We ring out 2017 with a big smile and sense of relief – no major economic or political upheavals. Equity markets across the globe performed well with notable performance from Argentina, Nigeria, and Turkey, which were all up better than 50%. The broad US stock market returned roughly 11%, while large cap and technology stocks returned high teens to mid-20% for the year.
The Fed raised overnight rates three times in 2017, leaving the Fed Funds rate at 1.50% (Prime bank lending rate at 4.50%); a substantive rate hike for the year. The Federal Reserve Banking system will have a new Chairman beginning in February, Jerome Powell, currently a member of the open market committee. The word on the street is the Fed will continue with its gradual rate increases and further reduction in balance sheet size.
Global debt markets remained surprisingly resilient given the clear trend toward higher rates. Defying expectations, the US 10-year Treasury bond ended the year yielding 2.41% (it began the year yielding 2.45% – despite a .75% hike, the yield was effectively unchanged). Throughout the year the Treasury bond yield curve flattened, an unfavorable response to Fed actions, suggesting an economic slowdown may be just around the corner.
The corporate bond market had a very favorable year as business fundamentals improved, profits grew and, at year-end, business’ received a future tax windfall through lower corporate tax rates delivered in the Tax Cut and Jobs Act of 2017.
The US Economy has logged two consecutive quarters of 3%+ growth. Currently employment levels remain high while inflationary pressures remain low. The impact of the Tax Reform Act is still being calculated.
Although the outlook remains constructive, we are mindful that a single catalytic event could cause a sharp adjustment in market prices – driven primarily by current excess valuations for many of the largest, most popular US stocks. We have been concerned by this for some time and will follow with a summary of how and why we think about price and value.
History shows periods of market overvaluations build slowly and are generally followed by abrupt corrections. We intend to protect client capital going into any correction in order to take advantage of bargain prices that may appear as a result.
Valuation – How and Why:
Stock prices in an open market system are ultimately set by supply and demand amongst market participants. A buyer and seller meet in the market, negotiate a price, effect a transaction, and there you have it, a fractional piece of a business trades hands.
Presumably these participants are knowledgeable about the worth of the business, and this informs their willingness to make an offer to purchase, or present a bid to sell.
How do they arrive at their independent conclusions? Assume the seller believes the business is fairly priced, thus is willing to sell his interest, while the buyer determines the purchase makes economic sense at the price, given his intent is to profit from the ongoing ownership of the business. Both buyer and seller have taken opposing positions in this transaction. How do they arrive at their decisions?
Every operating business can produce a Balance Sheet, Income Statement and Statement of Cash-flows. These are the building blocks for financial analysis. From these statements an investor can calculate a value and thus arrive at a price.
There are many ways to analyze financial statements. All forms of analysis are useful when attempting to value a company. Generally speaking, an investor will look at a balance sheet to determine asset value per share, an income statement to determine earnings per share, and a statement of cash-flows to reconcile change in cash. A company’s owner will want to track assets versus liabilities and see an improvement in net-worth. Likewise, for a business to succeed it needs to generate profits which can be tracked on an income statement by taking total revenue and subtracting all expenses.
The bottom line profit of a company flows into the balance sheet as retained earnings, and creates net-worth unless it is distributed to shareholders in the form of a dividend.
Investors must understand accounting rules to discern how a company’s financial statements are prepared. Companies in the United States comply with US Generally Accepted Accounting principles (US GAAP accounting). Non-US companies follow a slightly different set of rules known as International Financial Reporting Standards (IFRS). Conceptually these rules are the same, but in many instances the interpretations are quite different.
To this point, a knowledgeable investor can calculate the balance sheet or income statement value of a company. The greatest challenge for investors is to then determine what multiple or percentage of the net-worth or earnings should be applied to the company. For example, if a company has a net worth of $20.00 per share, would an investor ever pay more than $20.00? Or is that the cap on value? Alternatively, if a company earned $1.00 per share how much would an investor be willing to pay? Would he pay $5.00 for the stock believing he can recoup their entire investment over a five-year period? These are the simplest of questions an investor must answer in order to show up in the marketplace and make an Offer to purchase or submit a Bid to sell shares.
To put some perspective into this scenario, it’s worth noting the following facts. As of today, the 500 stocks that make up the widely followed S&P 500 Stock Index trade for multiples:
- Price/Book Value (net-worth) 3.4x
- Price/Earnings 25.7
In other words, the average company’s stock with a net-worth of $20.00 trades for $68.00 ($20 x 3.4) and a company that earns a $1.00 per shares trades for $25.70. In this case, an investor would need nearly 26 years of earnings to equal the price paid.
Why would anyone pay such a large premium for a business? The premium placed on a company’s share price is a function of investor expectation. The greater the expectation, the larger the premium. However, there are no hard & fast rules. A stock can trade for 10% of its net-worth or 1 times its earnings. Likewise, a stock can trade for 100 times net-worth or 1,000 times earnings. Remember, this is a market based system, so a buyer must beware. Price is set in the marketplace in a Bid/Offer system where a buyer and seller meet and trade shares. Informed? Knowledgeable? Rational? Not necessarily.
To arrive at a reasonable price to Buy or Sell requires both science and art. The calculation of Book Value or Earnings is straight forward (assuming one understands accounting convention). The art is discerning when a company’s shares are trading at too large a premium or too great a discount. The artistic aspect requires experience and judgment. There is often a wide range between price paid and underlying value as empirically calculated. This is why it is possible to achieve outsized returns over time. Buy during period of great pessimism. Sell during periods of great optimism.
In order to enter the marketplace and participate one only needs financial resources. No aptitude test is given or proof of financial IQ required. All are welcomed. Investors arrive in all conditions and with many viewpoints. How knowledgeable the investor is on the other side of the trade is an unknown. On Wall Street there is The Greater Fool Theory that goes like this, It doesn’t matter how much I pay, as long as a greater fool will pay more.
How and why securities are priced is subject to a great deal of interpretation. Investor sentiment and emotion play a large part in creating market excesses as well as market corrections.
We are currently in a period of great excess. The historic Price/Earnings multiple for the S&P 500 is roughly 15x, well below the current 25x. There are many reasons for this situation, but with some certainty we can say it won’t continue indefinitely. We will have a market correction at some point. Unfortunately, we cannot tell you precisely when that will occur, but with a high level of confidence, we can tell you it will occur.
As a result, we have become increasingly more cautious with each new record high achieved by the stock market. We have participated, but less and less as price valuations have become increasingly extended. We think there will be a time when having considerable cash reserves ready to employ will be a great advantage.
From Our Library:
Concentrate Investing, by Benello, Van Biema and Carlilse, cites this 1934 statement from Keynes. Keynes went on to establish an outstanding record of investment.
“I get more and more convinced that the right method in investments it to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.”
John Maynard Keynes
We begin the new year with eight associates working to identify undervalued stocks and bonds for inclusion in client portfolios. The infrequency of our trading activity is simply a reflection of the limited number of undervalued companies available to evaluate. We continue to endeavor to uncover that next bargain.
As we’ve stated here many times, we Eat Our Own Cooking, thus will commit your hard-earned capital only when we are willing to commit ours alongside. We think there is no better alignment of our interests than to know we hold the very same securities we recommend. With this in mind, we continue to look forward with optimism, seeking opportunity, but being stingy with what we are willing to pay.
As always, please let us know if you’ve had any changes in your investment circumstance that would prompt a change in how we think about your investment portfolio.
If you haven’t visited our website lately, please do. We use it to communicate with clients and other investors. www.GVI-Corp.com
Very best wishes,
Your Investment Research and Advisory Team
Global Value Investment Corp.