Searching For A Bargain - Volume II: A Detailed Contrarian Watch List Review

Summary

• International versus North American valuations. The United States is still expensive.
• A review of beaten-up sectors in America along with potential risks and rewards. Opportunities outside commodities are growing.
• A review of contrary Canadian sectors along with potential risks and rewards. Gold rallies out of the land of the unloved.

Introduction:

Twice a year I conduct a screen of North American indexes, international markets, and a top-to-bottom assessment of the existing watch list for Contra the Heard Investment Newsletter. Although valuations remain relatively high and economic conditions are deteriorating, many stocks and countries look attractive. Therefore, we think investors should be able to uncover good investments even in today’s environment.

The goal of this process is to identify opportunities worthy of further review. Contra’s watch list now includes 556 US names, 127 Canadian corporations, and 41 ETFs. By contrast, after the spring review there were 443 US stocks, 156 Canadian companies, and 52 ETFs. Those interested in that list can read more here: Searching For A Bargain: Where Contrarians Look After A Multi-Year Bull Market.

Of our updated list, only 33 US names, 13 Canadian stocks, and one ETF are being researched further, with the hope that a few of these will make good portfolio candidates this fall. At Contra the Heard, we do much of our buying in December, as tax loss selling tends to put downward pressure on beaten-up securities. This sometimes results in a better purchase price than we would see in other months.

Before reading further, keep in mind that I will not be discussing the individual names found during the process. Instead, this article will provide an overview of the countries and industries where contrary conditions exist.

International versus North American Valuations – The US Remains Expensive:

Unfortunately, American prices remain high compared to historic norms and other regions. One way to compare different markets is to use the so-called “Buffett Indicator” which compares a nation’s current market cap to gross domestic product ratio versus historic norms. Guru Focus provides this information here:

Source: Guru Focus’s Sept 16, 2019 Global Market Cap to Gross Domestic Product Table

Based on this metric, the United States is expensive and Canada is fairly valued. Though the Buffett Indicator is useful, considering an array of metrics produces more reliable signals. StarCapital does this by tracking a variety of metrics:

Source: StarCapital’s August 30, 2018 Global Stock Market Valuation Table

Here too, the United States looks lofty. According to StarCapital, it is one of the more expensive countries along with India, Ireland, Denmark, and Finland. Canada remain in the middle of the pack. Russia, Turkey, Greece, Italy, and China represent the most undervalued countries, with Israel, Austria, Spain, Portugal, and Singapore close behind.

Investing in out of luck lands may be rewarding, but it is risky. Russia and China rarely make the news for good behaviour. Both have high corruption, weak capital markets, and aren’t shining examples for the rule of law, transparency, and freedom of the press. This may cast doubt over the validity of corporate earnings, valuations, and economic data. Add on Western sanctions against Russia, and perhaps their price is justified. In China, the government faces the trade war, protests in Hong Kong, and slowing economic activity. Furthermore, the Chinese have taken on tremendous debt, which topped 300% of gross domestic product as of Q1 2019. Given this backdrop, it may be too soon to be focused on China.

Turkey, the second cheapest market, isn’t issue free either. It is working through its economic challenges, but political, social, and currency concerns remain. Israel seems less problematic, but its election outcome is too close to call, and investors should anticipate some turbulence no matter the result.

In Europe, Greece and Italy were the cheapest markets. Both have high debt to gross domestic product, poor demographics, and face political, social, and economic issues. While Greece’s July election resulted in a clear winner, Italy’s picture is murky. Still, we have a current position in a Greece ETF, and think it is worth the risk.

Other countries with beaten-up indexes and similar characteristics to Greece and Italy include Portugal and Spain. Remember the old PIIGS from the European Debt Crisis? (Portugal, Italy, Ireland, Greece, and Spain). Turns out that many of them still deserve being included in that acronym.

Further north, Austria looks undervalued, as do UK firms or UK based American Depositary Receipts. We think these British investments may be an excellent opportunity at some point, but we’ll wait for now given the negative rates across Europe, Brexit uncertainty, and the contraction in Germany.

