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Current market valuation, Investment strategy

Independent Value – 2013 End of Year Commentary

2013 has turned out to be an excellent year for those invested in equities generally, with such representative indices as the S&P 500,  the FTSE 100 and the STOXX Europe 600 up approximately 32%, 22% and. 17% respectively.

The Independent Value Portfolio, established on 24 October 2013, remained 100% in cash for the period to 31 December 2013, generating a nil return, versus 5.1% for the S&P 500 for that period by comparison. As a result, I do not feel any great “pain” in having held cash rather than equities during the short life of the Portfolio to date as I sought to identify (with much frustration and difficulty) attractive prospective investments.  The opportunity cost of this 5% forgone from a richly priced and ever-rising market is one that I am willing to bear as I look to preserve capital first and earn an adequate return second by investment in significantly undervalued businesses. The challenge in the present market is that identification of such businesses is extremely difficult. Nonetheless I believe that such businesses exist, regardless of the general price level of the stock market.

There is a sense that I have come late to the “party” with the launch of the Portfolio in October 2013 – many of the potential candidates for investment that have come to my attention over the last two months were much more reasonably priced at the beginning of 2013, and would have made suitable investments had I been active prior to October. Hindsight, and “what if” analysis is futile and unproductive however. I hold the very clear view that stock markets are significantly overvalued at present, and have been throughout 2013, due to abnormal, exceptional and indeed artificial economic conditions. The chief driver of such conditions has been the co-ordinated monetary stimulus programmes of central banks, known as Quantitative Easing (QE).

Taking the US example, the three rounds of QE since 2008 by the US Federal Reserve have resulted in a prolonged, but nevertheless temporary and non-normal relative value environment. With bond yields being suppressed to abnormally low levels, investors have been coerced into chasing yield and the prospect of relatively higher returns from equities in order to achieve their return expectations( as such expectations ceased to be feasible once QE reduced bond yields to all-time lows). This has led investors to bid up the price of common stocks, as they have become more willing to pay higher and higher prices in order to achieve required returns, rather than face the alternative of holding low and even negative-yielding bonds.

An additional impact of QE in justifying the higher valuations reached by common stocks over the last twelve months has been the elevated level of reported earnings-per-share and profit margins achieved by companies. Again in the US, both measures have reached new peak levels, according to Standard & Poors data. The S&P500 actual trailing twelve months reported EPS to June 2013 was an all-time high of $90.95, also giving an all-time high reported profit margin of 8.97%, versus the average since 2000 of 6.43%. So reported EPS has never been better, and margins have never been higher. And what of current and forward-looking expectations?  As we enter earnings season for Q4 FY2013, reported EPS for the full year to 31 December 2013 are expected to be yet another new peak number of $96.72, with 2014 reported EPS expected to be an even higher $106.00, based on Standard & Poors’ own Earnings and Estimates Report as of today’s writing. But one must ask whether the expectation of yet further increases in corporate earnings against a back drop of continued economic challenges is realistic? It must be remembered that recent earnings and profit margins have relied significantly on abnormally low interest rates, which have had the effect of boosting net margins due to the exceptionally low (and non-normal) debt-servicing costs enjoyed by large-capitalisation companies. Additionally, the reported EPS numbers have also been enhanced by significant share buy-back programmes initiated by companies over the last three years, with buy-backs in many instances achieved by companies issuing new debt to buy-back large blocks of their own shares (e.g. Apple).  This has the effect of reducing share count while bolstering the bottom line with advantageous interest costs.

When one considers that consumer spending remains weak, unemployment levels elevated and little to no meaningful new lending by banks to individuals or businesses (apart from the large and already well capitalised), one must question the validity and sustainability of current corporate profitability, and therefore current stock valuations. In a true economic recovery, corporations should be hiring and making capital investments at levels greater than they are at present. Furthermore, in a proper recovery, interest rates should rise as the economy normalises. The impact of this would be a downward re-pricing of assets,due to increased interest rates, and a natural decline in corporate margins to more normal levels as a natural consequence of greater competition engendered by improving conditions, increased hires and investment. Instead, what we have seen is a higher multiple driven by relative value/yield concerns being assigned by investors to artificial, non-normal new-peak earnings.  Indeed both Deutsche Bank and Goldman Sachs equity research has indicated that approx. 80% of the returns achieved by the S&P500 index in 2013 were attributable to multiple expansion, not earnings growth, despite earnings reaching new highs.

