slackening economic growth (both internationally and domestically—from higher unemployment and a weakening consumer), a further rise in long-term interest rates, and oil price increases. China, a material engine of world growth for the last several years, could struggle with protectionism, rising debt, overbuilding, and poor demographics.
Poor demographics—aging populations and low fertility rates—are a problem in most developed economies. Over 2 births per woman are required to sustain population levels. South Korea is running at 1.1, having been only 0.7 in 2023. China and Japan were at 1.7 and 1.4 respectively last year. And immigration isn’t helping in these countries. In fact, China has net migration. Canada and the U.S. aren’t much better with birth rates averaging 1.4 and 1.7 respectively in the last couple years. Immigration helps but both countries are looking to be limit immigrants.
Money supply aggregates have been contracting. Lenders are skittish, so the velocity of money—how quickly it moves around the system—is falling too. This stifles growth.
The resulting disinflationary effects should allow interest rates to fall; however, despite true inflation easing (e.g., declining real-time rents though leases still show higher figures), inflationary expectations have increased from concerns about labour costs, energy prices (including electricity), raw materials, and transportation. While the increase in inflationary expectations could continue for a few months related to temporary price increases from hurricanes, fires, tariffs, and bird flu, we believe secular disinflationary forces remain in place, namely lower population growth, technological advances, and debt-suppressed growth rates—debt is too high everywhere.
Global capacity utilization has fallen to levels associated with all previous recessions in the last 60 years. Factories aren’t as full. A sign of moderating growth. China has slipped well below its average utilization, resulting in outright deflation and should lead to lower prices elsewhere too.
Albeit down from recent highs, the ISM Services level at 53 (from the ISM Report on Business surveys), is still indicating expansion. The U.S. economy is expected to grow by 2.9% this quarter. Unemployment is only 4%. The current picture is still rosy. And the markets refuse to sell off, even in the face of tariff threats and other Trump administration uncertainties. It’s as if the markets are ignoring the President. A t-shirt kind of summed up the markets’ attitude, “I Survived the Tariff War of February 4 to February 4.”
Our Strategy
We continue to hold a partial hedge against market declines for our Growth accounts by shorting an S&P 500 ETF (or holding an inverse long ETF) and/or the Vanguard Total World Stock ETF.
Despite our concern about a recession, we are constantly analyzing quality businesses, those with competitive advantages, high returns on invested capital, strong free cash flows, and healthy balance sheets; however, their share prices must be undervalued relative to our FMV estimates. On a bottom-up basis, we are finding fewer opportunities than usual since most companies are fairly valued or overvalued. Yet another reason why we remain defensive.
The U.S. stock market is over twice as expensive as foreign markets. It’s no wonder that we’ve been finding more investment opportunities outside of the U.S.
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.
Harrow is a highly focused (no pun intended) ophthalmic pharmaceutical company with 17 branded eye therapies. Its sales should materially lift, primarily from 2 new drugs: IHEEZO, an ocular anesthetic gel which works fast, has a predictable duration, and an 82% reorder rate, is desirable for retinal specialists who make more per procedure with it and for patients who prefer a gel to a needle in their eye (who wouldn’t?), and it has its own permanent reimbursement code—the only U.S. reimbursable anesthetic; and VEVYE, the first water-free cyclosporine for treating dry-eye disease, delivering 22x more cyclosporine to the cornea than competitor Restasis, and Harrow’s product already has a 92% refill rate likely because of its rapid onset, only twice daily dosing, and better tolerability. The company has a $1.1 billion market cap. Meanwhile management has guided to $1 billion of annual revenue by the end of 2027, which should imply over $300 million in annual earnings. Our FMV estimate is more than 4 times the current share price, though the company just became profitable last year, competition is stiff, and growth is dependent on a successful rollout by its growing sales team.
All Cap Portfolios—Changes
Changes to our large cap positions are 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 74 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 Veolia Group, Kesko Oyj, Cooper Companies, Ceasars Entertainment, and Deutsche Post (DHL). We sold Becton, Dickinson and Comcast, after buying them recently, when each fell below TRAC™ floors. We bought and sold Capgemini, when it lifted to a ceiling in line with our FMV estimate, and we sold Deere & Company, U.S. Bancorp, lululemon athletica, Sony Group, Disney, and Koninklijke Ahold Delhaize for the same reasons.
Veolia Group, listed in Paris, provides water, waste, and energy management solutions. The company serves over 110 million customers with wastewater services and generates over 40 terawatt-hours of energy. The rise of PFAS (per- and polyfluoroalkyl substances) in water is a boon for Veolia; it estimates achieving $1 billion in PFAS pollutants treatment revenues by 2030. Synergies from its merger with Suez are ahead of schedule and we expect more efficiencies to be identified over the next year. In the most recent 9 months, lower energy pricing impacted district heating and cooling networks, an issue we are monitoring. Our FMV estimate is €38.