Although Argentina and Colombia were too small to be included in the list above, both have unloved exchanges. While Colombia is tied to energy and Venezuela, Argentina has collapsed and remains trapped in a centuries-old pattern of default and devaluation. Recently the Argentinian economy has shrunk, and inflation has sored to over 50%. In August, President Mauricio Macri was defeated in a primary election result, casting doubt over his ability to win the October election. In the aftermath of his August defeat, currency and capital markets imploded, the country implemented capital controls, and the odds of default skyrocketed. This market is truly beaten-up, and Argentinian entities are hurting.

Our challenge is trying to determine if the bad news is baked into these foreign stories. Though there are many index funds which follow these geographies, a handful of ETFs which track these countries specifically are:

• Global X MSCI Argentina ETF (NYSEARCA:ARGT)
• iShares MSCI Austria ETF (NYSEARCA:EWO)
• Deutsche X Trackers Harvest CSI 300 China A-Shares ETF (NYSEARCA:ASHR)
• iShares China Large-Cap ETF (NYSEARCA:FXI)
• iShares MSCI China ETF (NASDAQ:MCHI)
• SPDR S&P China ETF (NYSEARCA:GXC)
• Global X MSCI Colombia ETF (NYSEARCA:GXG)
• Global X MSCI Greece ETF (NYSEARCA:GREK)
• iShares MSCI Israel Capped ETF (NYSEARCA:EIS)
• VanEck Vectors Israel ETF (NYSEARCA:ISRA)
• iShares MSCI Italy ETF (NYSEARCA:EWI)
• Global X MSCI Portugal ETF (NYSEARCA:PGAL)
• iShares MSCI Russia Capped ETF (NYSEARCA:ERUS)
• VanEck Vectors Russia ETF (NYSEARCA:RSX)
• VanEck Vectors Russia Small-Cap ETF (NYSEARCA:RSXJ)
• iShares MSCI Singapore Capped ETF (NYSEARCA:EWS)
• iShares MSCI Spain Capped ETF (NYSEARCA:EWP)
• iShares MSCI Turkey ETF (NASDAQ:TUR)

Going long on these cheaper markets is one strategy, but shorting the expensive markets is another – however, we don’t short. This is because the risk/reward is asymmetric, and valuations are a terrible timing tool. Securities that appear expensive can stay expensive for a long time. For those who do short, though, a list of ETFs covering these hot markets includes:

• iShares MSCI Denmark Capped ETF (BATS:EDEN)
• iShares MSCI Finland Capped Investable Market Index ETF (BATS:EFNL)
• iShares MSCI India Index ETF (BATS:INDA)
• WisdomTree India Earnings ETF (NYSEARCA:EPI)
• iShares S&P India Nifty Fifty Index ETF (NASDAQ:INDY)
• iShares MSCI India Small Cap Index ETF (BATS:SMIN)
• Invesco India ETF (NYSEARCA:PIN)
• VanEck Vectors India Small-Cap Index ETF (NYSEARCA:SCIF)
• iShares MSCI Ireland Capped ETF (NYSEARCA:EIRL)
• Invesco QQQ ETF (NASDAQ:QQQ)
• iShares Core S&P 500 ETF (NYSEARCA:IVV)
• SPDR S&P 500 Trust ETF (NYSEARCA:SPY)
• Vanguard S&P 500 ETF (NYSEARCA:VOO)
• Vanguard Total Stock Market ETF (NYSEARCA:VTI)

Although ETFs are useful for generating overseas exposure, fund managers can adjust an ETF’s sectoral weights by modifying the underlying index the ETF tracks. This is often done annually and is called “rebalancing” – and means that investors may not end up owning what they anticipated. Our Greek ETF, for example, has modified its weightings in the past. Seeking Alpha contributor, Martin Vlcek, wrote about this rebalancing issue years ago – his excellent article can be found here: GREK Rebalancing: The Trojan Horse Has Just Been Delivered.

