"Those are my principles, and if you don't like them…well, I have others." – Groucho Marx
Of course, principles are supposed to be unbendable. But the recent global financial crisis and recessions have forced even the most thoughtful investors to revisit some of their long-held beliefs and evaluate whether some of these were true principles or just old habits. For example, one of my most successful and well-known value-investor friends commented a couple of years after the crisis, “Maybe we should have paid more attention to the macro picture.” I suspect that many value investors, who profess to be above all bottom-up stock pickers, have felt that way.
“Reality is merely an illusion, albeit a very persistent one,” said Albert Einstein. In the view of value investors, and from a very long-term perspective, the current liquidity-driven markets may be an aberration, but stubborn aberrations are worth paying attention to.
It all started under the U.S. Federal Reserve chairmanship of Alan Greenspan, when leading economists and central bankers adopted the notion that consumers’ net worth is what drives consumption, and more generally the whole economy. Since the two main components of a consumer’s net worth are home values and stock and bond portfolios, it became customary, at the first sign of an economic slowdown, for the Fed to intervene to boost these assets. This was done, directly or indirectly, by injecting liquidity into the banking system (to make home mortgages cheaper) and into the financial markets (to encourage discretionary spending by making investors feel richer).
Soon, however, it was no longer deemed necessary to wait for an economic slowdown. In what became known as the “Greenspan Put,” the Fed began to intervene without waiting for actual economic deterioration; i.e., whenever a stock market correction became somewhat worrisome. Not surprisingly, investors progressively convinced themselves that no major bear market in stocks or bonds could occur under the Fed’s watch, and eventually widespread complacency became “irrational exuberance.”
Liquidity, a concept that heretofore had been used mostly by relatively obscure technical analysts to predict short-term fluctuations in the stock markets, has become for the last several years the main driver, and therefore the most keenly watched indicator, not only of these markets, but also of the global economies.
Like most value investors, Tocqueville’s approach is primarily “bottom-up”: Individual stock selection prevails over macro opinions, be they about the economy or the markets.
This approach generally has been vindicated in the past, as value investors tended to outperform a majority of money managers over full market cycles; and this outperformance has been achieved principally during bear markets, by losing less than most. The reason, I believe, is so obvious as to sound simplistic: When a stock is selling close to the “intrinsic” value of its underlying company’s shares, it does not have to travel down very much to find a floor.
In spite of this “unquestionable” logic, the great majority of portfolios (including those of some iconic value investors) were engulfed in the panicky downward spiral that followed the Lehman Bros. failure, between the summer of 2008 and the final bottom, in early 2009.
As I remember it, things had been relatively comfortable during the S&P 500 decline of about 17 percent between October 2007 and August 2008. But then, with the failures of Bear Stearns and Lehman Bros., market liquidity all but dried up. Between panic liquidations and forced sales, the market lost another 42 percent in less than seven months!
That part of the overall 53-percent decline from the 2007 top to the 2009 bottom was generally indiscriminate – more so than I can remember throughout my career, with the possible exception of the one-day crash of 1987; but that violent but brief market episode did not trigger a global financial crisis or recession.
After this more-recent experience, one could not help but conclude that liquidity conditions could develop at the macro level that would trump the most careful stock picking. More important, perhaps, liquidity seems to have played just as big a role in the recoveries of the markets and the economies as it did in their collapse. The various stages of monetary “quantitative easing” implemented by the Fed, and soon emulated in diverse fashions by a majority of large central banks, engineered financial recoveries that have now carried a number of major stock markets to new highs. Meanwhile, recovery in the global economy, where quantitative easing first helped avoid a threatening collapse, seems to be gaining traction and spreading abroad.
Now that economic recovery is more visible, there is a great deal of debate about the aftermath of quantitative easing. Some argue that, since there is no proof that quantitative easing benefited the economies much in the first place, its disappearance will be a non-event. Others disagree and argue that, since we have become addicted to the effects of limitless liquidity, the aftermath will be characterized by withdrawal symptoms similar to those exhibited by drug addicts during detox treatment.
Debating the unprovable would be a futile exercise. However, I remember that it used to be said that when the United States caught a cold, Canada and Mexico would catch pneumonia. The impact of policy changes is often observable earlier and more directly at the periphery of large economies than inside them.
