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The Science of Hitting
The Science of Hitting
Articles (454) 

A Sound Premise, Distorted with Time

April 19, 2013 | About:

The recent decimation of spot prices for gold has revealed a lot about the way certain market participants think. As the price of gold moved higher and higher for years on end – and especially after the financial crisis – those proclaiming it as the ultimate safe haven and investment grew louder and louder; with each tick higher, their convictions grew stronger, and their estimates on where prices were heading steadily climbed.

Warren Buffett penned the following in the 2011 shareholder letter when discussing non-productive assets - a topic that came up time and again during the Q&A at the annual meeting in May 2012, when gold was trading around $1600 per ounce:

“The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As 'bandwagon' investors join any party, they create their own truth – for a while.”

If you remember back to when gold was running up towards $2,000 per ounce, the conversation was often based around this line of logic: (A) Some broad macroeconomic statement – fill in as you see fit; and (B) As a result, gold is worth more than its current price. Obviously, this fails to address a critical component of the equation: the relationship between price and value. The gold enthusiasts wouldn’t hear it. The price action proved they were “right,” and that’s all they needed.

Again, let’s go back to Buffett; this is from his interview with the FCIC discussing the housing boom and bust:

“The basic cause was, you know, embedded in, partly in psychology, partly in reality in a growing and finally pervasive belief that house prices couldn’t go down. And everybody succumbed, virtually everybody succumbed to that. But that’s the only way you get a bubble is when basically a very high percentage of the population buys into some originally sound premise--and it’s quite interesting how that develops--originally sound premise that becomes distorted as time passes and people forget the original sound premise and start focusing solely on the price action.”

This perfectly encapsulates the conversation around gold: Every move higher was loosely tied back as a reaction to the “events” mentioned above. Regardless of where gold prices had started, this line of logic suggested that they must move higher. Eventually, the price action alone was all that anybody needed to justify more; it alone became the premise for an investment in gold (with charts showing its astounding run over the prior years as further “evidence”).

I don’t bring this up to pick on the gold bugs; I think we may be in the midst of seeing a similar story play out in equities. With interest rates at their lowest levels in decades, fixed income looks quite unattractive by most measures. In addition, the recent run up among the major U.S. indices (which makes poor fixed income yields look even worse by comparison) has further fueled the conclusion that exposure to equities is a must.

One particular group of stocks are commonly perceived as a sound alternative to fixed income securities - dividend payers. As the thinking goes, dividend-paying companies offer the best of both worlds – in many cases the yields are higher than long term bonds; in addition, they offer the potential for price appreciation over time. This idea has become increasingly prevalent amongst the most popular investment blogs (“Dividend Growth Investors” are a dime a dozen) – and more importantly, it has started to be reinforced in a meaningful way by price action.

To be clear, I think we are still in the very early stages, assuming this were to play out at all; however, I think an example would shed some light on what companies fit this description (from my view).

Waste Management (WM) has spent the better part of the past decade giving back profits to investors in the form of dividends and share repurchases. As a result, sales and earnings – on an absolute basis – have been relatively stagnant; this measure looks materially better only after accounting for the decrease in shares outstanding from the aforementioned buyback. However, WM is running into a problem – while earnings haven’t moved higher for many years, the company continued to reward shareholders with higher and higher dividends. As a result, the payout ratio (on 2012 figures) has roughly doubled – from about 40% to 80%. They’ve alleviated some of the problem by pulling back on share repurchases (at least in 2012), which bought them a bit of breathing room; after averaging a collective return to shareholders (via dividends and buybacks) of more than 100% of net income for years on end, reality looks like it’s starting to set in. In addition, the company has nearly $10 billion in debt – a level that has increased by about 20% in the last five years, but with unchanged interest expense due to lower rates.

On the plus side, the stock sports a solid dividend yield of 3.7% - and one that’s been growing; this, along with earnings/cash flow stability, means that it is a likely favorite among the dividend crowd. Year to date, the stock has moved 13% higher. It currently has a trailing P/E around 20x.

This is one example, and isn’t even particularly egregious; however, it’s not too difficult to imagine what will be said if this stock is eventually trading at 25 or 30 times earnings – “it still has a dividend yield higher than 10-year Treasuries!”

If this were to play out (and to reiterate, I don't think we're there today), just remember how quickly things can change – as gold investors have realized over the past eighteen months, it would take many years of dividend payments to cover the losses on an equity position where the earnings multiple cratered from 25, to 10-15x.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct". I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 4.0/5 (22 votes)



Swnyc2 - 4 years ago    Report SPAM
Dear Science,

Nice article as usual,

It seems we continue to be in synch, as I've recently decreased my position in RSG, which is just one or two steps behind WM in valuation and payout ratio.

The problem is that when interest rates go up, there will be few places to hide.

Equities generally do poorly when inflation increases. Those that do best typically are "safe" stocks with pricing power like WMT. However, these stocks are also generally looking expensive.

So what is one to do? One could sell equities and hold cash. The problem is that it is unclear exactly when inflation and interest rates will increase. Because I don't believe I can time the market, I don't like this option.

Another strategy, which I've recently considered, is to rotate into some stocks where the price is not so reflective of FCF. This can be a diverse group. Some examples could include JCP, KWK, GTI, and COCO.

