A few years ago, there was a TV commercial for the Toyota Camry featuring singer Kelly Clarkson and ESPN’s legendary sportscaster Chris Berman. It pointed out all the positive attributes of the new car with Clarkson’s hit, “Stronger,” playing in the background. As we look out into the second half of 2017, it is important to understand we believe the U.S. stock market has tried to “kill” investor enthusiasm. We would argue this enhances the position of the value-oriented and long duration equity manager in a way that does not kill us but makes us "stronger."
What is killing investor enthusiasm?
We see some obvious factors that are killing investor enthusiasm. First, up to 50% of large-cap U.S. equity ownership comes through owning the S&P 500 Index. For the stock market in general, it is like having a favorite sports team and having no individual players you root for or keep track of. Maybe Vanguard will form fantasy stock market leagues where index investors select a few stocks to follow and measure.
Second, the S&P 500 is heavily committed to the five largest tech stocks and, as a result, it is the most heavily overweighted it has been since 1999. This has multiple negative effects on investor enthusiasm. The success of the tech companies becomes myopic and usually appears to be a detriment to other S&P 500 companies. It narrows the number of successful stocks and it has the appearance of sucking all the stock market oxygen out of the room.
Third, the election of Donald Trump as president of the United States has ushered in an “in your face” era in politics. We had polarized politics in the Obama era, but now the power is held by exactly the opposite group of politicians and regulators. We would remind everyone how similar the lack of investor enthusiasm was in the first 18 months of Ronald Reagan’s presidency (from January of 1981 to July of 1982).
Fourth, this is the most anemic economic recovery from a deep recession in my lifetime. Slow growth has caused investors to crave sales or profit growth the way women crave a view of Ryan Gosling’s washboard stomach. Without faster economic growth, it is hard for main street businesses to gain investor enthusiasm.
Lastly, the stocks that have been successful rarely split their stock price to a level attractive to individual investors. It would be like selling 10 baseball cards for $25 per pack. Even though you like baseball cards, you cannot afford the entry price. Most of today’s success stories trade for more than $100 per share, a level that would have triggered a stock split in prior eras.
How does this make us stronger?
We believe the lack of enthusiasm for stocks and today’s set of circumstances provides a blueprint to future profits in U.S. large-cap stocks. Bargains are available, especially among companies which are viewed to be damaged by tech stock hegemony. Our portfolio currently trades at one of the biggest discounts to the S&P 500 Index since inception 9.5 years ago. This fact guarantees nothing in the short run, but should bode well long term.
Maniacal activity in tech stocks is easy for us to avoid, even when it causes us to underperform. Warren Buffett (Trades, Portfolio) says, “Excitement and expense is the enemy of your portfolio.” If anyone can prove there is no excess excitement attached to tech stocks today, they are not watching the semiconductor stocks. Mania avoidance makes us stronger.
The lack of investor enthusiasm is forcing investors to be more patient and should play into the hands of stronger, low turnover managers like us. Studies have shown the turnover among U.S. large-cap equity managers is 62%, costing them about 0.84% of their returns annually. In comparison, we have averaged less than 20% turnover the last eight years (1). Buffett says, “The stock market was formed to move money from those who are impatient to those who are patient.”
The last thing which is not killing us and makes us stronger is the demographic set up for the next 15 years. As you can see below, the number of 35 to 44-year-old Americans will explode in the next 10 years. This bodes well for marriages and household formation, not to mention a ramp up in the birthrate. Economic growth comes from more people and more productivity.
Today’s Circumstances
Numerous factors created by today’s circumstances make us stronger. Interest rates are historically low as seen in the chart below:
Stock prices in the S&P 500 Index are the most bifurcated since 1999 (see chart below) and set up a very positive 2000-2002 run for value investors.
Housing should drive higher gross domestic proudct growth as this chart shows:
Where are the bargains?
The same forces that are killing enthusiasm for stocks have been especially detrimental to the prices of media companies, drug and biotech companies and retail companies. The media companies like Disney (DIS, Financial), Tegna (TGNA, Financial) and Scripps Network (SNI, Financial) look particularly attractive. We also believe health care stocks like Amgen (AMGN, Financial) and Walgreens (WBA, Financial) live under the cloud of polarized politics.
In our view, homebuilders are held back by regulatory restrictions and some labor shortages. For long duration investors like us, NVR (NVR, Financial) and Lennar (LEN, Financial) look very good as the biggest economic need in our society (a lack of standalone homes) gets solved. The extrapolation of the death of retail driven by the success of Amazon (AMZN, Financial) has bolstered our interest in eBay (EBAY, Financial), Nordstrom (JWN, Financial) and Target (TGT, Financial).
If the pain of sitting through these years of low investor enthusiasm makes us stronger, we could be vindicated with multiyear rewards for patient long duration investors. Thank you for your confidence and trust in our stock-picking discipline.
(1) Source: Edelen, R.E. and Kadlec, G. (2016). “Shedding Light on 'Invisible' Costs: Trading Costs and Mutual Fund Performance.” Financial Analyst Journal.
Disclosure:Ă‚ Smead is long SNI, DIS, TGNA, AMGN, WBA, NVR, LEN, EBAY, JWN and TGT.Ă‚
The information contained in this newsletter represents Smead Capital Management's opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Bill Smead, CIO and CEO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past 12-month period is available upon request.
