“…and the home of the brave.”
October 23, 2020
Market Summary – 3rd Quarter, 2020
“There are known knowns; there are things that we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know….it is the latter category that tend to be the difficult ones.
– U.S. Secretary of Defense Donald Rumsfeld in 2002
It may be an understatement to say that 2020 is proving to be a confusing and often chaotic time for investors. We continue to struggle with the COVID-19 pandemic that has altered life as we know it, and the roller coaster economy that has existed since COVID emerged. We’re in the midst of an election season that could last into next year if the results are contested. At a time when headlines keep coming at a fast and furious pace, investors may feel it is an act of courage just to stay invested.
When fear is peaking and uncertainty is rampant, investors can often uncover real value in the market. This is precisely the type of environment where the foundations for great wealth are laid. Despite the uneasiness many feel about the state of the country, a very important fact has not changed – our American capitalist system remains the greatest wealth-creation vehicle that’s ever existed. Even so, not every investor will succeed. The system works best when you buy the right businesses at the right price.
©David Shanahan/The New Yorker Collection/The Cartoon Bank
The issues that have dominated the headlines all year are well-recognized realities. While the daily news is enough to give anybody a reason to feel unsettled, successful investors can differentiate between material and immaterial issues when it comes to long-term wealth building. This is a year highlighted by a number of distractions – “shiny objects” that can cause you to lose your focus as an investor.
Today, the major threats – rising COVID 19 infection rates, the prospect of another partial economic shutdown, the uncertainty about when a vaccine will become widely available and the potential for a contested election – are well defined and understood by the public in general and the markets in particular. In the immortal words of Donald Rumsfeld we quoted above, these would qualify as “known knowns” or perhaps, “known unknowns.” For example, a COVID vaccine seems to be a certainty (known), but the timing and effectiveness of it are unknown. The fact that 15,000 lawyers have been enlisted by the presidential campaigns to deal with contested election scenarios tells us that the potential for a disputed outcome is known.1 The unknown, of course, is the final outcome. Importantly, investors would be hard pressed to think of a single market meltdown caused by a known known or a known unknown.
Rumsfeld also famously referred to the “unknown unknowns.” History tells us that it is these “out-of-the-blue” circumstances that can create unanticipated negative consequences. The Titanic wasn’t sunk by an iceberg that was seen miles away, but by the sudden emergence of one that was, in the words of the ship’s lookout, “right ahead.” The market has been subject to similar circumstances when investors were blindsided by events that were not widely foreseen. It occurred with the sudden emergence of the COVID-19 pandemic as an economic threat in late February that led to a 37 percent market downturn in a matter of weeks. The same was true of the financial crisis of 2008 and the terrorist attacks of Sep. 11, 2001.
In each case, there was a sudden jolt of unexpected pain. Yet savvy investors who held their ground were rewarded in short order. Those investors who focused on owning great businesses at proper prices were best positioned to weather these storms.
The market will always be subject to sudden shocks, often with rapid consequences. Don’t expect “known knowns” or “known unknowns” to suddenly catch the market off-guard. In today’s environment, the “knowns” are vast, given how every investor has instant, 24-hour access to the latest news. The media may create an environment of fear, but investors should not live in fear of challenges that are known.
At the same time, it is counterproductive for investors to fret about risks that are not clearly visible to us. To live in fear of what cannot be predicted is an exercise in futility. Markets may rise or fall over the next six months. The reality is that nobody can tell you with certainty what the future holds. Too many investors in the past have made the mistake of pulling out of the market awaiting some well-publicized, media-saturated event of great foreboding that often doesn’t materialize. Remember Y2K?
©David Sipress/The New Yorker Collection/The Cartoon Bank
The lessons of Sir Isaac Newton
What has more bearing on the ability of investors to weather market storms and prosper in the long run is to pay attention to valuation. The biggest risk to investors today may not be the pandemic or the chaotic election scene, but their seemingly magnetic draw to own a beloved, select group of mega-cap stocks that are extremely expensive.
Our founder, Sr. Portfolio Manager Phil Grodnick, often states “Valuation is to markets as gravity is to physics.” These words serve as a timely reminder that no stock has an unlimited price ceiling, nor is it wise to assume it is safe to own even a great business at too high of a price. Ultimately, the financial fundamentals of the underlying business have to live up to the expectations created by the stock market. Very smart people often fail to recognize this. So-called “momentum” investors have dominated the market’s 2020 rally, just as they have in recent times. Look at the wild performance of the so-called FAANGM2 stocks over the past decade.
This chart illustrates how the small group of FAANGM stocks has essentially driven the broader performance of the S&P 500 since 2013. If the performance of these six stocks is subtracted from that of the rest of the index (green line), the stock market’s performance is much more subdued.
Momentum “investors” seek to latch on to rising stocks like these and hope the bandwagon doesn’t stop. We don’t call this investing, but speculation. As the trend persists, it gains more legitimacy in the eyes of investors and may work for a period of time. For those who believe such fads can be extrapolated into a long-term trend, we’ve got a tulip bulb farm we’d like to sell you. Ultimately, valuation rules the day and overvalued stocks will crash beneath the weight of unsustainable expectations.
