Value in Hard Work

“The dictionary is the only place where success comes before work.”

—Vince Lombardi

The lazy days of summer are just beginning, but for the markets, they’ve been going on for several years. Signs of indifference are widespread. For example, instead of rolling up their sleeves and doing the hard work of fundamental analysis, many investors have taken the path of least resistance and simply poured money into passive index funds and exchange traded funds (ETF). While these products may serve a role in an asset allocation strategy, we’d suggest current valuations leave them open to painful losses if, and when, an inevitable correction occurs.

Current low volatility for stocks, in our view, is another symptom of the lackadaisical route many are following. As shown below, the Chicago Board Options Exchange Volatility Index (VIX) has been shuffling along near historic lows for months. Levels like this often point to rampant group think where a single popular view spreads and no one stops to ask the hard questions—what happens when interest rates go up? Can big tech really grow fast enough to support current lofty valuations?

Many management teams, recognizing an effortless way to boost earnings, have taken to borrowing on the cheap to fund stock buybacks. With fewer shares outstanding, earnings can go up without any actual improvement in margins and sales. Thanks to an all-too-willing Federal Reserve Board that has flooded the economy with easy money, the low effort approach has been working—at least for now.

So what could bring an end to this current cycle? Here are a few things we are watching:

  • Anemic gross domestic product growth points to earnings pressure going forward.
  • Consumer debt levels that are at pre-financial crisis highs.
  • A softer dollar that could trigger higher inflation and raise costs for businesses.
  • The impact of elevated short-term interest rates, which could take a toll on highly leveraged companies.

These items could be a headwind for many companies but expensive growth names may be the ones with the most to lose. Based on current multiples, the market is pricing in growth for these businesses that outpaces even some of the most optimistic scenarios from analysts. That means the slightest earnings misstep could be magnified and result in significant pressure.

The future, in our view, is much brighter for reasonably valued companies. As growth/momentum begins to wilt under the weight of ever increasing expectations, value should once again attract investor attention. Additionally, many sensibly priced businesses are just beginning to see their earnings inflect and, therefore, will be building off a more manageable comparison base as opposed to trying to meet unrealistic projections. Put simply, we’d rather invest in businesses that have ample room to improve than those that have no room for error.