Today, the U.S. dollar remains squarely at the heart of the world monetary system, and I therefore find it ominous that, no sooner has the Fed started “tapering” its quantitative-easing experiment than currency turmoil is spreading among emerging markets and economies. There is at least a possibility that investors may be underestimating the potential impact of the withdrawal of the Greenspan (and Bernanke) “puts.” To me as a money manager, complacency always spells risk.
The developments I just outlined did not alter the “value-contrarian” principles that have guided me since my early days on Wall Street, and still guide me and my close associates. But they changed somewhat how these principles get incorporated into our investment strategy.
For example, we feel more comfortable holding cash now than in the past. This is not so much that we have suddenly developed a belief in market timing and expect the market to collapse.
Rather, it just seems to us that, after the recent recoveries and at current valuation levels, the upside potential for the U.S. market and several others seems limited. And when the upside is limited, the downside risks loom proportionally larger.
Crestmont Research’s Ed Easterling, author of Probable Outcomes (Cypress House, 2011), has done a lot of work on long-term (secular) market cycles. One can argue about details of methodology or the precise selection of dates, but his research makes the following quite clear:
- Bull and bear markets are determined primarily by increases or decreases in the market price/earnings (P/E) ratio; and
- It is more profitable to buy when the market P/E is low than when it is high.
The table below is extracted from a larger one published on Crestmont Research.com:
As of January 31, the Shiller P/E ratio stands at about 25. A number of analysts and investors have tweaked the traditional P/E ratio to smooth earnings cyclicality or to add some other valuation factors. The best known are Jeremy Grantham (Trades, Portfolio), of GMO; John Hussman (Trades, Portfolio), of the Hussman Funds; Ed Easterling, of Crestmont Research; and recent Nobel laureate Robert Shiller, of Yale University. None of them claims that his version is a useful market-timing tool, but most have predicted with some accuracy the kind of future returns one can expect over the 7 to 10 years following, given levels of valuation.
Unfortunately, from current valuation levels, most of these long-term projections are somewhere between uninspiring and dismal.
At this stage of a discussion, a broker would typically tell you, “This is not a stock market, but a market of stocks,” implying that there are always attractive investments somewhere, even when the overall market seems overpriced. And although this is a typical sales pitch, they usually are correct. This time, however, we may have to work harder to find those attractive investments.
On September 25, 2013, Business Insider published the graph below:
Compustat, I/B/E/S, and Goldman Sachs Global Investment Research
David Kostin, Goldman Sachs’ chief U.S. equity strategist, explained that investor demand for “value” has been so pervasive that low-valuation stocks had outperformed higher valuation peers by 12 percent in 2013. As a result, the distribution of S&P 500 P/E multiples was now its tightest in at least 25 years, implying less differentiation of companies based on valuation.
“With valuation clustered together, we believe there are attractive relative value opportunities where companies with different fundamentals are trading at very similar valuation levels.”
In theory, that would indicate that there are attractive relative values in the market since companies experiencing rapid growth, for example, might be selling at valuations similar to those of more mundane companies. But we have never been very attracted to relative value: It does not seem very smart, for instance, to buy a stock just because it is cheaper than another stock, which might itself be way overpriced. What we are looking for is absolute value in terms of potential return from cash flow, earnings, dividends, asset sales, etc. In this quest, I believe we have some advantage.
Listed companies, the analysts who follow them, and the executives who run them have become increasingly short-term minded in recent years. Stocks now routinely respond to whether they “beat” or “miss” quarterly consensus estimates of sales and earnings, and much of the stock trading takes place on that basis. Needless to say, quarterly earnings have very little to do with long-term strategies or other fundamental factors. By focusing on them, financial analysis has become nearly useless to long-term, fundamental investors.
We believe that by taking a three- to five-year horizon in our research, we have a chance to anticipate and benefit from real and material change in companies and industries, rather than being hostage to minor fluctuations in investors’ perceptions. We will occasionally be wrong, of course, mostly in timing; but at least we will have a chance to realize meaningful gains when we are right – with much less trading.
Our old principle still holds: Bottom-up stock picking prevails over our macro opinions. If we like an investment idea, we will buy it, regardless of our overall cash position. But we normally will start accumulating it slowly, always assuming that cheap may become cheaper before our hoped-for scenario unfolds.
Many of our friends and clients make fun of the fact that, when markets go down, I sound euphoric. But it’s not because I am masochistic; it’s just that the stocks I want to buy are becoming cheaper. We don’t like cash for its defensiveness, but for its potentiality.