2023 | Q2 -Don’t Mistake Longevity for Validity
“Men, otherwise of very good sense, have been drawn into this practice through an overweening desire of sudden wealth and an easy credulity of what they so earnestly wished might be true; while the rational and most certain methods of acquiring riches by industry and frugality are neglected or forgotten.”
- Benjamin Franklin, discussing “treasure seekers” who used diving rods to look for buried loot
As we gain experience in life, we tend to gain greater appreciation for the expression, “with age comes wisdom.” This is in contrast to those who, given limited life experience, profess to know it all. Consider the example of the turkey that was born on the day after Thanksgiving. The newborn bird adjusts to a routine of daily care and feeding by a farmer, to the point that the turkey comes to assume that the farmer is his friend. Over the course of 45 to 50 weeks, the turkey experiences nothing to suggest otherwise.
The trust the turkey formed over that short period of time is shattered just prior to the next Thanksgiving. The turkey’s assumptions were based on a limited sample size, as it anticipated that life would go on as it always did. Unbeknownst to the bird, the “surprise” outcome was inevitable. With its incomplete perspective, the turkey mistook longevity for validity.
©Edward Frascino / The New Yorker Collection/The Cartoon Bank
Proper perspective is critical in most of life’s pursuits. Investing is no exception. Consider the “lessons” of a more extended time period the era since the financial crisis of 2008. As documented in previous letters, we’ve just experienced an unprecedented period that featured massive quantitative easing by the Federal Reserve, coupled with tremendous fiscal stimulus by the federal government. The liquidity provided over this timeframe exceeded, by far, the level of stimulus provided during any crisis in recorded history. The artificial environment it created inspired a speculative frenzy rarely seen before. This environment encouraged many investors to eschew many of the market’s fundamental principles. Strategies that have historically been disastrous for investors ignoring valuations and fundamentals in favor of chasing popular (but expensive) momentum plays actually thrived in this era.
Monetary policy played a key role. The environment of “free” money stemmed from the Federal Reserve’s zero interest rate policy. How unusual was this? Consider that in more than 5,000 years of recorded data, interest rates reached zero percent in fewer than 15 years (or 0.3% of the time). Nearly all those instances occurred between 2009 and 2022.1 Additional liquidity came from record levels of government stimulus to individuals and businesses in response to the COVID pandemic. This excess liquidity was reflected in the nation’s M2 money supply, the Federal Reserve’s measure of available cash and other liquid assets. It grew dramatically over this period, from $7.5 trillion at the start of 2008 to $21.7 trillion a year ago.2 With money freely available, investors were emboldened to assume greater risk and dismiss fundamentals, such as valuation. In this unusually hospitable environment, these investors were often rewarded for ignoring key investment principles.
To no one’s surprise, the era of seemingly unlimited liquidity came to an end. An inflation surge, the first of its kind in more than 40 years, forced the Fed’s hand, requiring it to aggressively raise interest rates and end its quantitative easing program that had boosted asset prices. The artificial environment created by the Fed, with its dovish monetary policy that kept interest rates at historically low levels, is no more. This longstanding era of “free money” is over. Gone with it is the false reality that chasing momentum and ignoring fundamentals is a winning strategy.
In today’s market, investors need to realize that what worked over the previous decade plus is not likely to keep on working when we’ve returned to a normalized economic environment, with interest rates well above zero percent and liquidity in decline. There’s a legitimate concern that too many investors remain inclined to believe that what drove the markets before 2022 still applies in today’s new reality. The accumulated wisdom of our years in the markets has taught us that fads and trends may carry a portfolio for a short period of time, but investors who ignore valuation will ultimately experience pain.
The chopping block awaits
Those who believed that they had the markets figured out prior to 2022 were quickly disabused of that notion last year when the Fed began to raise interest rates at the fastest pace in history. Like the turkey born in late November, these investors confused longevity for validity. They were suddenly reminded that markets can act irrationally longer than misplaced portfolios can stay afloat.
