Where we stand…again
January 20, 2016
Market Summary – 4th Quarter, 2015
“It is the soothing thing about history that it does repeat itself.”
– Gertrude Stein
The stock market finds itself in an unusual position as we look back on 2015. While most will view the headline number for the S&P 500 and see it as a year when the market generated a flat return (the S&P 500 was down 0.73%), the reality beneath the surface is much different. Incredibly, just four stocks (known as FANG – the acronym for Facebook, Amazon, Netflix and Google) that achieved dramatic gains are responsible for keeping the stock market from a far more negative result. This is a prime example of how the numbers can be deceiving. Since the S&P 500’s performance is market-cap weighted (larger stocks have more impact on the return), these four stocks, representing close to 6% of the index, had an outsized impact that buoyed the performance of the index. The Equal Weighted S&P 500 Index, where each of the 500 stocks generates 0.2% of its return, declined 4.11% in 2015. Other broader market measures show even weaker performance among stocks.
To further demonstrate how challenging 2015 was for investors, consider that the median stock in the Russell 3000 Index (which is comprised of nearly 98% of U.S. equities) finished 2015 down over 20% from its 52-week high1.
In short, this was a very narrowly-driven market where fundamentals mattered less than the desire of investors to jump on the bandwagon of selected “hot” stocks. This makes things extremely challenging for active managers, particularly those focused on investing in individual equities that offer fundamental value. We saw a similar lack of breadth and disregard for value in 2011, when only ten stocks were responsible for nearly 90% of the market’s gains. In that year, the remaining 490 stocks in the S&P index generated flat or negative returns, or were too small to have a significant impact on the final result. Yet over the next two years the S&P 500 would return over 53%.
Less important than what has already happened in the market is what this foretells for the future. We’ve never pretended that we could forecast what the stock market will do on a day-to-day basis, or even over the next year. However, we can recognize trends that have occurred in previous market cycles. Today’s market demonstrates all the hallmarks of one of those periods in time that present investors with both tremendous risk and unique opportunities. The key is to be on the right side of the divide.
Déjà vu all over again
Back in 1998, we sent our clients a newsletter titled “Where We Stand.” It was a period when technology stocks soared, particularly the new kids on the block at the time – the “dotcom” stocks. Left behind during this market surge was a large number of stocks that offered great value, but generated surprisingly little enthusiasm from investors.
We described how the narrow group of stock market “winners” during that period was becoming dangerously expensive. We noted then that just six large-cap stocks (Microsoft, Intel, Cisco, Schering Plough, Pfizer and Coke) reached a combined market capitalization exceeding $1 trillion. That was greater than the combined market capitalization of 81 well-established and profitable companies that lacked the sizzle and celebrity of the aforementioned six. As is the case today, investors were throwing money into a select cabal of stocks, driving their prices to unsustainable levels. At the same time, they were overlooking the obvious long-term value opportunity offered by these 81 stocks and many others like them. The group of 81 generated combined revenues that were 15 times greater than what was created by the six red-hot stocks that drove the market’s performance. Clearly, the six stocks were priced higher than warranted by the business realities facing each of these companies, trading at an average of 50 times trailing earnings. This was an unsustainable path. The simple question was where a long-term investor would feel more comfortable putting money to work – in an overpriced group of stocks that just enjoyed a long, prosperous run, or the other 81 stocks that generated significantly more earnings and revenue, and could be purchased at value prices?
Fast forward to 2015 where we are faced with a similar disparity. The story of the year in the stock market is that FANG combined to generate nearly an 83% return in the past year. By contrast, the broader S&P 500 Index finished 2015 slightly down. Given the dramatic performance of these four stocks, it is clear that the non-FANG segment of the market was generally flat or in the red for the year. In this environment of dramatically divergent performance, the combined market capitalization of the FANG stocks soared to $1.2 trillion, and their average price/earnings ratio is about 60 times earnings2.
Similar to our list of 81 stocks in 1998, today we can identify a group of 70 stocks in the S&P 500 Index that, combined, have about the same market capitalization as FANG3. Once again, these are high quality, profitable companies that generate far more revenue than FANG, and, we believe, also offer much greater value to the patient investor. On a market-cap weighted average these stocks trade at less than 10.5 times earnings. So as you think about the most effective strategy to build wealth for the future, and about where the risks may be the greatest, where would you invest your money today?
