The Equity Valuation Paradox

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Dear Fellow Investors,

"You May Be Right—I May Be Crazy

You May Be Right by Billy Joel

Long time stock market participants sometimes talk about having a “feel for the market.” A better way to think about “feel” is that years of experience may help you understand present day situations because of their similarity to a prior situation. We will call on Billy Joel and his song, “You May Be Right”, to teach us on this subject.

Lately, our “feel” for the current stock market rhymes with circumstances which existed in 1999. At that time, the excitement about technology stocks and the prospect of their future growth made value investors like us look “crazy” not to own them. I remember being personally ridiculed for not owning the hot stocks of that year. We have been getting the same kind of feedback recently. Today, “you may be right” when it comes to the highest price-to-earnings (PE) companies with the fastest growth rates, but they are inflating the overall PE of the S&P 500 (like they did in 1999) and setting up a huge spread between the index and the companies which meet our eight criteria for stock selection.

“Friday night I crashed your party Saturday I said I'm sorry Sunday came and trashed me out again I was only having fun Wasn't hurting anyone And we all enjoyed the weekend for a change”

In 1999, the S&P 500 Index rose around 20% and the entire gain came from the technology and telecom sectors of the index. No other sector “crashed your party” in the tech sector as Microsoft (MSFT), Cisco (CSCO), Lucent, Sun Microsystems and EMC (EMC) dominated the index performance. We spent the whole year with meritorious stocks, which fit our criteria and “said I’m sorry.” We made no money that year, because we had consciously decided the year before to abstain from owning the futuristic momentum stocks at 60-100 times profits or anything even closely resembling them. Our theory was, if there is going to be a hurricane in Miami, you don’t want to be in Palm Beach.

In the recent past, much has been written about the way the success of the S&P 500 and the revenue growth of technology stocks bedazzled investors. Just like in 1999, the “old economy” stocks, especially financials and media, have “trashed me out again.” We aren’t “hurting anyone” this year, but we are missing out on the gains the market has offered. In short, it feels like being “trapped in a combat zone.”

“You may be right I may be crazy But it just may be a lunatic you're looking for Turn out the light Don't try to save me You may be wrong for all I know But you may be right”

“You may be right” to own these glamorous and massively-capitalized stocks and we “may be crazy” not to own them. John Maynard Keynes recognized this while cautioning: “the market can stay irrational longer than most can stay solvent.” In the first half of the tech bubble, Fed Chairman Alan Greenspan warned us of “Irrational Exuberance” in late 1996, more than three years before that tech bubble burst. Regardless of how long the party will last, let’s dig into the numbers put out in academia to see where we might be today:

David Dreman’s study rebalanced the portfolio each year and showed the same thing that Bauman, Conover and Miller showed in their study. These studies were expanding on the powerful work with a static portfolio Francis Nicholson did[i]. He held the 100 cheapest stocks for seven years in his study from 1937-1962. Let us say one more time, cheap stocks outperform more expensive ones and expensive stocks underperform all the four cheaper quintiles of the S&P 500 Index over long duration time periods. Billy Joel would argue that “it just may be a lunatic you’re looking for.” The lunatic is the one who stands against the tide while the expensive stocks are ruling the day and hogging up stock market capitalization.

Over a ten-year time period, those who own overpriced securities, as a group, “turn out the light” on any ability to beat the market average or earn the index return. Microsoft is just now getting back to its high of early 2000. Cisco is around $31 per share and has to go up more than 2.5 times to get back to the old high. Lucent went down and out before getting acquired in what looked like a “take-under.” Sun Microsystems got taken under at a few dollars per share (crushing what was a $100 stock) and EMC is going private at a price one third of the highs of the tech bubble. The S&P 500 Index has gain over 114% since the beginning of 2000. Please “don’t try to save me” by using the argument that it is different this time!

We believe the spread between the cheapest and the most expensive common shares needs examination because it appears like it is the highest since 1999. When it comes to historical situations like this (the Nifty-Fifty stocks of 1972, the Dow Jones Industrial Average in the summer of 1987 and 1999’s tech bubble), risks are very high for both the owners of these expensive securities and the passive indexes are loaded with them by mandate.