In 2023 irrationality temporarily returned to the markets, driven by the simultaneous outbreak of the two human emotions with the power to shock the stock market fear and greed. Fear derived from the failure of three regional banks. Greed was in full throttle amid the news of immediately tangible applications of artificial intelligence (AI), such as ChatGPT. As this emotional tide swelled, investors responded in the only manner that they have known to work over the “free money” era by fervently buying the megacap technology names. This has, in essence, become a conditioned response due to the temporary precedent set by the artificially low interest rate environment. Given the cult-like following for these high priced stocks, they’ve puzzlingly served as perceived investor safe havens and growth leaders.
Investors’ impulse reactions were reflected in 2023’s strong start for the S&P 500 Index. Seven businesses (Apple, Microsoft, Nvidia, Amazon, Meta, Alphabet, and Broadcom) have earned the moniker “The Magnificent Seven.” These megacap growth technology names, continue to defy fundamental valuation principles and have propelled higher, accounting for nearly 80% of the S&P 500’s year to date returns.
Source: Bloomberg and Bernstein analysis
It was like pre 2022 all over again. Just as before, valuations of some of these stocks were driven to unsustainable levels (i.e., Nvidia stock with a price-to-earnings ratio of 220, compared to 22 for the S&P 500.3 In mid May, the market capitalization value of Apple’s stock alone surpassed that of the combined components of the Russell 2000 Index.4
The strong price performance of these seven stocks, and the meager contribution to the S&P 500 Index’s year to date returns by the other 493 stocks in the index, may give some investors the impression that only a select number of businesses are thriving in today’s economy. Yet this is not the case. Many businesses are performing well, but it’s not reflected in their stock prices. MPMG clients have no doubt noticed the strong performance of their portfolio so far this year, despite not owning any of the Magnificent Seven stocks that are driving the market. We believe that this is a testament to our willingness to own less followed and underappreciated businesses, many of which are not members of the S&P 500 Index.
The upside of the market’s infatuation with these megacap growth stocks is that there remain numerous attractive investment opportunities still out there. Low valuations often represent what is, for the present, low expectations. This puts investors in an advantageous position. There are companies among those 493 “underperforming stocks” of the S&P 500 (and elsewhere in the market) that we believe will continue to generate strong financial performance, and eventually be recognized by the markets. This is more likely to happen given the current economic landscape.
This landscape is one of reduced liquidity. Earlier in the letter, we mentioned how during the “free money” era, M2 reached record high levels. Since last year, M2 has fallen at its fastest rate since the measure was created in 1959, and will likely fall further.5 This confirms that the excess liquidity fueling the post-financial crisis surge in speculative stocks no longer exists, even if the consequences of such a dramatic change have yet to emerge.
As a narrow group of stocks become even more expensive, a greater degree of speculation is required for those investors who choose to keep putting money into “Magnificent Seven” companies and other popular growth stocks. By being forced to pay excessive valuations for the right to follow the herd, investors will likely discover the limited upside potential of owning expensive stocks. Inevitably, these overpriced stocks, like the trusting turkey, will face the chopping block. As appealing as the idea of investing in the “Magnificent Seven” may seem, it should be remembered that in the classic Western of the same name, four of the seven characters didn’t make it to the final credits.
Growth-Value disparities persist
History shows that market leadership alternates between value and growth investing strategies. Growth stocks generally perform best when interest rates are low, an environment that tends to reward more speculative approaches. A virtual tidal wave of liquidity in the post 2008 era facilitated an unprecedented run for growth stocks. The question investors must ask themselves is, “Now that the environment has changed, and liquidity is working in reverse, isn’t it fair to expect that the market will reward a different category of stocks?”
We’ve spoken often in our newsletters about the unprecedented disparity in the performance of growth and value stocks over this extended period of time. As the chart below shows, the performance gap reached its widest point at the end of 2021, just before the Fed altered the underlying envi-ronment. Then the disparity between value and growth began to compress.
