The Valuation 50 returned 4.45% in the 2nd quarter of 2019, outperforming the SPY by 22 bps. The Valuation 50 outperformed the SPY by 20 bps and 117 bps in April and June respectively, and underperformed the SPY by 101 bps in May. (Total returns)
Value Versus Cheapness: Same, Same, But Different
Cheapness has existed as an investment concept forever, but it became institutionalized with the Fama/French’s 1993 three factor model. Cheapness has never been the same as hundreds of billions was poured into equity investment strategies focused on buying “low price to something” stocks supported by reams of back test data. In addition, thousands of small investment professionals and amateurs replicate much of the process the large firms employ via access to abundant datasets on Yahoo! Finance and other such services. This frenzy has culminated with the Morningstar Large Cap Value Category underperforming the SP 500 by approximately 250 bps annually in the last 10 years. During the same period, The Applied Finance Valuation 50 has outperformed the SP 500 by approximately 90 bps annually. Let’s explore why.
Thefreedictionary.com begins to identify why an approach such as the Valuation 50 differs significantly from a “low price to something” investment strategy:
Value: Monetary or material worth
Cheapness: Relatively low in cost
Finding stocks that are low in cost relative to last year’s earnings, book value or complex combination thereof (low price to something) is hunting for cheapness. From a portfolio construction perspective, cheapness has been an acceptable approach for decades, and likely will be again in the future. However, cheapness is not value. Cheapness works to the extent enough cheap stocks also happen to have value in excess of their market price at the same time. But there is no reason such overlap must exist – (remember that annual 250 bps shortfall?)
In the past decade, the business models of the world’s largest companies have dramatically changed. How much R&D were companies spending relative to Net Income in 1998 compared to today’s market leaders? As technology accelerates the creation and disruption of industries and business models, accounting based relationships that worked well in a backtests setting will at best lag (a decade?) in efficacy until new formulations are specified and at worst are not robust enough (or maybe never?) to keep up. Another example, companies will start capitalizing operating lease payments. How will current quantitative models handle such changes in leverage compared to decades of data that ignored such treatment? It is important to always remember – Cheapness is not value. An attempted work around this by more sophisticated investors has been to augment their cheapness indicators with other variables that attempt to capture more true value characteristics, such as the growth and profitability as specified in the Fama/French 5 factor model (For a discussion on the profitability addition to such models see our white paper on The Gross Profitability Trap). By moving their Cheapness investing style to closer replicate a Value approach, the better investment houses improved on the Category performance but ultimately fall short of true Value investing. It is unfortunate that Cheapness investing or “low price to something” investing has become the “spokesperson” for Value investing. True Value investing requires specifying a firm’s expected future cash flows discounted for time and risk to determine if it is worth more or less than its current traded price. Afterall, why should anyone think that last year’s earnings, next year’s earnings, or current book value represent the intrinsic value of a company which is the present value of ALL EXPECTED future net cash flows? Cheapness is a noisy proxy for Value, but Value is such a powerful investment concept, even a little goes a long way to support Cheapness strategies.
Applied Finance is a true “Value” investor, developing intrinsic value estimates by generating cash flow, and risk estimates for 20,000 global stocks weekly to determine their intrinsic value. Therefore, it is not surprising that The Valuation 50 results have deviated significantly from cheapness strategies. In a typical slice of the most attractive or unattractive stocks ranked on price to book vs deviations from intrinsic value, the overlap is less than 40%. Cheapness is not Value. The Valuation 50 is a unique investment strategy that has performed extraordinarily well, ranking in the top 5% for Large Cap Strategies since its inception in 2004 according the Zephyr. We look forward to continuously exploring the differences between our valuation approach to investing versus common cheapness strategies, and why the data points to valuation as a superior strategy for long-term investors.