My thinking is that when interest rates rise, stocks whose values are based more on asset value or special circumstances, rather than forward cash flow, may not be hurt so badly.

What do you think?


The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM


That's a good point, and I'm certainly not advocating that one bail out of equities. My concern would be contained to companies with characteristics like WM, which can loosely be described as "safety + dividend". I think this combo is in the sweet spot for the "fixed income alternative" crowd - a nice mix of safety (again, reinforcement via price action is critical) and a yield that puts the 10-year to shame; this is a sound premise - but if price vs. value is substituted for bond yield vs. dividend yield, then I think it could setup to end very badly over time (especially for companies like WM, that payout the vast majority of their earnings in dividends, and as a result have limited room to reinvest in their business).

To your question, what is one to do? I can tell you what I've done; go back and read my portfolio review article from January 5th if you're interested in my holdings. I bought a bit more Microsoft early this year when it dipped under $27, but not too much; I will likely add more to MSFT in the near future (read the most recent transcript, particularly on the shift to multi-year licensing in MBD and the continued success in S&T; other segments have key improvements as well).

Besides that, I haven't bought anything else (close to adding more to FLIR though). In terms of selling, I've pulled back ever so slightly on JNJ & PEP as they've got much closer to my fair value targets; I'll continue to do so with each 5% gain (roughly) in the near term, but I'm in no rush to do so for many of the reasons you've noted. If I'm forced into cash as holdings become overvalued, so be it; I will not chase equities if I cannot find undervalued stocks.

Thanks for the comment! Would love to hear your thoughts on that!
Swnyc2 - 4 years ago    Report SPAM

I just read this news story and thought of FLIR and you.

For the reasons that you've described above, I recently sold all of my JNJ, BDX, SNY, some of my RSG, and none of my SPLS (it's just too cheap!).

I, too,like MSFT and most recently purchased more at the beginning of the year. It currently comprises 12% of my portfolio. (I don't have any plans to add more soon, as I'm unwilling to run as concentrated a portfolio as you.)

I've had to find some other equities to replace them.

GM and NOV are a couple inexpensive low/no yielding stocks that I've purchased recently in substantial amounts. I think they likely would withstand an interest rate increase better than most.

And, as I said above, I've purchased some "special" stocks whose prices may not be influenced so much by interest rates due to special situations. They may be considered to be a bit more speculative (JCP, KWK, COCO, GTI). I haven't bought a lot of any single stock. I'd consider buying more of each of them except for JCP.

We will see.

The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

I saw that on the news the night of! Pretty cool stuff...

Agreed on JNJ; I peg fair value a bit higher than the current price, but agree that it's got much closer to FV than it was a few months ago. I'm also cognizant of a few key concerns, particularly (1) the potential for private label to really hit OTC medicines, and (2) poor capital allocation, namely issuing equity to acquire Synthes - a decision that really annoyed me, to say the least.

Agreed on SPLS - I'm concerned of making the position to large (due to the long-term headwinds for brick and mortar retail), but like the stock a lot with an FCF yield in the teens and sound capital allocation (I think any large scale M&A is unlikely after the result on Corporate Express).

On MSFT, this quarter was the first move towards shifting sentiment - people are starting to realize that MSFT's offerings, especially in MBD and S&T, will be in the enterprise for a long, long time. This holiday season, we will see cheaper and cheaper touch screens (tablets, phones, PC's, and Ultrabooks) featuring Win8; I've said it before and I'll say it again - I wouldn't be surprised to see this stock much, much higher in a relatively short period of time.

On JCP, I'm waiting for quarterly results; I also want to see how discussions around debt issuance play out (really want them to utilize those non-core assets ASAP).

Thanks for writing back!

Varunfriend premium member - 4 years ago
Great article Science .. really enjoyed reading it.

Two questions come to mind and am curious to hear your and everyone elses thoughts on:

1. Is Fixed income being unattractive not a direct result of the exact mindset you describe? If so, should the fixed income bubble not be closer to being popped compared to equity bubble you describe?

2. When you decide to sell something at Fair value, does it make more sense to try to sell it at (1+taxrate)*FV rather than FV if your gains are not in a tax advantaged account?

The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

Glad you liked it!

1) Explain further - not sure I'm understanding exactly what you mean.

2) That's a good point and one worth consideration; if you're in a business that can generate attractive returns over time, the hurdle rate to sell should be pretty high for exactly that reason. Obviously it also depend on what alternative opportunities you have available to you.

Thanks for the comment!

Varunfriend premium member - 4 years ago
What I meant by (1) was that general sentiment is that fixed income is "safe" and as markets stretch for yield it is likely that there is a bubble there .. my hypothesis is that a bubble in dividend paying equities is only a sideeffect of the distortion in the fixed income markets. If that is true, then (in theory) it would mean that the fixed income bubble should be far closer to getting popped compared to equity bubble and potentially a lot more devastating too.
The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM
I hear what you're saying - I'd only note that nearly everyone thinks bonds are overvalued; I think an equity bubble in dividend paying stocks (particularly lower quality dividends - in my mind, ones like WM) could sneak up on people with time...
Varunfriend premium member - 4 years ago
I guess the Yogi Berra quote "Nobody goes to that restaurant anymore. It's too crowded" ... is quite apt here :).

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