The rotation into value stocks was in its nascent stages until the combination of the AI frenzy and the unanticipated failure of several regional banks caught the market by surprise. Nevertheless, the “flight to safety” pursued in growth stocks appears to represent investors confusing longevity for validity.
Excessive valuations may become much more of a liability for investment portfolios than was the case over this previous, extended period of growth stock domination. By pushing valuations to unsustainable levels, investors have created, in many circumstances, unrealistic expectations for growth stocks. By contrast, fairly priced value stocks offer downside protection should the economy face headwinds, and if the economy gains strength, that should benefit economically sensitive stocks that were not part of the market’s rally in the first half of 2023. Regardless of the conditions, we are not in the camp of the popular market sentiment today that says only a handful of stocks can prosper.
Instead, we believe that the market is positioned to unleash tremendous, wealth-creating potential among a multitude of overlooked stocks. That’s why it’s important to focus on what we consider to be truly great businesses that are attractively priced. Despite the market’s lapse into a comfortable formula in the first half of the year, rewarding a narrow band of excessively-valued stocks, investors need to consider the broader economic signals being sent. It’s important not to make assumptions in the manner of the aforementioned turkey. Don’t be deceived into thinking the same formula will work just because it has recently and because everyone else is doing it. We believe that we are back in your grandfather’s stock market again, featuring a more normalized, not artificially-stimulated, economy. We believe that the best opportunity to build long-term wealth comes not by chasing returns generated by overpriced momentum stocks, but by following a different path – seeking out overlooked, undervalued companies that offer tremendous, long-term potential. This strategy is designed to both avoid significant losses (paying the right price for stocks eliminates much of the risk taken by those chasing momentum), and build long-term wealth.
The objective is simple – to reach the finish line – your ultimate investment goals – in a prudent but profitable way. Don’t mistake longevity for validity, but instead, recognize that slow and steady wins the race.
Celebrating the wisdom of the world’s great innovators
After a three-year hiatus due to the pandemic, we’re happy to bring back our popular MPMG Speaker Series this year. In August, our audience will be treated to hearing from one of the nation’s most renowned biographers, Walter Isaacson. His work has focused on some of the world’s most creative and innovative visionaries, past and present.
We find his appearance particularly timely as we consider this a vital time for investors to avoid the herd and think independently. Mr. Isaac-son has documented the lives and successes of a number of individuals who are easily labeled as “geniuses.” Yet what really sets these difference-makers apart is their ability to think outside the box, to go against the grain of popular opinion and to demonstrate the courage of their convictions. We admire all of these individuals who have made such an impact on our world, and feel that as investors, we can learn from all of them. We look forward to hearing Mr. Isaacson explain how this unique group of individuals succeed.
The subjects of Isaacson’s books range from great historical figures such as Leonard da Vinci, Ben Franklin and Albert Einstein to more contemporary subjects such as Steve Jobs, Henry Kissinger and Nobel Prize winner Jennifer Doudna, known for her groundbreaking work on CRISPR gene editing. Mr. Isaacson’s highly-anticipated next biography is about business magnate and inventor Elon Musk, and is due out this fall.
We look forward to seeing many of you at our event and are happy that we will all be able to again congregate and celebrate.
This is a ticketed event offered by invitation only. If you have any questions please feel free to contact Sarah Rude at (612) 334-2000 or s.rude@mpmgllc.com.
~MPMG
1 Goldstein, Steve, “Interest rates haven’t been this low in 5,000 years,” Marketwatch.com, July 30, 2021.
2 Source: Board of Governors of the Federal Reserve System.
3 As of June 30, 2023, based on trailing 12-months earnings.
4 Adinolfi, Joseph, “A stock-market milestone: Apple is now worth more than the entire Russell 2000,” Morningstar.com, May 20, 2023.
5 Vanjani, Karishma, “M2 Contracted for a Sixth Straight Month. It’s a Promising Sign for Inflaion,” Barron’s, June 27, 2023.
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.
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