These days, the investment highway seems more treacherous than an L.A. freeway in a rainstorm. Defensive techniques aren’t just for driving. Value has become defensive again, just as it was in the aftermath of the late 1990s Tech Bubble.
Poplar Forest’s portfolios are currently valued at one of the largest price-to-earnings discounts to the S&P 500 since we’ve been in business. In effect, the market is suggesting that the outlook for our companies is less attractive than it has ever been. We disagree. Our companies may be underdogs, but when we look out over the next 3-5 years, we believe that their fundamentals will more than beat the spread.
With the economy getting back to normal more quickly than expected, the U.S. Federal Reserve will soon start the multi-year process of normalizing monetary policy. In the face of potentially rising interest rates, investor worries are growing: stocks look expensive, bond prices go down when yields rise, and cash earns nothing. But, there is a fourth option: value stocks.
With growth stocks having reasserted themselves as interest rates trended lower during the second quarter, some naysayers are already predicting the end of this value cycle. I couldn’t disagree more. For one, I continue to believe that bond yields have separated from reality due to price manipulation on behalf of central banks at home and abroad.
During these wild market swings, we’ve seen a marked change in the type of companies that investors favor. Former growth darlings are being sold to free up funds to purchase shares of economically-sensitive businesses. Investors want beneficiaries of economic reopening and reflation driven by vaccine deployment and continued fiscal and monetary stimulus. As a result, value stocks have begun to materially outperform growth stocks.
The most important job for our investment team is to identify situations where embedded expectations are unreasonably low while avoiding stocks that are cheap for good reason (aka value traps). Cheap stocks can stay cheap unless fundamentals turn out to be better than expected. In contrast, the “great” company that merely ends up being “good” often generates disappointing results for its shareholders - just like so many New Year’s Eves.
While investors seem to be increasingly addicted to free money, I’m becoming ever more worried about the unintended long-term consequences of low rates, especially given the Fed’s new ultra-dovish policy targeting higher inflation. As former Fed Chair Martin said: “What’s good for the United States is good for the New York Stock Exchange. But what’s good for the New York Stock Exchange might not be good for the United States.”
I've been thinking about this lately as I've watched the Federal Reserve try to rekindle our economic fire amid the COVID-19 pandemic. In campfire cookery terms, the virus has been like a once in a hundred year downpour that soaked the woodpile -- wet wood doesn’t burn well. Fortunately, the Fed has trillions of dollars of industrial strength lighter fluid. When combined with the dry kindling that is the U.S. Congress’s fiscal stimulus, the economy could soon be cooking again. With our portfolio trading at less than 14x depressed 2020 estimated earnings, we feel very well positioned for recovery.
I’ve been investing for almost 40 years now, so I’ve lived through many booms and busts, however, I’ve never seen anything quite like the COVID Crash. It took just 20 days for the S&P 500 to fall the 20% required to put us in a bear market. For the first time since 1997, stock market circuit breakers, designed to slow selloffs, were triggered three times in six days. We’ve experienced unprecedented day-to-day volatility: in March, the S&P 500 moved up or down by at least 4% in eight consecutive sessions, eclipsing the old record of six days in 1929. The pace of change is unprecedented.
At roughly 11x estimated earnings, the companies we own continue to be priced at attractive absolute levels and at historically wide discounts to the market despite offering market-like earnings growth prospects. Whether we compare ourselves to broad market indices (S&P at 18x, Russell Value at 15x) or to other value managers (Peer average 15x), we offer differentiated portfolios of what we believe are incredibly compelling investment opportunities.
