How do you sleep at night?
October 24, 2019
Market Summary – 3rd Quarter, 2019
“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
~Quote often attributed to Mark Twain
A common question investors are asked is whether they can “sleep at night” holding the portfolio of investments they own. Interestingly, the answer often depends on what’s happening in the market at the time.
For example, a select group of very familiar, mostly technology-oriented stocks has worked extremely well for a number of years, outshining the rest of the market. Owning these stocks has done little to disrupt sleep patterns. But it reinforces an important and risky trend – recency bias.
Investors tend to take events that just happened and extrapolate them into long-term trends. In doing so, they often overlook factors that will likely have a greater impact on their ability to accumulate and preserve wealth in the long run.
Losing perspective on “bad” news
Recency bias regularly comes into play via the quarterly earnings reports issued by publicly traded companies. The business media is inclined to exaggerate the significance of these quarterly events, encouraging short-term thinking by investors. Too many investment decisions are made based on the latest news, with little concern for the long-term implications or underlying fundamentals that more properly reflect the true potential of a company.
The trend toward short-term thinking is exacerbated by the fast money, headline-based, computer-driven traders who flash money in and out of stocks, indices or other instruments looking for a quick, narrow profit. Reactions to quarterly earnings announcements and forecasts seem to create greater volatility today than was the case in the past. But do quarterly numbers really tell the whole story about the long-term prospects of a specific stock?
What we see as market overreactions to short-term events occurred recently to two different businesses in our portfolio. While there were negative short-term ramifications for each of their stocks, we find we can still sleep at night. Let’s examine the two cases and explain our long-term confidence:
Corning is a rarity – a long-established company (170 years of history) that is on the forefront of today’s technological innovation. Many investors have the misperception that Corning is an old-line, unimaginative glass company. To the contrary, it is one of the most innovative technology companies in the world. Its smart glass technology is used in mobile phones and tablets, a business that should get a boost as the industry transitions to 5G technology. It is a major provider of fiber optic cable that is rapidly replacing copper wires for high-speed Internet transmission. This will enable many of the macro trends shaping the future such as the “Internet of Things” (the interconnection of web-enabled devices that will lead to new innovation and greater efficiency) and artificial intelligence. It also provides innovative solutions to the automobile, life sciences, and television screen markets. Corning’s growth opportunities are tremendous.
Corning invests in research and development at about double the rate of its average competitor, demonstrating its commitment to future growth. It recently received a $250 million grant from an Apple Inc. development fund to help it pursue the next generation of glass for consumer devices. This was on top of a previous $200 million award from the same fund.
Yet this seemed forgotten in mid-September when Corning lowered its expectations for earnings in the coming quarter. This was primarily due not to permanent flaws in its business model, but because some of its telecommunications customers decided to delay orders for a few quarters.
The demand for fiber cable is significant. There is bi-partisan pressure from Washington to build out a robust 5G network for a variety of reasons, including national security. This technological revolution will spur dramatic business innovation for years to come.
Despite the disappointing announcement, Corning, in our judgement, retains its long-run value. It returned $12.5 billion to shareholders over the last 3-1/2 years, even as it invested $10 billion in its own growth. The firm projects returning an additional $8 to $10 billion to shareholders over the next four years. That’s impressive for a company with a market capitalization of nearly $22 billion1. It is hard to imagine a future featuring 5G and improved technology without Corning, and we believe that the stock offers real value today.
FedEx, one of American’s legendary startup success stories from the 1970s, remains an intriguing story today. It is that rare, publicly traded company that is essentially an oligopoly. Shipping business competition is limited primarily to UPS and DHL. The likelihood of a new competitor challenging this dominance is slim. It would require investing in a fleet of planes, tens of thousands of vehicles and hundreds of distribution centers, not to mention the labor required to operate it all. To match what FedEx or UPS has today could require an investment of over $120 billion2, more than three times the current market capitalization for FedEx3.
