The markets began the year on an upward tear. Enthusiasm surrounding the newly elected Trump administration and its presumed market friendly policies, along with a Fed Reserve Bank that was clearly hinting at improved economic indicators, full levels of employment and reignited inflationary trends, drove most equity indices upward.
It appeared the Fed might have been on track to raise overnight interest rates four times in 2017 and return to a more normal level of accommodation after a December rate hike was followed by a March hike. Then came the Q1 2017 GDP report, which hit with a thud. Economic growth measured a tepid 0.6% annualized, far below the promised 4%+ market participants had been expecting from the new administration. The consumer remained in hiding, retail sales were soft, housing data slowed and spending didn’t expand as expected. The 10 year US Treasury – the benchmark for market interest rates – settled at 2.33%, indicating more uncertainty from market participants.
The bond market is suggesting slower growth ahead. Suddenly the Fed’s wisdom is being called into question.
We are defensively positioned. Although we remain cautiously optimistic, our fully invested client portfolio is holding roughly 20% cash at present. Our cash level reflects the absence of attractively priced equity and debt investments. As it should be, when market valuations peak – price levels rise ahead of underlying values – we have more selling than buying activity. Likewise, as prices correct and valuations become more enticing, typically a function of the inevitable market correction, we find more attractive positons to add to portfolios.
We aren’t timing the market, rather, we are allowing market price levels to create opportunity to sell into higher prices and buy into lower prices. Our current positioning suggests overall price levels are elevated. Of course, the market is a collection of stocks and while the average may be high, there will be stocks that are still attractively valued and others that are overvalued. We simply find a diminished number of undervalued stocks to look at today.
The Stock Fairy:
We all remember the tooth fairy who appeared overnight and exchanged a token amount of currency for our lost tooth. The tooth had no value, but that didn’t stop the tooth fairy from visiting us and delighting us at daybreak (depending on mom or dad’s perspective).
The stock market can function in much the same way. The value of any stock on a given day is a function of perspective of the participants showing up at the marketplace. At the most basic level, stock prices are set by supply and demand. If there is more demand than available supply, or more buyers than sellers, share prices rise. Most companies have a limited supply of stock available and owned by shareholders. In order for a stock transaction to occur there must be both a willing seller and willing buyer. They meet in the marketplace and exchange shares for dollars. Implicitly, when the current shareholder sells his shares, he believes the shares are fairly-valued, while the participant buying presumably believes the shares are undervalued. Who is right? Obviously only time will tell. Yet the supply/demand nature of the marketplace prevails and in the process share prices are quoted and traded daily.
Let’s contrast this to a business being sold in a private transaction. In this case, a buyer and seller meet and set a price. There is no open market in which the business trades, no fractional interests being bought and sold on a daily basis. Both the buyer and seller will have an expectation of value for the business. A thorough analysis of the business, its financial condition, its competitive positioning and future outlook will be considered by the buyer in order to establish a price. The seller will then have to consider if the price being offered is consistent with his own appraisal of the business. The seller will be knowledgeable and assess the value of his business. He, of course, will seek top dollar. The buyer, after conducting rigorous due diligence, will have a range of value, and drive for the best possible price – meaning the lowest bid possible. It’s fairly common in private business transactions that the gap between the buyer’s bid and seller’s offer is too wide and consequently, no transaction occurs.
In the public marketplace, however, buyers and sellers show up daily. The only requirement to enter the marketplace is that one possess cash or the ability to borrow cash on credit; that is, all one needs in order to make an offer is access to cash. Buyers enter the market at their own risk. There is no requirement that thorough analysis and due diligence be performed, there are no attorneys combing through transaction documents and there are no banks involved in preparing loan documents. In fact, buyers needn’t do anything other than place an offer to buy through a broker-dealer or intermediary. Assuming there is a seller of shares willing to match the offer, a transaction occurs. The seller only needs to have ownership of shares and a willingness to liquidate – no further analysis is required.
As odd as it may seem, this is basically how capital markets function. Regardless of whether trading stocks, bonds or other financial instruments, the market works on this bid/offer basis.
You may be thinking there must be more knowledgeable participants. Consider the following recent example.