“I've been stranded in the combat zone I walked through Bedford Stuy alone Even rode my motorcycle in the rain And you told me not to drive But I made it home alive So you said that only proves that I'm insane”

We dug into today’s S&P 500 and found a stunning disparity between the most expensive 100 stocks, the index average and the cheapest stocks in the index. To remain conservative in our examination, we avoided companies with negative earnings in the calculation and chose to equally weight the stocks. If this was done by market cap, the chart would be even more striking:

It is no wonder that we have felt like we are “stranded in a combat zone” in the stock market. Money moving into passive indexes is systematically buying drastically more of the most expensive stocks and the lack of liquidity exacerbated by an increasingly narrow market causes value managers like us to feel like we are “walking through Bedford Stuy alone.” As investors who lived through the 1999 episode, it reminds us how we can “make it home alive.” Why is the spread so immense and what could change in the stock market to see the playing field gravitate to the mean and take us back to more historical norms? “Remember how I found you there Alone in your electric chair I told you dirty jokes until you smiled You were lonely for a man I said take me as I am 'Cause you might enjoy some madness for a while”

The reason why academic studies on valuation agree is as simple as a truism from an old proverb; “a bird in the hand is worth two in the bush.” When investors get overly excited about technology stocks or the Nifty-Fifty in 1972 or Blue Chips in 1987, like we believe they are today, it looks like they are spending time in the “electric chair” with a “dirty joke smile.” Ben Inker, of Grantham Mayo Van Otterloo, shared the academic theory we think is connected to the current mania for tech stocks, including companies which might or might not have earnings coming far out into the future. Inker explained that the historically low interest rates have driven investors to extend the duration of their stock investments in the same way investors have extended duration in the bond market:

“Over the last six or seven years, most financial assets have done very well. The performance divide has not been between low-risk assets and high-risk assets or between liquid assets and illiquid assets, but between long-duration assets and short-duration assets. Long-duration assets such as stocks, bonds, real estate, and private equity have benefitted from a large fall in the discount rate associated with their cash flows, while short-duration assets have been hurt by the same fall. Investors tend to tilt their portfolios in favor of those assets that have done well. Today that pushes them to be increasing effective duration in their portfolios, right when the potential returns to those assets have dropped.”[ii]

For us, Inker goes on to explain that the bird in the hand has been left for dead by the two in the bush and it takes way longer to get to the bush than it did when interest rates were higher.

“Now think of all the years you tried to Find someone to satisfy you I might be as crazy as you say If I'm crazy then it's true That it's all because of you And you wouldn't want me any other way”

We at Smead Capital are doubling down on the idea that the interest rates, which determine the discount rate for long-duration assets, are going to rise. What could possibly “satisfy you” if that happens? First, we think it takes much better economic growth and higher loan demand to get there. We like banks and insurance companies which reside in the 100 cheapest stocks and will be positively affected by an increase in the velocity of money and the spread between short-term and long-term interest rates. We believe JP Morgan (JPM), Wells Fargo (WFC), Bank of America (BAC), American Express (AXP) and Aflac (AXP) stand to benefit from this era and fall in the cheapest quintile.

Second, we seem “crazy” as we anticipate the positive effects that a baby boom among women from 30-40 years of age could have on the U.S. economy. We like Disney (DIS) and Comcast (CMCSA) for entertaining kids and high speed access to the home. We think a large number of those homes will be built by NVR (NVR), the maker of Ryan Homes in 15 states.

Lastly, we believe the long-duration agony for those who have stretched on PE ratios and technology dominance will do the opposite of “satisfy you.” We think you’ll get the same comeuppance that these prior over-pricing episodes produced. Fortunately, it will re-explain and solidify that the academic studies show expensive common stocks as a group under-perform on a long-duration basis, like they have in every historical and worthy academic study we’ve seen. The buyer of expensive common stocks should beware. When it comes to extremes like this, investors should find “the lunatic you’re looking for.”

Warm Regards,

William Smead

The information contained in this missive 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 twelve-month period is available upon request.

©2016 Smead Capital Management, Inc. All rights reserved.

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