This week, we start with a quote that is quite relevant to financial markets today, the charts below and our overall investment strategy. Bridgewater Associates founder Ray Dalio reiterated in his most recent missive that as an investor one should "Identify the paradigm you’re in, examine if and how it is unsustainable, and visualize how the paradigm shift will transpire when that which is unsustainable stops."
The paradigm we’re currently in was recently laid out by JP Morgan’s quant strategist Marko Kolanovic in his most recent research piece which is summarized in this Bloomberg article.
He states that “While there is a secular trend of value becoming cheaper and low-volatility stocks becoming more expensive due to secular decline in yields, the nearly vertical move the last few months is not sustainable. The bubble of low volatility stocks versus value stocks is now more significant than any relative valuation bubble the equity market experienced in modern history.”
In other words, the relative difference in the valuations of low volatility stocks (like utilities, real estate, consumer staples, etc.) compared to value stocks (“cheap” stocks on statistical metrics like P/E, P/S, P/B, EV/EBITDA, etc.) has never been greater. Put yet another way, people are paying the highest premium in history for perceived safety in low volatility stocks relative to value stocks.
I love Kolanovic's research and the data certainly backs up his claim. A simple eyeball test of the chart below (from the Bloomberg article) would lead one to believe the current trend of low volatility stocks over value stocks is unsustainable and likely to reverse soon. As Dalio would say, the paradigm is likely to shift soon, perhaps catalyzed by stabilization in trade policy or the U.S. simply avoiding a deep recession.
This might be the most powerful chart I’ve seen all year and is worth some reflection. There is so much information embedded here that we could spend the entire email focused on this one chart.
The green line shows the relative valuation of value stocks vs. the broader market while the blue line juxtaposes the relative valuation of value stocks with low volatility stocks. When the green line moves downward, value is underperforming the market and vice versa. When the blue line is falling, value is underperforming low volatility stocks and vice versa.
There are a few big takeaways here.
(1) The first is that relative valuation trends tend to move in long cycles.
For example, the last few years of the 20th century leading into the tech bubble saw massive outperformance of growth and underperformance of value relative to the broader market. This was when magazines were running articles questioning if value disciples like Warren Buffett had lost their touch. He hadn’t and his investment vehicle Berkshire Hathaway massively outperformed the broader market for years afterwards. The market was simply punishing the types of cheap stocks he favored and was rewarding money-losing ventures he eschewed.
Since the tech bubble’s bursting, we’ve basically seen two long cycles: the post-tech bubble years saw massive outperformance of value over growth and low volatility stocks up until the financial crisis when the paradigm reversed and value has since underperformed the broader market and low volatility stocks.
(2) The more timely takeaway is that we are close to all-time lows in the relative valuation of value stocks compared to the broader market.
We’re also at record-breaking relative valuation levels of value stocks compared to low volatility stocks. As Kolanovic stated in the quote above, the parabolic outperformance of low volatility is entirely unsustainable and represents a massive opportunity in value stocks which our portfolios are currently overweighted.
Recognizing the extreme nature of this trend, we’ve grown increasingly cautious of perceived “safety,” low volatility stocks that many investors are viewing as bond proxies. Procter & Gamble ($PG) is a “feel good” name that fit this description. While P&G is without question a world-class company, is an investment in it at today’s high valuation “safe” simply because it has exhibited low volatility lately?
Compare Procter & Gamble to Alphabet (parent company of Google), for example. Consider that P&G and Alphabet both trade at ~27x trailing earnings and ~25x forward earnings. So they are valued as if they have similar earnings prospects in the future. (P/E ratios are largely how investors express optimism or pessimism in companies. The higher the P/E ratio, the more investors expect from a company in the future and vice versa.) But the earnings streams themselves are vastly different. Here’s a homemade table of the last six years of revenue (in billions) and earnings per share for $PG and $GOOGL:
Which company, given the similar valuations, would you rather own? We think the answer is quite clear. Alphabet has more than doubled revenue in the last six years and is still growing at almost 20% annually while P&G has seen revenue decline by around 20% over the last half-decade. Also, keep in mind that P&G carries net debt while Alphabet has about $100b in net cash. Yes, Alphabet has some regulatory risk that P&G doesn’t and they are very different businesses, but the moral of the story remains the same. This isn’t an homage to Alphabet, it’s simply a reflection on the fact that people are paying far too much for companies with low, no or negative top and bottom-line growth simply because they feel “safe” owning them. They’re also currently willing to let go of stable businesses at garage sale prices simply because they may have a little dirt on them.
If low volatility stocks are pricey, what’s cheap? Wall Street.
Take the chart below, for example, which highlights the dividend yield of the various market sectors. Utilities, which are now quite expensive relative to the market (Utilities have historically traded at a discounted multiple to the broader market. Today they trade at a premium.) now yield less than financials for the first time EVER in recent weeks. This doesn’t even factor in buybacks, which are just another way to return capital to shareholders. Wells Fargo, for example, sports a ~4% dividend yield (in line with other financials below) but will also buy back around 11% of the shares outstanding this year, bring the total shareholder return yield to around 15% in a single year. Not too shabby!
Next, we have an article from The Economist highlighting America’s record-long expansion.
The article does a good job laying out the simultaneous hot and cold U.S. economy, with manufacturing in the doldrums but consumers feeling fine overall. The main risks it lays out to the continued expansion are trade instability, financial shocks and political upheaval. The Fed seems to have burned its hand badly enough with its poor signaling in the 4th quarter of 2018 that it won’t likely end the party anytime soon. An upcoming election in 2020 could increase uncertainty over the future of policy as both parties seem to be veering further away from each other, not closer together. Perhaps the only thing we have to fear is fear itself!
We finish with an article published on Wednesday afternoon highlighting Netflix’s first quarterly U.S. subscriber decrease in its history which sent the stock down double-digits after hours.
While we don’t own Netflix, we own many companies that compete or interact with it in some way so its prospects are of interest to us. As fund manager Jeff Ubben (who helped convince Fox they needed to sell to Disney) recently said, “Netflix is a high wire act.” What he meant was that because Netflix rarely makes more in a quarter than they spend, they are highly susceptible to the whims of investors and the broader capital markets. As long as the market believes in the story, they can access seemingly limitless capital to invest in original content which should keep subscribers engaged. If access to capital dries up, either because of a misstep like missed estimates of subscriber growth or simply a financial panic, they could face some turbulence. While the growth story for Netflix is mostly international anyways (notice all the Spanish language content popping up these days?), it will be interesting to see if the sustained price increases of the past few years slow down in response to slowing growth.