Shipping firms are expected to thrive in this era of e-commerce, where volume alone is projected to double to 100 million units shipped daily by 2026. Such dramatic growth would be considered notable for any industry. A key portion of that is due to the increasing flexibility consumers have to return merchandise they ordered online. This again requires the services of firms like FedEx. Its business in returned merchandise is up 35% since 20154.
FedEx is putting billions of dollars to work to improve its infrastructure network and position itself to be the dominant company in its space. This will help it gain traction in the burgeoning Asian and European markets. The result, says chairman and CEO Fred Smith, is that FedEx “will, in the short zone market….be the low cost, high service producer.” If the economy holds its own, Smith anticipates FedEx will easily hit its target of 10 to 15 percent annual earnings growth per share going forward4.
Yet this bright future was lost on investors on September 18th when FedEx failed to meet current earnings expectations. It reduced earnings guidance for 2019 from $15 per share to $12 per share. FedEx finds itself caught between a rock and a hard place. Its business is lagging below expectations as industrial growth slows due to trade tensions. Yet it is spending massive amounts to upgrade its ability to meet the demands of the growing e-commerce business. The stock took a 13 percent hit the day after the earnings announcement was made, and its share price was down over 40% from its peak in January 2018.
Based on price-to-earnings ratio, FedEx is valued at a one-third discount to the S&P 500 index, yet its earnings growth prospects are greater. This well-positioned company serves a rapidly expanding marketplace. It has a seemingly impenetrable business model and a strong balance sheet. We are confident that this industry leader will recover and remain an attractive investment for the long run.
Should you be comfortable?
We sleep well at night because we own what we believe to be great businesses like Corning and FedEx that generate products and services designed to fulfill global demand. Typically, what these businesses create cannot be easily replicated. What’s more, these are well-managed companies with low debt levels. We believe that they are in a strong financial position to ride out any obstacles that may arise along the way, whether specific to their business or related to the broader economy. The firms that are included in our portfolio are often out-of-favor in the market, creating excellent opportunities to capture meaningful value. Buying good businesses at a discount provides an important degree of downside protection. Appropriately-valued stocks are not as susceptible to dramatic drops compared to today’s high-flying stocks.
By contrast, we wonder how some investors can sleep at night when they base portfolio decisions on a belief that the status quo in the market will continue indefinitely. Investing in the parts of the market that have proven to be popular under current circumstances can lull some investors to sleep, but perhaps they shouldn’t feel so content.
The “Bizarro” world of today’s markets
Bizarro characters are a creation of comic book writers, but the concept may be applicable for investors. In the Superman comics for example, Bizarro Superman was cloned from the Man of Steel, but in reality spoke and often acted in ways that were opposite to Superman.
Today’s markets have a Bizarro element to them. Investors are lulled into dismissing the risk in popular investments that continue to gain ground despite what we believe to be egregious valuations. We’ve mentioned many times the top-heavy nature of the S&P 500, for example, driven by the unbridled popularity of a handful of technology stocks. While investors may mistakenly presume that these stocks will never go down, the reality is that as their valuations grow, the risk of owning these stocks multiplies.
Investors’ recency bias has driven a select group of stocks to the most prominent positions in the market today. Microsoft, Apple, Amazon and Facebook are the four largest stocks in the index5. How realistic is it to think that these four, “must-own” stocks will always maintain such a prominent position?
History says it isn’t likely. The largest stocks in the index change frequently. Consider that at this time in the year 2000, the four largest stocks in the S&P 500 were GE, Exxon, Citigroup and Pfizer. Here’s what happened to those stocks since that time:
Investors in the year 2000 might have convinced themselves that they earned a good night’s sleep by owning these big, blue chip stocks. But in fact, three of the four stocks proved to be overvalued. Investors in these stocks found that their wealth was not enhanced or even preserved, but actually eroded. For those who invested in the largest stocks during other time periods, such as 1960 or 1980, the experience would have been similar.