Assume nothing and ask the right questions
In our 1998 letter, we laid out a series of important questions that are just as relevant today as we consider the state of FANG stocks versus more attractively-priced stocks in the market (reflected in the list above). “What people forgot to ask themselves…was, ‘What am I getting for my money? What kind of revenues? What kind of cash flow…and real (not merely anticipated) earnings? Could good business-people make competitive returns if the same companies were privatized at those prices?’ And perhaps most important, ‘What are the risks if I’m wrong?’ ” In 1998 and again today, too many investors fail to ask those questions as they ride the wave of a small group of stocks that are – temporarily – red hot.
Facebook, Amazon, Netflix and Google and a small handful of other stocks have attracted investor dollars by demonstrating an ability to grow earnings and revenue in what is otherwise a relatively “growth-less” world. There is no questioning the strength or quality of these companies. The key question is at what point do good businesses become overpriced, and therefore, lousy investments? We think stocks that have a combined P/E ratio of 60 (in other words, paying $60 for $1 of earnings) should be considered dangerously overvalued, no matter how strong their business prospects may be.
Investors too often become overly influenced by recent events and extrapolate them out over the long term. In this case, many believe that slow growth will be with us forever, and only FANG-like companies can prosper in such an environment. But as is always the case in the investment markets, this is merely a moment in time that has worked to the benefit of a select group of stocks. We have not seen the end of vibrant economic growth in the U.S. or around the world. Investors shouldn’t repeat a common mistake of thinking that what is happening now represents what will happen in the future. Our enthusiasm today centers not on what worked last year. The value opportunities presented by overlooked businesses make today’s markets as appealing to us as they did at the end of the dotcom boom.
Will history repeat itself?
Our expectation in 1998 that attractively valued stocks would ultimately be recognized by investors and rewarded by the market, proved to be correct. While it took about a year for the stock market to sort it all out, value stocks began to prosper as the 1990s came to a close. Our determination to position investors where better values existed helped our clients flourish as the once high-flying technology sector crashed. Overly-priced stocks took a nosedive so severe that many who invested in them, or even in the S&P 500 Index, found that it took more than a decade to recover from their losses. In our opinion, there has never been a better example of how paying the right price for a stock matters even more than the apparent success of a company, particularly when price disparities become so dramatic.
We believe that we are in a position today where history is very likely to repeat itself. We are as convinced as we ever have been that patient investors who recognize value will be rewarded over the long run. As was the case in the late 1990s, we believe the narrow group of stocks that have enjoyed a dramatic upside in recent times are most susceptible to a correction. Stocks that have been overlooked and are attractively priced are better positioned, in our view, to weather the market’s storms. Value stocks may not generate the excitement of the FANGs (or be the subject of a hit Hollywood movie like Facebook in “The Social Network,”), but they’ve demonstrated an ability to prosper in challenging times, when other types of stocks are being decimated. Value stocks, in our opinion, have significant upside potential, particularly given the strength of their businesses compared to their relatively low valuations. We also believe that they are well positioned to weather the likely gyrations we’ll see in the market in 2016 and beyond. By contrast, investors who are too reliant on the performance of FANGs (including index investors) may be prone to the full impact of a bear market when it next occurs.
© Mick Stevens/The New Yorker Collection/The Cartoon Bank
The simple question for investors now is where they feel the best opportunity for appreciation, and the best defense against downside, exists. Is it in stocks that have risen dramatically in price with equally dramatic valuations, or in quality stocks that have been overlooked by the market for an extended period of time and are “on sale?” We know where we stand.
1 “2016 Outlook – The Stealth Bear Is Revealed”, MKM Partners, January 3, 2016
2As of market close on 12/16/15
3This list of 70 companies in the S&P 500 is provided for illustrative purposes only. Any company identified or discussed is not an individual recommendation. You should not assume MPMG has or will hold investments in these companies, nor should you assume these will be profitable investments.