The S&P 500 is currently priced at approx. 17x 2014 estimated EPS, which may not appear overly expensive. This is deceptive however, is it clearly reflects one of the most problematic yet reliable of analysts’ habits, the simple and mechanical extrapolation of current margins into the future.  At best this extrapolation of inflated, non-normal margins is aggressively optimistic, and at worst totally misleading. I view it as the latter.  Should eventual EPS fall short by just 10%, this multiple becomes 19x, while a 20% shortfall would move the multiple to approx. 23x. Multiples suddenly shift from full to very expensive, and afford little-to-no margin of safety at the general level. It must also be remembered that a fall in margins does not necessarily need to come about as a result of a “black swan” style global shock, new recession or other adverse event, but should naturally come about if a true recovery takes hold, as a consequence of the factors already mentioned, including higher interest rates, increased hiring and capital investment, and increased corporate competition. The fact that the US Federal Reserve opted to only reduce rather than unwind its bond purchase programme recently further suggests that a recovery is some way off. Thus  the stock market remains underpinned by an artificial back-stop.

In my view then, prospective relative return based on artificial conditions arising from abnormal interventionist monetary policy, rather than a focus on, and appreciation of, sound business fundamentals, became the primary focus for equity investors during 2013. This resulted in the relegation of the principle of capital preservation to second place, and where capital preservation is sacrificed for the prospect of higher returns being sought by frustrated investors willing to pay more and more achieve returns, things usually do not end very well. Other potential warning signals that featured in previous market bubbles also re-appeared during 2013, which should prompt investors to consider whether irrational exuberance is again at hand: there was a significant increase in the number of IPO’s of companies of questionable quality (Violin Memory being one such example, and the frenzy around the Twitter flotation indicating another), junk bond yields of c. 5%, renewed appetite for covenant-lite loans and CLO structures, investor margin debt at record highs, and a noticeable number of acknowledged investment experts publicly stating that the stock market is generally fairly valued (Buffett, Icahn, Druckenmiller, Cooperman all stated as much during the second half of the year). None of these potential warning signals deterred investors however, with equity fund inflows reaching a decade high by November, suggesting that while the smart money may be moving out of stocks, the dumb money is destined to play the role of greater fool once again. To my mind, all of these factors, coupled with the undeniably high price of common stocks by any conventional valuation metric at present poses a clear and undeniable basis for concern.

In such a risky environment then, what approach should be taken by the individual investor seeking to avoid permanent loss while growing his capital at an acceptable rate of return? Certainly, there should be no hesitation or reluctance to hold a significant amount of cash, given the risk inherent in holding bonds or equities generally at present. However, history has shown that undervalued securities may be found in any market environment, and I believe this holds true in the current climate – one simply has to apply additional rigour and endeavour to find value. I have identified the following as pockets of potential value as we enter 2014:

  1. Out-of-favour sectors – there are potentially undervalued businesses in those sectors and industries that did not participate in the QE-induced general uplift during 2013 ( e.g. basic materials – gold miners)
  2. Non-market correlated situations –potential opportunities in special situations or “work-outs,” involving M&A, spin-offs, tenders, liquidations and/or turnarounds, where businesses face company-specific catalysts or events that may unlock value, but which are independent of broad market themes, or a general advance in stock prices
  3. Generally undervalued businesses – although now much harder to identify, there remain businesses that may currently be suffering from temporary, reactionary price declines on short-term news flow, or  be undervalued due to either a lack of coverage or understanding of their operations. This can include both large-cap companies, and small-cap/illiquid securities

One benefit arising from the overvalued market at present is that it affords the patient investor the time to identify those businesses of excellent quality that may be suitable for investment in the future. Current price levels mean that there is no sensible reason to invest in Starbucks for example, priced now at c. 50x FCF.  However Mr. Market may very well offer it for sale at a lower price that undervalues the business in the future , allowing the patient and prepared investor to take advantage and profit.

Despite having been in cash for over two months and having seen equities perform strongly over the last 12 months, I feel no sudden urge or compulsion to jump headfirst into stocks. I am happy to maintain a patient and disciplined approach, seeking out absolute rather than relative value.  This approach may not do anything for my short-term returns, but thankfully I am not in the short-term game. Unless there is a significant correction across the general market, it is unlikely that I will be anywhere near fully invested in 2014. I will instead investigate businesses that fall into the three main categories of potential opportunity described above, and look forward to a great correction to provide me with better opportunities to grow my capital with significantly less risk.

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