Other traditional “safe havens” in the equity market today are no panacea, either. The S&P 500 utilities sector has the highest forward price-to-earnings valuation since data was first collected. Consumer staples stocks are valued at more than 20x estimated future earnings. Stocks most closely correlated to U.S. Treasury securities are at their most expensive level since 2004. Paying a premium for investments with below-market growth potential should not aid your sleeping habits either.
Prepare for a valuation-based correction
Markets have experienced volatility over the past few months, and since the bull market began in 2009, there have been a number of corrections (declines of 10% or more). Yet all of these corrections have been what we consider to be headline-driven, and the S&P 500 quickly bounced back once that news faded into the background. Examples include a 16% drop in 2010 as Greece faced a debt crisis; the S&P 500 recovered in a little more than six months. The onset of the Arab Spring in 2011 led to an 18% drop that took less than ten months to overcome. In 2015, a slowdown in China’s economy pushed the S&P 500 down nearly 12%, and it took a year to recover. Just last December, a yield curve inversion and simmering trade tensions with China led to a 16% decline in the S&P 500, but it recovered in less than 90 days. In contrast to these headline-driven corrections, valuation-based corrections tend to be much more severe, particularly for those who invested in popular and overvalued equities.
In such a correction, stocks that have grown to significant valuations over an extended period of time are subject to dramatic, long-lasting declines. By contrast, underappreciated segments of the market start to recover. One of the most prominent valuation-based corrections began when the Dow approached 1,000 in 1966 before beginning a long decline. It would not fully recover for another 16 years. More recently in 2000 it required over 15 years for the Nasdaq to return to break-even. That’s a significant period of time for an investor to wait to recover lost value in a portfolio. In both instances, those who invested in “what’s working” in the market were exposed to the most negative consequences.
This is why value investing works over time, even if it doesn’t work all of the time. A focus on price helps limit the risk of being subject to the worst that such valuation-based corrections can deliver. As exemplified by the experience of GE, Pfizer and Citigroup in the table to the left, the correction in overvalued stocks can take years, even decades, to overcome. By contrast, MPMG’s investment style has proven to be remarkably resilient, limiting the impact of difficult periods in the market.
We relish a good night’s sleep. We’ve found that paying the right price for a stock is better than counting sheep. This is increasingly important in today’s market, where a significant number of stocks have been driven to unsustainable levels. 33 stocks in the S&P 500 have a price-to-sales ratio of more than 10x6. This includes MasterCard (18x sales), Visa (16x sales), Adobe (13x sales), and Nvidia (11x sales). Microsoft and Facebook are knocking on the door of this threshold. Why is this a warning sign?
Consider this lesson from the frothy days of the dot-com bubble in the early 2000s. One of the popular stocks of the day was Sun Microsystems. It was priced at $64 per share at its peak. Two years later, its founder, Scott McNealy, stated that at that price, it was valued at ten times sales. “To give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I have a zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes, which is very hard.”
To wrap up his point, McNealy said, “Now having done that, would any of you like to buy my stock at $64 (at 10x sales)? Do you realize how ridiculous those basic assumptions are? What were you thinking?”7 Sun’s stock eventually dropped to as low as $10/share.
The lessons from that era must be remembered, as an increasing number of “hot” stocks continue to achieve unsustainable valuations. To investors who find those types of stocks represented in their portfolio, we respectfully ask them, “how do you sleep at night?”
1 As of October 7, 2019.
2 Aten, Jason, “It Will Cost Amazon $122 Billion to Build Its Own Delivery Network…”, inc.com, July 18, 2019.
3 As of October 7, 2019
4 FedEx Corp Q1 2020 Earnings Call, Sep. 17, 2019.
5 As of Sep. 30, 2019.
6As of October 10, 2019.
7Bloomberg Businessweek, “A Talk With Scott McNealy,” March 31, 2002.
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.