In addition to the rebalancing problem, The Big Short maverick Michael Burry has recently taken issue with index funds. According to Burry, index funds have removed price discovery from equity markets. Instead of price setting based on security level analysis, indexes determine a securities price based on capital flows, but these flows are blind to an asset’s underlying value, financial risk, and growth prospects. To him, this appears a lot like the collateralized debt obligation bubble underpinning the subprime mortgage crisis. Add on a liquidity disconnect between the billions linked through ETFs to stocks that trade at a fraction of that volume, and he thinks it will end in disaster. Is he right? We don’t know, but internally we have discussed the issues of liquidity and limited security level price discovery often.

It is also worth noting that Michael Burry is not alone pointing out issues with ETFs. Howard Marks has compared an ETF’s price discovery mechanism to buying assets on auto-pilot, and warns they are not as liquid as they appear. Others have pointed out how ETF flows have driven up the prices and valuations for the “fantastic four” (McDonalds, Caterpillar, Boeing, and 3M) as if they were FAANGS despite deteriorating growth prospects. The late Godfather of ETFs Jack Bogle was concerned by the proliferation of ETFs using leverage or ETFs that focused on narrow market niches too. Even Moody’s issued a warning earlier this year about ETF liquidity. Perhaps a “buyer beware” sticker on these products is a good idea.

Given these issues, our preference is to generate foreign exposure through American Depositary Receipts or invest in international organizations listed in North America. They are a mixed blessing however, as they give investors exposure to enterprises abroad but generally come with high fees too. Nevertheless, many global telecoms, financials, and utilities are on our list.

Beaten-up American Sectors – Opportunities Expand Beyond Commodities:

American stocks may be hot versus other geographies, but there are still segments with low valuations. This time around, our US watch list actually grew from 443 to 556 names.

Source: Guru Focus’s S&P 500 sectoral breakdown – Sept 2019

Energy remains littered with dozens of downtrodden outfits, but for good reason. Many in oil and gas carry huge debts, and the industry is faced with a difficult macro environment. Other debt heavy industries which showed up in droves this time include REITS, steel companies, specialty chemical makers, coal miners, and sea-borne shippers.

Despite the multi-year downturn in shipping, it is somewhere we’ve spent some real time assessing. One company which we have a position in is Diana Shipping (NYSE:DSX). Unlike many peers, it has a relatively strong balance sheet, has had minimal dilution, and has engaged in many tender offers over the last year. You can read more about the company, its buyback, and the shipping industry in general in our recent post here: Diana Shipping: Expect More Tender Offers And Buybacks.

Retail is another space that has featured regularly on our lists over the last two years, and this review was no exception. Dozens of entities from watches and women’s apparel to discount stores and home furnishings were on the list. Compared with oil and gas, it’s easier to find retailers with clean financials. Still, fashion is fickle, the transition to online is hurting, and tariffs may squeeze margins. A retailer Contra the Heard currently owns is Hibbett (NASDAQ:HIBB). You can learn more about this organization and why we like it here: Hibbett Sports: Thesis, Results, & Outlook.

Within financials, three subsectors generated multiple hits. First, 18 or so asset managers made it through the filter. They are generally small-caps, with eroding assets under management, and are struggling to compete against low fee passive funds. This segment may be ripe for consolidation. Secondly, many insurance companies made it through the screen this time – most of them were in property and casualty insurance. Finally, nearly two dozen regional banks made the list as well. Even a decade out from the Financial Crisis, this arena is still recovering, and we continue to see opportunity. Earlier this year I wrote about my post 2008 experience with US regional banks: Introspection Is Key: Assessing Past Regional Bank Trades And Their Post-Sale Performance. An important caveat to keep in mind is that though regional banks look undervalued and may be primed for further consolidation, they often do poorly when interest rates fall, as it compresses net interest margins.

