Sitting On The Other Side Of The Fence - A Value Investing Story
Summary
- Staying away from the red-hot semiconductors sector & FAANG stocks has been a true challenge for value investors.
- Value & Quality stocks have been underperforming for quite a while.
- Lofty market valuations further increased the risk of owning hot stocks.
- Update on my portfolio & strategy.
In this article, I want to take a step back from all the figures, balance sheets, and cash flows and share some of my thinking behind the current state of the market and some of the stocks that are currently appealing to the vast majority of retail investors.
What Is Hot These Days
Source: medium.com
Robinhood recently released the updated list of the top 20 stock held by customers on the platform. The list gives us a good idea of which stocks do Millennials prefer:
Source: investors.com
As a contrarian and value investor, it gives me some comfort knowing that I hold none of these stocks. Before people start jumping on conclusions, I must say that the list contains some of the highest quality companies in the world; however, the price that people are paying for most of these is prohibitively high. Of course, some companies are of much higher quality and more reasonably priced than others and as such would certainly appeal to value investors. In my view, these include Apple (AAPL), Ford (F), Bank of America (BAC), and perhaps even GE.
Not surprisingly, all FAANG stocks are present in the list, including the very hot semiconductors such as Nvidia (NVDA) and Micron Technology (MU). The list even includes some stocks considered by many as highly toxic and very speculative - Fitbit (FIT), GoPro (GPRO), Netflix (NFLX), and Tesla (TSLA).
Many of the stocks above have been disconnected from their fundamentals for quite a while now with many investors daring to even short them and go against the herd. So far, this has proven to be a foolish game as excitement around some of the names above keeps growing. One of the main reasons why this disconnection from fundamentals is persisting is that Millennials think fundamentally different from the previous generations (see below).
Millennials believe in expression of their social, political, and environmental values through their investments. That is why innovators such as Elon Musk have managed to keep the hype alive around Tesla.
FAANGs/FAAMGs
Although the term FAANG includes Netflix, in my view, it is much more appropriate to exclude it and add Microsoft instead to make the list more consistent with all major U.S. ecosystem players. There are two main reasons why I have taken these stocks out from my investable universe for now:
1) Valuation - most of them are priced at a hefty premium which assumes unreasonable levels of top and bottom line growth. I believe that there is a very high probability that investors in some of these companies will come to a rude awakening in the very near future as growth comes to a stall. Companies like Amazon (AMZN) trade at 3 digit P/E multiple, which as simple as it sounds is a ridiculous valuation assuming that eventually, Amazon will have to earn nearly $40bn of net income to value the company at x20 P/E. This means that on current figures, AMZN profits will have to increase 10-fold while assuming 0% price increase. I believe that the wrong assumption that most people make is that simply because you are disrupting an industry you will capture the profits currently made within that sector.
Of course, I'll have to point out that some companies like Apple, for example, are much more reasonably valued, perhaps this is one of the reasons why value investors such as Warren Buffett like Apple so much.
Source: Morningstar.com
2) Regulation risk - I see that as a largely underestimated risk for all of the above-listed stocks. As we have seen with Facebook (FB) recently, governments are increasingly worried about the huge power concentrated in companies such as Facebook and Google (GOOG) (GOOGL). The same way as electricity has become a key resource post-industrial revolution, information is now the most important resource. As a natural course of events, governments usually intervene to regulate the usage of these key resources. I see no reason why ecosystem players such as the FAAMGs would not be put under regulation in the same way as utilities are now heavily regulated. I realize that I am entering a bit more speculative territory here, but I feel that at present investors are mostly dismissing the risk of more government intervention.
The FAAMG stocks now make up a very large proportion of the market or S&P 500 for simplicity. According to CNBC only four of them - Apple, Microsoft, Amazon, and Facebook made more than 10% of the S&P last year. At the same time, Amazon, Microsoft, and Netflix are responsible for 71% of S&P 500 returns so far this year. These companies, as successful as they might be, have essentially become the market. Such a high concentration of the S&P 500 in just a few companies is concerning as these very highly priced companies could easily trigger significant pullback and volatility once their stock prices start reflecting fundamentals.
Another indication of the risk associated with FAAMG is the high correlation between an equal-weighted FAAMG portfolio and the S&P 500 (see below). The 1-year daily return correlation has not been that high since the 2008-2009 period.
Source: Author's calculations based on data from Yahoo Finance
A regression on Fama & French 5-factors also points out that these companies have almost no exposure to any of the factors other than the market.
Source: Author's calculations based on Fama & French 5-factor portfolios
At the same time, it has been extremely hard not to be part of this FAAMGs frenzy. Most investors not being part of it have been underperforming the market, while at the same time, a simple equal-weighted FAAMG portfolio has outperformed the market by a very wide margin. Another implication of this disruption oriented frenzy is the underperformance of iconic value investors such as David Einhorn. Even Warren Buffett's Berkshire Hathaway (BRK.A) (BRK.B) has been blamed of underperformance against the S&P 500 with people accusing him for not understanding the "new economy".
Well, for the time being, I plan on staying on the other side of the fence, alongside people who do not understand the 'new economy'.
How About Value And Quality
So how did Value (HML) and Quality (RMW) factors perform over the last 10-years, well you guessed it:
Source: Author's calculations based on Fama & French 5-factor portfolios
The value factor actually fell 13% over the period, while RMW returned merely 17% over the last 10 years.