Looking Backward and Forward
After enjoying another positive month in April for the US large cap. equity market, we all became complacent that a trade agreement between the US and China was around the corner. After all, we heard from both countries’ leadership that substantial progress had been made. Chinese President Xi called for negotiations to end as soon as possible, and President Trump predicted a monumental announcement in the coming weeks. While we all know a deal is not done until it is done, it still came as a big surprise in early May when President Trump tweeted on a Sunday that he would raise tariffs on $200 billion Chinese imports from 10% to 25% immediately, as China tried to renegotiate the trade deal after a consensus had been drafted.
Amid the trade deal impasse with China, President Trump in late May suddenly threatened to impose a 5% tariff on Mexican goods to be implemented right away, and the duties would increase every month until reaching 25% in October, unless Mexico stopped illegal immigration from crossing the US/Mexico border. Luckily, the threats worked and Mexico quickly reached an agreement with the US promising to take “unprecedented steps” to increase enforcement to curb irregular migration, including the deployment of its National Guard throughout the country — giving priority to Mexico’s southern border.
Fast forward to June, it is again the Fed that came to rescue, with Fed Chairman Powell on June 4 signaling an openness to cut interest rates if necessary, as the Fed keeps a close watch on disputes between the U.S. and its largest trading partners. US equity market rallied. As the month went on, the equity rally continued as it became clear Trump and Xi would meet at the G20 meeting later in the month. Then they actually met and agreed to restart the trade talk between the two nations.
The Trump presidency, in addition to impacting the equity market with big policy moves in areas such as corporate tax cuts and deregulation, has been unusually active in stirring up daily volatility. The President certainly holds little back when expressing his views on everything from interest rates, to big tech dominance, to drug prices, to whatever. Further, he seems to enjoy the “shock and awe” caused by his tweets. He likely cherishes the influence his tweets have in moving the market day in and day out, and strategically seems willing to endure short term volatility for long term policy wins. The latest Mexican tariff incident is a perfect example of how he announced a significant policy move in a seemingly random fashion, which however had to be a long, well calculated move. While traders trade, we believe investors with long term perspectives like us are better equipped to deal with the presidency under Trump. President Trump enjoys and embraces using public communication as a vehicle to achieve his goals, and he has no issue sharing the “sausage making” with the public to further his agenda. When making investment decisions, we have learned to focus on actions not words, and focus on the probable final outcome of his actions rather than taking at face value the actions themselves. Despite what many say or believe, the Trump Presidency, in our view, is not a negative to the equity market, if we can all learn to react more rationally to Trump’s words and actions daily. We still believe a grand trade deal with China will have a significant, positive long term impact on the US economy, as it will help protect the intellectual property right of US firms, enhance competitiveness of the manufacturing sectors, and secure the US’ long lasting dominance on technology and global economy as a whole. Alternatively, should a deal not materialize, we believe the groundwork is in place to begin securing new supply chains throughout Asia, Mexico, and to renew US based manufacturing. This path will likely create short-term pains for all concerned but may ultimately result in multiple trade partners reducing China’s influence on the US economy and achieving a geo-political goal of slowing down China’s continued economic rise. We will follow this news closely to understand the long-term ramifications on US markets and Valuation 50 companies.
Looking forward, we believe the biggest risk for the US equity market in the near term, is probably the Fed not cutting rates, as traders are pricing in nearly 100% chance of a 25 bps cut of the Fed Fund rate at the Fed’s July 30/31 meeting. Maybe we shouldn’t all be so sure – Fed officials likely would want to see some hard evidence that the outlook for the US economy has materially worsened since they met on June 19, but one major worry has been temporarily resolved when the US and China agreed to renew the trade talks more than a week ago. We strongly believe the Fed should make their rates decisions irrespective of political and market demand. The Fed’s dual mandate to achieve both stable prices and maximum sustainable employment suggests rate decisions should be based on data of the economy rather than volatile market moves. We believe whatever the market may demand at any moment, what is good for long term economic growth will eventually be good for long term market prices.
