2021 | Q3 - The Conversations that you Never Hear
“When the music stops, in terms of liquidity, things will get complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
- Chuck Prince, CEO, Citigroup, in July 2007 before the financial crisis hit
(Mr. Prince resigned from his job in November 2007 amid disgrace resulting from the mortgage crisis.)
The music has gone on-and-on for the better part of the last decade, and investors keep on dancing. They continue to pour money into the expensive mega-cap stocks, mostly without pause, and with seemingly little consideration to the increasing risks associated with doing so. Dance fever has even infected a number of unlikely participants…value managers. We have had some anecdotal conversations with professional value managers who have been unable to withstand the allure of chasing returns by owning these mega cap growth stocks.
The underlying story has been repeated so much that it’s almost like a broken record – value stocks have been mostly out-of-favor for a historically long period of time, going back to 2010. During this time, mega-cap technology stocks like Alphabet (Google), Amazon, Apple, Facebook and Microsoft seem to be considered, in a sense, the “safe havens” of the stock market. A failure to own these stocks has resulted in these investors lagging the popular indices. We’ve certainly been talking about this phenomenon in a number of our recent newsletters. You may be tired of hearing about it, just as we are tired of talking about it.
©Teresa Burns Parkhurst / The New Yorker Collection/The Cartoon Bank
So let us tell you more about a story you haven’t heard much about. It’s about the things we hear in our “closed-door” conversations with some of our counterparts who, like us, are professional value managers.
A number of them tell us (and we see it based upon what they own for their clients) that while they espouse the virtues of value investing in their public stances, they have veered away from their investment mandate and, more surprisingly, their deepest-held beliefs as investors. In order to keep pace with equity market indices against which they base their performance (which helps attract and retain assets), these managers have chosen to invest in some of the major, mega-cap technology names that are currently off the charts in terms of valuation. What’s more, they refuse to sell these same securities for fear of not keeping up with the index. These managers are, in our opinion, gambling with their customers’ money that this momentum trade will keep working, and that they will be able to avoid the potentially catastrophic losses that may occur when the momentum ends. This is, in our judgement, a dereliction of duty. Value managers must remain disciplined and uncompromising in their commitment to respecting individual company valuation. They must not be swayed by self-interest or the allure of momentum. We believe that trying to keep pace with an index, which is subject to the temperamental emotions of the investing public, isn’t in the best interests of their clients. These index-following managers have demonstrated that they are driven not by their principles or standards, but by FOMO – the Fear Of Missing Out.
An inflection point
We see notable symbolism in this development among our value brethren, and a reason for optimism that the market may be close to reaching an inflection point. Today’s conversations bear a stark resemblance to many we had in another period of runaway valuations. Back in the late 1990s, we spoke with investment managers who, like us, focus on a value approach. At that time, one of the stocks riding in the stratosphere of the dot-com bubble was a relatively new company called Cisco Systems. Amazingly, many value managers shared with us (while downplaying to their clients) that despite Cisco’s stock being valued at more than 20 times its sales, it was included in their portfolio mix. This high-flying stock, one that didn’t pay a dividend, was even held by managers of income-oriented funds.
The reason? They were concerned that if they didn’t own Cisco, their portfolios would fail to keep pace with the broader market. Or to state it in different terms, it was another case of FOMO. Their investment mandate and personal convictions about how to best achieve returns over the long-term took a backseat to short-term performance.
Those managers paid a price. Cisco’s stock peaked at $82.06 per share on March 27, 2000, and then the bottom fell out. At its low less than two years later, Cisco’s share price dropped to $7.11. It has slowly recovered, but not completely. 21 years after peaking, Cisco’s price is still more than 30 percent below its all-time high¹.
The logic of valuation
Our steadfast commitment to value investing is centered on individual company valuations. History has shown us that the price one pays for an asset not only offers the greatest protection against losses, but also lays the foundation for future capital appreciation.
One valuation measure that is raising eyebrows is “price-to-sales” ratio. It demonstrates in stark terms just how unrealistic investor expectations can be. We saw it soar off the charts in the late 1990s and early 2000s, and a similar trend is happening today. 25 percent of stocks in the S&P 500 Index are now trading above the ten times sales mark. The only time more stocks fell into that range was before the aforementioned dot-com crash.
Source: GMO, Compustat, Standard & Poor’s
What makes the “ten times annual sales” a reasonable reflection of market frothiness? Reflecting back on the dot-com days, Scott McNealy, CEO of Sun Microsystems, another tech stock that reached unrealistic price levels, had this to say:
At 10 times revenues, to give you a 10-year payback, I have to pay you 100% of revenues for 10 straight years in dividends. That assumes I can get that by my shareholders. That assumes I have 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. And that assumes you pay no taxes on your dividends, which is kind of illegal. And that assumes with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at $64? Do you realize how ridiculous those basic assumptions are? You don’t need any transparency. You don’t need any footnotes. What were you thinking?”²
This isn’t just theory. History provides lessons on the downside of paying a price that sets unrealistic expectations. The Sun Microsystems stock price dropped from over $60 to $3.11 by the end of 2002. Equities that sold for 10 times sales have underperformed the market by more than 4 percent per year since 1980. This reduced what was a 30-fold gain realized in the broader stock market to just a 4-fold gain over that four-decade period.