The obsolete accounting standards are, of course, partly to blame for the value factor underperformance as current accounting standards prohibit companies from booking intangible assets on their balance sheet unless an acquisition takes place. This has made the P/B ratio or book value of assets merely useless in this new age of digitalization. Therefore, the HML factor which is constructed using the P/B ratio has been mostly focused on companies with less intangible assets.
Despite the accounting standards shortcomings, one thing is clear - the market factor has outperformed all other Fama & French factors by a very wide margin. When will that trend reverse is hard to tell, but one thing seems certain - this can't go forever.
How I Am Positioning Myself
There are few very simple steps that I am taking to weather the storm of any market reversal.
First, as hard as it is during these exciting times of disruption, technology innovation, and high market return, I am keeping a large proportion of my portfolio in cash or cash equivalents. At the moment, 30% of my portfolio is in cash or equivalents, but I am aiming to slowly increase this up to 50% should the market valuations continue to hit new all-time highs. In this category of assets, I hold cash in various currencies and gold - mostly through ETFs. Cash is the obvious choice as interest rates are at all-time lows and hence, the bond market is highly priced, gold, on the other hand, is excellent hedge against inflation or any other market turmoil. Treasuries and other short-term government bonds are another instrument that I am planning on using within that category.
Second, I am staying away from the hot technology sector and focusing on factor exposure. In terms of sector exposure, commodities and basic materials are one which I find particularly appealing as overproduction over the recent years has caused some essential and limited in supply commodities to trade at unreasonably low levels. The beaten-down materials sector also offers good hedge against the long forgotten inflation and ties well with non-cyclical industries such as consumer staples - a sector where I also see a lot of value.
At present, my portfolio is as follows:
Disposals
Since my last portfolio update, I sold off two companies - VCO and HPS. The reason why I sold VCO is that management decided to delist VCO's ADR and I have no access to the Chilean market through my ISA account. HPS, I decided to sell because I would like to increase my exposure to stable non-cyclical companies and reduce exposure to turnaround stories such as HPS, as these are very vulnerable in the current market situation, especially after considering the political rhetoric. Furthermore, HPS has stopped publishing quarterly reports on their IR page which for me is a cause of concern.
Additions
On the buy side, I initiated four new positions in Colgate-Palmolive (CL), Phillips 66 (PSX), Energy Fuels (UUUU), and Intrepid Potash (IPI).
Colgate-Palmolive and Phillips 66 are both high-quality businesses that I am planning on covering in more detail in some of my next articles. Although not being very cheap, both companies have significant competitive advantages that allow them to earn higher ROIC than their peers. At the same time, they have conservative balance sheets, good factor exposure, and a well backed up dividend yield.
My main motive behind the purchase of Intrepid Potash and Energy Fuels is very different to that of CL and PSX. Both IPI and UUUU are very well positioned to benefit from a turnaround of prices in their commodities - Potash and Uranium ore. I cover my reasons for investing in IPI here. Uranium is another beaten down commodity which is essential for the global energy market. Although very frowned upon, nuclear energy remains as one of the top candidates to solve the global warming effect without us having to turn off the lights.
Existing Positions
Of my existing positions, GM, Coty (COTY), and Associated British Foods (OTCPK:ASBFY) declined over the past few months. GM, which I last covered in June, declined mostly due to commodity and exchange rate headwinds. At the same time, the company continued to execute flawlessly while receiving recognition from SoftBank (OTCPK:SFTBY) for its autonomous driving technology. This is creating an excellent opportunity to build on my position over the next few months.
Coty and Associated British Foods, which I covered back in July and April, also fell due to disappointing quarterly results. I am not concerned about these companies as the overall thesis for investing in them has not changed, while the pull-back in price has made them more appealing for increasing positions in the future.
The heavy lifting over the last few months was done by Cleveland-Cliffs (CLF) which increased by around 55% since my last portfolio update. Apart from the excellent execution, CLF has been a great hedge against rising commodity prices which caused some headaches at GM.
Conclusion
Being value investor has been hard over the past few years. Value and quality stocks significantly underperformed the market, which is now dominated by high-growth cyclical semiconductors and the FAAMGs. Iconic value investors such as Warren Buffett and David Einhorn are underperforming the market while many investors focused on high-growth stocks are rejoicing. Whether this trend of value underperformance is due to reverse anytime soon is hard to tell, however, as far as history is concerned - value stocks are due for a comeback.
This article was written by
Vladimir Dimitrov, CFA is a former strategy consultant within the field of brand and intangible assets valuation. During his career in the City of London he has been working with some of the largest global brands within the technology, telecom and banking sectors.
He graduated from the London School of Economics and is interested in finding reasonably priced businesses with sustainable long-term competitive advantages.
Vladimir is the leader of the investing group The Roundabout Investor where he teaches the process of evaluating roundabout investments; defined by potential high capital return, growth in free cash flow, safe dividends and conservative capital allocation. He offers weekly investment ideas, a model portfolio, a watchlist, macro outlooks, and sector deep dives. Learn more.Analyst’s Disclosure: I am/we are long ASBFY, GM, COTY, CL, CLF, UUUU, IPI, PSX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Please do your own due diligence and consult with your financial advisor, if you have one, before making any investment decisions. The author is not acting in an investment adviser capacity. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.
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