Those of you who know us well know that we focus on fundamental valuation. While a broadly referenced valuation metric is the price-to-earnings (P/E) ratio, we at MPMG find this to be a highly flawed tool. We’ve learned over our combined 80+ years of experience that earnings can be (and often are) manipulated. That can make the “E” part of the ratio elusive. In our judgment, a company’s price-to-sales figure can be a more reliable valuation metric, as sales numbers are far more difficult to manipulate. This table demonstrates a clear risk in the FAANGM collective; at nearly 3 times greater than the price-to-sales ratio of the S&P 500 Index excluding itself, these FAANGM stocks appears to be meaningfully overvalued.
One of the smartest people of his time was Sir Isaac Newton. The famed physicist certainly understood gravity, but apparently did not appreciate the subtleties of successful investing. Three hundred years ago, Newton joined the crowd in trying a major momentum trade himself, the soon to be ill-fated South Sea Co. While it began as a trading company with a promised monopoly on business to Spanish colonies of South America, it ultimately assumed portions of Britain’s national debt as part of its business scheme. The company used its influence to get a leg up on competing firms, and its stock price soared as it became considered an essential, “must own” investment. South Sea’s stock value grew by eight times in early 1720, far beyond levels justified by its underlying business. The bubble burst in a matter of months.3 Like many investors, Newton was wiped out, losing the equivalent of $3 million in today’s dollars.4 It is a lesson from the Master of Gravity that his laws of physics apply to the markets as well.
The next wave
There are signs that a cyclical global economic recovery is upon us. For much of the past decade, in the absence of significant economic growth, stocks of companies demonstrating an ability to increase sales and earnings in a growth-challenged environment stood out. The aforementioned FAANGM stocks were particularly rewarded. But a change appears to be in the works. The Federal Reserve forecasts 4 percent growth in U.S. Gross Domestic Product in 2021.5 If that’s the case, it will be the fastest annual rate of growth in more than two decades. In such an environment, the FAANGM stocks would be viewed as less special. We believe this will trigger a rotation out of popular momentum stocks and into undervalued ones that carry less risk but retain attractive upside potential.
Other real-time data supports this trend. Business confidence has rebounded significantly from its recession-period low and business activity worldwide is surging.6 The housing market has shown surprising strength, with new housing starts exceeding expectations.”7 Through all of this, the Federal Reserve has fully indicated its plans to remain interventionist in providing liquidity to the market and keeping interest rates near 0% for the foreseeable future.
These factors are a reminder that we will move past the current state of chaos and uncertainty. The big question for investors is where to find opportunity as the economy continues to recover. We believe that well-positioned companies available at relatively bargain prices offer the truest, long-term potential for significant wealth accumulation. They offer both attractive opportunities for appreciation and a buffer against what is likely to be a volatile market environment as 2020 winds down.
Home of the brave
The media can be counted on to fill its 24-hour news window in the chaotic closing months of 2020 with endless speculation about how events might play out. We’re focused, instead, on what has made our approach successful over the long haul. It’s important to remember that through various periods of turmoil in the past, capitalism always demonstrates a special capacity to overcome difficult obstacles.
We’re already seeing those capabilities today in the rapid development of COVID vaccines and therapeutics. The technological advances of the past are playing a big role in helping scientific companies make swift progress in tackling the greatest health challenge of our lifetimes. While the journey to return to a normal life again may seem long, we know there’s a better future on the horizon. And there are undervalued businesses that stand to prosper. Even with dramatic alterations in the economic environment, we believe that a select number of companies are well positioned to prosper.
In the past ten years, successful investing has been confined to doing what was most popular and comfortable. In the coming decade, we’re confident that investors will be required to go against the crowd in order to succeed. Going against the crowd is not easy; it requires bravery. Bravery isn’t just a trait that this country is built upon, but it also lies in the heart of every successful investor.
1TrendMacro, Zoom meeting with election fraud expert John Fund, Sep. 3, 2020. (https://trendmacro.com/videos/zoom-meeting-election-fraud-expert-john-fund)
2This is an acronym for a group of giant, popular technology stocks – Facebook, Amazon, Apple, Netflix, Google (Alphabet) and Microsoft.
3Harvard Business School, The South Sea Bubble Collection – Baker Library, “South Sea Bubble Short History.” (https://www.library.hbs.edu/hc/ssb/history.html)
4Kessler, Andy, “Newton’s Law of Stock Momentum,” The Wall Street Journal, Sep. 13, 2020.
5Jasinski, Nicholas, “The Tech Boom Is Slowing. Here’s What Could Be Coming Next,” Barron’s, Sep. 20, 2020.
6Brown, David, “Why pandemic-shaken investors should be optimistic about global economic prospects,” South China Morning Post.
7Chen, Stephen, “2021: The Good, The Bad And The Ugly,” Forbes, Oct. 1, 2020.
Established in 1995, Minneapolis Portfolio Management Group, LLC actively manages separate accounts for individuals, families, trusts, retirement funds, and institutions. Our proven value-oriented investment philosophy has created long-term wealth for our clients.
Visit our website at: www.MPMGLLC.com
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted. Market returns discussed in this letter are total returns (including reinvestment of dividends) unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.