In addition, earnings season will begin in full force with JP Morgan (JPM) reporting on July 16. As of end of June, the SP500 19Q2 EPS is expected to decline 2.6% Y-o-Y, with revenues growing 3.8%. The index’s profit decline is expected to be mainly driven by Materials, and InfoTech sectors, owning largely to challenges in industries such as Metals & Mining, Semiconductors & Semiconductor Equipment, and Technology Hardware, Storage, & Peripherals. A significantly worse earnings season will certainly create volatility in the short term. For 2019, SP500 EPS and revenue are now expected to grow 2.7% and 4.4% respectively, vs the 7.9% and 5.3% expected at the end of 2018.
Looking further down the road, we believe the Healthcare and Technology sectors face changes that are much harder to predict.
Year to date, the healthcare sector was among the worst performing sectors in the SP500, underperforming the index by 753 bps and 333 bps in Q1 and Q2 respectively. A wide range of industries have been under siege as lawmakers demand tighter regulations, transparency on drug prices, and some Democratic presidential hopefuls propose the country implement a single-payer system, or “Medicare for All.” Managed care companies, health insurance companies, and drug wholesalers were the first to see their share prices pull back. Biotech and pharmaceutical stocks also fared poorly, as pressures remain on curbing drug price inflation, and some high profile drug companies are also facing patent cliffs in the foreseeable future and are struggling with new pipeline breakthroughs. In the Valuation 50’s healthcare holdings, two of the seven names – Celgene (CELG) and Allergan (AGN) have recently agreed to be bought out with relatively significant premiums to their latest prices. While we are happy to be able to potentially exit the two long term holdings at their 52-week high prices, navigating the current environment and finding winner replacement ideas won’t be easy. We expect the ongoing debate to remain a cloud over the industry leading into 2020, but expect drug price and overall health services pricing to be more pressing issues facing the industry than the possibility of universal care. As a long only sector neutral strategy, the Valuation 50 aims to own health companies that have the resources, the scale, the mindset, and the resolve to adapt and lead in any change or revolution ahead in the healthcare arena. Besides, the 50 aims to own health companies that command generous valuation buffers to give us sufficient downside protection.
Another important event that helped spike volatility in Q2 was antitrust concerns over big tech. The Justice Department in early June agreed to handle potential antitrust investigations related to Apple and Google, while the Federal Trade Commission will take on Facebook and Amazon. Lawmakers in the House are also looking into the tech giants’ possible anti-competitive behavior. This new development injected fear into investors that the first overhaul of antitrust rules in decades could emerge to keep up with an industry that didn’t exist when the prior laws were written. Given that President Trump, Democratic presidential candidates, Congress and consumers are all criticizing Silicon Valley over disinformation, privacy breaches and political bias, years of investigation and scrutiny may be warranted. However, Tech stocks quickly recovered the big losses they initially incurred upon the release of the news, which seems to suggest investors are betting the prospect of severe consequence is slim. A quick historic look at antitrust outcomes does suggest government efforts have been largely ineffective. In fact, there have been only three breakups in non-merger cases in the US, with the last one being the 1982 breakup of AT&T. The other two were breaking up United Shoe Machinery and Standard Oil, too long ago to be relevant to today’s discussion.
More relevant to today’s antitrust discussion are probably the two futile government lawsuits against IBM and Microsoft. In 1969, the government sued IBM for monopolizing “interstate trade and commerce in general-purpose digital computers,”. The lawsuit had proceeded for 13 years before it was eventually dropped. While some have blamed the DoJ’s arrogance and incompetence in botching the suit, the IBM case was long regarded as proof that the Justice Department cannot and should not try to restructure major global industries. In 1998, the US government wanted to break up Microsoft into an application and operating system business, an action it had pursued since 1992. Ultimately, the DoJ and MSFT settled in 2001 with the government imposing some constraints on Windows operating system businesses, including limits on certain contracting practices, mandated disclosure of certain software program interfaces and protocols, and etc. Both IBM and Microsoft provide relevant examples to illustrate how competition in the fiercely competitive tech industry might make antitrust issues mute regardless of how impervious to competition a company may appear. Market force is certainly the preferable choice over a breakup remedy forced by the government in a society like the US, which for most part still values free choice over government intervention. Needless to say, a forced break up is messy, painful, and usually hurt most stakeholders.