The final sectors that surfaced consistently during this screen include auto-parts providers, transportation / logistics operations, medical equipment makers, semi-conductor companies, communication equipment manufacturers, homebuilders, building product suppliers, and construction / engineering firms. Unlike shipping, steel making, and energy, there are candidates here with reasonable growth prospects, consistent cash flows, and good balance sheets.

Rounding out the American list were a handful of ventures not part of a larger downdraft. Many of them have fallen as a result of specific problems related to changes in pricing power and cash flows, their balance sheets, or shifts in their sales trajectory. Other times they are engaged in a protracted turnaround or were once-darling stocks that have failed to meet expectations. Therefore, in addition to the aforementioned sectors, we have a motley mix of care facilities, casinos, drug manufacturers, biotech firms, and food packaging companies to watch.

Contrary Canadian Opportunities – Gold Rallies Hard:

For years the Canadian watch list has been dominated by gold and energy – but that has changed. This is largely because gold miners overall have rallied, and at the same time many oil and gas companies have been culled due to high debt. This means our Canadian list actually shrank with this review, dropping to 127 names from 156 six months ago.

Sectors that showed up frequently in the US also appeared in Canada. These industries included retail, construction / engineering, REITs, transportation / logistics, building materials, and asset managers. Excluding currency, the risks associated with these industries do not discriminate by geography, and the same considerations made when reviewing American securities need to be applied to Canadian firms too. Remembering this should eliminate “home bias”.

Canada also produced opportunities in seafood, grain storage, and farm equipment distribution, and I’ve now started tracking some banks and homebuilders as well. Though the banks and homebuilders are not contrary today, they’re showing cracks and may be attractive down the road.

Income-oriented Canadian investors may be interested in preferred shares. The segment has had a rough year, especially on the rate reset side. Three ETFs which follow the Canadian preferred share universe are:

• BMO Laddered Preferred Share Index ETF: ZPR on the TSX
• Horizons Active Preferred Share ETF: HPR on the TSX
• iShares S&P/TSX Canadian Preferred Share ETF: CPD on the TSX (CYSXF ANALYSIS & NEWS - ISHARES S&P/TSX CANADIAN PREFERRED SHARE INDEX ETF)

Contra’s principals and I sometimes purchase preferreds personally. We have not, however, bought a preferred share ETF or invested in preferred shares for either portfolio at Contra the Heard. This is because volumes are low, the market is volatile, and assessing them adds complexity. While they offer income and seem cheap, the securities are not a free lunch.

Conclusion:

Despite the high global valuations, there are several unloved, and – hopefully – undervalued opportunities out there, but downtrodden securities are often priced that way for a reason. As contrarian investors, we aim to proceed carefully. This requires homework, patience, and weighting portfolio additions appropriately. Even then, it doesn’t always work out, and sometimes investments go south. My next step is to focus on a small handful of names to understand their risks and the rewards, and then invest accordingly.

Though here at Contra we are bottom up investors, we keep the macro picture in mind. In addition to expensive global markets, volatility remains low, and debt levels are high. The debt binge since the Great Recession should not be underestimated, as it’s slowly seeped into all segments of the economy, from federal governments and corporations right down to small businesses and individuals. Unfortunately, valuations and debt metrics also make terrible timing tools. Their forward-looking value is confined to determining the potential magnitude of downturns or rallies when a sea change occurs. Bond market activity can be a better timing tool, and with yields inverted, there are current warning signs. At Contra the Heard, our solution to this macro outlook is to try and pick cheap securities, bet size appropriately, and maintain cash on hand.

Feel free to like, share, and comment on this article. If you have more specific questions about the watch list or our process, please contact me directly through Seeking Alpha or email me at [e-mail].

Disclaimer:

The opinions expressed – imperfect and often subject to change – are not intended nor should be taken as advice or guidance. Contra the Heard Investment Newsletter is not an investment advisor or financial advisor. Contra the Heard Investment Newsletter provides research, it does not advise. The information enclosed in this article is deemed to be accurate and reliable, but is not guaranteed by the author.

Analyst’s Disclosure: I am/we are long DSX, GREK, HIBB. 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.