Barron’s Magazine, a credible weekly financial publication, recently printed an article featuring CarMax (NYSE: KXM) as its subject with shares trading at $45. The journalist interviewed two Wall Street analysts, one from Goldman Sachs, the other from Morgan Stanley, both respected and credible research houses. You might assume these knowledgeable analysts would arrive at a reasonably close appraisal of the value of the business. Here’s the surprise: Goldman rated KMX a BUY with a price target of $50. Morgan Stanley rated KMX a SELL with a price target of $35. How can this be? The shares trade at $45. Two knowledgeable analysts are suggesting very different values for the business. Presumably they can access all publicly available information and have a thorough understanding of the industry and macroeconomic factors impacting valuations, yet they arrive at opposite conclusions.
For years we have cautioned clients when looking at quoted share prices. The last quoted price is merely the reflection of the price at which two market participants agreed to exchange shares. There is no assurance that price reflects the underlying worth or value of the business. Share pricing is inherently inefficient as a result of the market-based system.
Capital markets exist simply to provide liquidity or ease of conversion of a fractional ownership interest in a business to cash at a moment’s notice. A participant could show up at the marketplace on Monday morning and within minutes invest a fortune in any one of thousands of publicly traded businesses. The very same day the entire portfolio could be liquidated, no questions asked. Would the participant’s fortunes depend on thorough analysis, unique insights, skill or otherwise? Not necessarily.
Our caution to clients is this: take with a large grain of salt the last or recently quoted share price. Whether you look daily at the market or monthly at your statement, the last quoted price may be very different than the value an informed buyer would assign to the business. We rely on thorough analytical process and rigorous due diligence to establish the value of each business in which we invest.
Our analysis allows us to establish an appraised value for every business. Experience shows that market participants frequently bid share prices both above and below appraised value. In an efficiently-priced market we would expect a share price to equal its appraised value, but this is rarely the case. Consequently, we invest when we believe the last quoted price is well below our appraised value. We follow company developments closely, holding each security until it trades at or above our appraised value, at which time we sell the position. From time to time, a stock’s price will continue to appreciate after we exit the position at our appraised value, further evidence of the inefficiencies of market pricing and the impact of investor emotion.
We operate under the axiom, “bought right is half sold.” Our job is to exploit market inefficiencies by buying when shares trade significantly below appraised value and selling when prices return to or exceed appraised value.
From Our Library:
We have been reading Philip Fischer’s book Common Stocks and Uncommon Profits. Fischer reminds us of the importance of investment timeframe and perspective with his many sage statements, such as the following:
One, which I mentioned several times elsewhere, is the need for patience if big profits are to be made from investment. Put another way, it is often easier to tell what will happen to the price of a stock than how much time will elapse before it happens. The other is the inherently deceptive nature of the stock market. Doing what everybody else is doing at the moment, and therefore what you have an irresistible urge to do, is often the wrong thing to do at all.
Although Fischer originally penned his work in 1958, his sentiments stand the test of time.
It’s hard to believe our firm is approaching its 10th anniversary. We have been fortunate to employ a very bright and committed team of analysts and advisors. I want to acknowledge their consistent efforts and long hours committed to seeking investment excellence.
In 2015, we renamed the firm Global Value Investment Corp. to better reflect the scope and scale of our work. In 2017, we established a research office in central India where we now directly employ several analysts through our newly created subsidiary, Global Value Research Company – India. They begin their work day as we are concluding ours, allowing us to share unique global perspectives and experiences as well as assimilating news and information flow on a near 24-hour basis. In 2015, we began offering investment research and advisory services to investment professionals across the country through our Milwaukee Institutional Asset Management division. We have developed many relationships in which we exchange market information and perspectives with other investment professionals. In fact, we just added another associate who will work from our new office in Boston.
Throughout these changes, we have remained focused on investment research and analysis, seeking undervalued equity and debt investments. At this point we have a much deeper bench to drawn upon for both research and advisory services. I believe you will notice our expanded capacity. Regardless of when or where you call our office, you can expect a knowledgeable associate to answer in person and provide the client service on which we have prided ourselves over the years. Remember, our associates own the same equity issues we recommend for purchase in client portfolios.
If you’ve had a change in, or would like to update, your investment objectives or portfolio restrictions, please let us know so we can make appropriate adjustments. We are ever mindful of the trust and confidence placed in us by our clients and continue to dedicate ourselves to investment excellence.
Very best wishes,
Your Investment Research and Advisory Team
Global Value Investment Corp.