Kesko Oyj, listed in Helsinki, owns and operates 1,800 grocery stores, building supply stores, and car dealerships across Finland, Sweden, Norway, Estonia, Poland, and Denmark. Its combined operations, generating over €16 billion of revenue, make it one of the largest retailers in Europe. Sales and earnings growth have been weak, particularly in building, due to the weak European economy. Recent results show signs that its performance may have troughed; Q4 sales and operating margins increased for the first time in eight quarters. We expect 2025 to be another muted year for Kesko, but the depressed shares do not reflect an eventual turnaround in economic growth or a reversion to higher returns on invested capital. Our FMV estimate is €23.
Cooper Companies was re-purchased once again. It is one of the 4 major global contact lens manufacturers. Cooper ended the year with record revenues. Its market is growing at 5 to 7% per annum. Cooper’s cutting-edge portfolio of vision solutions has taken market share, which should translate to a better-than-industry revenue growth rate of 6 to 8%. Management’s preference is to use free cash flow to pay down variable rate debt, though we’d prefer management to be more aggressive with share buybacks since the share price is undervalued. There are signs that competitors, notably Johnson & Johnson, are fighting back with aggressive rebates, though this has yet to dent Cooper’s momentum. Our FMV estimate is $110.
Ceasars Entertainment owns 50 casino properties across 15 states and in Canada (not a state!). The current incarnation of Ceasars is the result of a 2020 combination between Eldorado Resorts and the former Ceasars Entertainment. Eldorado has a long history of successful acquisitions, but the Ceasars deal was its biggest to date, resulting in over $26 billion of long-term debt against $4.5 billion of equity. To pare down debt, Ceasars has been selling non-core assets, such as the World Series of Poker intellectual property rights. Recent results have been hurt by weakness in its regional properties; however, we believe these issues are temporary. Cash flow should expand materially once the $435 million New Orleans’ renovation is completed. While its digital results reached an all-time high in the quarter, we believe there will be consolidation in online betting as the large technology companies enter the sector. Our FMV estimate is $45.
Deutsche Post, better known as DHL, is listed in Frankfurt and is one of the largest global logistics companies. DHL’s market share in many European and Asian countries exceeds 50%. The new U.S. administration stance on trade may strengthen EAFE trading ties, a potential tailwind for DHL. The company’s asset light model translates to less cap-ex spending than its competitors, UPS and FedEx. This also translates to high teens return on invested capital and ample cash flow generation for dividends and share buy backs. DHL reported flat EBIT growth in its latest quarter, reflective of a challenging European economy. Longer-term, we believe it can grow sales by 3-5%, led by faster growing divisions such as Express, eCommerce, and Supply Chain. Our estimated FMV is €50.
Income Holdings
U.S. high-yield corporate bonds (ICE BofA Index) yield 7.1%. Long-term U.S. government bond yields have risen, even while the Fed has lowered short-term rates. The bond market appears concerned with a lack of buyers for longer-term bonds and rising inflationary expectations. Spreads in the U.S. high-yield corporate bond market are still too narrow for our liking, and we remain worried about rising spreads caused by a possible recession and the rising delinquencies that typically accompany a downturn.
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 5.4%, and most of our income holdings—bonds, preferred shares, REITs, and high-yielding common shares—trade below our FMV estimates.
We recently repurchased Segro, a U.K.-based owner of warehouse and industrial properties yielding 3.9%, after it fell back to a discount to our estimated £9 FMV. We sold Invesque debentures because we were concerned about its restructuring plan.
Lowered Expectations
A MADtv skit from years ago parodied dating, where the participants had better than anticipated outcomes because expectations were set so low. On the contrary, U.S. and Canadian stock markets have set the expectations bar way too high. Outcomes are more likely to disappoint.
Indexes are overly concentrated in companies whose performance has been outstanding. This has been reinforced by a piling on effect from overly optimistic animal spirits, driving stock prices too high. Interestingly, Research Affiliates recently wrote a paper illustrating that buying companies that were kicked out of the index (talk about low expectations), would have resulted in a doubling of the index return over the last 30 years. It’s not merely about the underlying fundamentals but also the embedded expectations that govern prices relative to proper company valuations.
Because investors often lower expectations too far for certain individual companies, we search for compelling opportunities where shares price are, in our analysis, temporarily detached from our estimated values, providing potential undervalued entry points. Our criteria include high-quality, preferably non-cyclical, more predictable businesses.
Our expectations are already lowered for general market returns. When expectations are this high, our fear of losing overcomes any fear of missing out. We still see a high probability of an economic downturn and remain defensively positioned for that reason as well, and we continue to hold some cash and hedges that should protect our portfolios when everybody else’s expectations are lowered.
Randall Abramson, CFA
Generation PMCA Corp.
February 14, 2025