Source: GMO, Compustat, Standard & Poor’s
Sustainability matters
The falls of Cisco and Sun Microsystems serve as reminders that “up” is not the only direction for stocks. At some point, underlying value must justify the prices these stocks carry.
The market’s appetite for technology remains recklessly insatiable. Today, nearly 40 percent of the S&P 500 Index is made up of two sectors that represent what many would define as the growth-heavy technology marketplace. It includes the technology sector itself (28 percent) and communications services (11 percent), which mostly includes stocks in the digital marketplace³. For points of reference, consider that the “digital economy” represents less than 10% of the U.S. economy⁴. In addition, today’s 40% weighting is considerably larger than technology’s previous dot-com peak of a 34% weighting within the S&P 500 Index.
While it may be difficult to sit back and observe as stocks that we believe carry significant risk continue to prosper, we recognize that this has created an outstanding opportunity for us to acquire quality (and underappreciated) businesses at a discount to what we think that they are worth. Once again, history can serve as a guide.
Let’s go back to the “dot-com bust” era from the early years of the new millennium. At the start of that period, value had been out of favor for an extended period of time, not unlike the past decade. When the music ended in 2000, many investors were caught by surprise. The Nasdaq Composite Index (which was heavily weighted towards these dot-com names) fell by 78%; it took 16 years to recover these losses. The S&P 500 Index also crashed, falling by nearly 50%. It would take almost 13 years to fully recover from these losses. By contrast, those who demonstrated patience and a belief that valuations matter, a position that was at odds with the market’s overwhelming momentum, prospered. This demonstrates why we remain so committed to our value investment methodology. When the markets are roaring, value investors tend to do well – but not necessarily as well as growth investors. But when the cycle shifts, growth investors are prone to significant losses, while value investors tend to be much better protected . . . and can actually thrive. For many value investors, this means that you get to keep your money even when the cycle shifts, as it inevitably will. Ultimately, price matters, even if there are periods where it doesn’t seem to.
Third quarter head fake?
Following a decade of growth stock dominance, the tide began turning toward value stocks in the closing months of 2020 and first half of 2021. At this point, we had a vaccine to the COVID-19 virus, the economy was booming, and interest rates were rising quickly. As we’ve pointed out in past newsletters, rising interest rates generally benefit value stocks, and are a hindrance to companies carrying robust valuations.
This economic upturn made those select few mega-cap technology stocks that dominated the market a lot less appealing. Impressive investment opportunities shifted to other segments of the market. Investors recognized that it wasn’t necessary to pay extreme premiums for a narrow band of stocks when the economy would bolster the prospects of many far more attractively valued businesses.
Summer brought about two unexpected trends. The rise of the Delta variant led to a significant spike in COVID-19 infections, and interest rates temporarily declined. In addition, global supply chain disruptions slowed manufacturing activity, and caused prices to soar for specific items. Investors reacted to this news by seeking out their newfound “safe haven” stocks: those same, mega-cap technology firms that remained pricey by most valuation measures.
This seems counterintuitive. We believe that the developments that emerged over the summer will fade. The Delta variant is already beginning to subside and vaccination rates are again moving in a positive direction. Interest rates began moving up again in late September. Global supply chain issues may linger for a bit, but just as with the development of vaccines, we expect that capitalistic ingenuity, opportunism and boldness will lead to a resolution.
By all accounts, consumer demand remains robust. In fact, consumers are now spending 20% more than they were pre-COVID5. Analysts have increased projections for 3rd quarter earnings estimates of the S&P 500 by nearly 3 percent, with another 10% boost in earnings forecast for 2022.
We believe that the summertime mood shift in the markets is transitory. The economy appears poised for continued strong growth, a trend that is likely to benefit select businesses that have been out-of-favor for an extended period of time.
Dance ‘til you drop?
Dancing may be fun while the music is playing, but sometimes it goes on far too long. It did for Chuck Prince (see the quote at the top of the letter). Mere months after he uttered his famous line, he resigned from his job at Citigroup as the firm found itself on the brink of failure and became one of the financial giants requiring a government bailout. The rest of us don’t have the luxury of a government bailout to recoup our speculative losses. Investors banking on the music to keep playing indefinitely should be forewarned that “closing time” may be here before long. Don’t mistake longevity for validity. The idea that elevated valuations are sustainable is not a sound investment concept.
We believe that investors who chase index performance set themselves up for a fall when an inevitable shift in the market occurs. This isn’t what we do. We aren’t afraid to position our portfolio in a way that diverges from an index if we believe that it is the best interest of our clients. In fact, we believe our willingness to separate ourselves from the popular trends of the day is what sets us apart, and creates the best opportunity for our clients to protect and grow their wealth over the long run.
~MPMG
1 As of September 30, 2021.
2 Bloomberg Businessweek, March 31, 2002.
3 S&P Dow Jones Indices, “S&P 500 Factsheet,” September 30, 2021.
4 U.S. Bureau of Economic Analysis, “Updated Digital Economy Estimates – June 2021,” data for the year ending 2019.
5 Hugh Son. CNBC. “JPMorgan’s Dimon says supply chain hiccups will soon ease, points to extraordinary consumer demand.” October 11, 2021.
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.
Companies mentioned in this document were chosen based on MPMG’s view of the products and/or services offered or provided by the companies in light of current economic and market observations and reported trends. For a complete listing of MPMG’s recommendations over the preceding 12 months, please contact MPMG at (612) 334-2000.