Is a prolonged period of rewarding high-revenue-growth about to end? (Mid-4Q19 Quarterly Newsletter)
December 15, 2019
CWC Portfolio Manager Michael Hubbert talks valuation. #cwcculture
A Word from the Co-Editors
Kit-Victoria (Weil) Wells – Culture & Communications Officer
Catalina Cherny-Santos – Organizational Efficiency Manager
One of the cornerstones of Christopher Weil & Company, Inc. (“CWC”)’s investment approach decrees that valuations matter. Simply put, if you buy good companies at fair prices, the returns will likely compound in your favor over time. We are careful not to confuse good products with good companies. Good companies can fund their own capital expenditures and sustain a high return on their investment while building a path forward to returning capital to investors or reinvesting capital at a higher rate of return. A good product, on the other hand, can be enjoyable and/or useful but not necessarily made by a company that fulfills the above criteria. In this mid-quarter newsletter, Mike Hubbert, one of our Portfolio Managers, lays out the finer points of our belief that an opportunity exists in small-cap value.
Why Small-Cap Value Today?
Michael Hubbert – CWC Portfolio Manager
Since roughly 2009, the U.S. markets (as well as many global markets) have been in a prolonged period of rewarding high-revenue-growth companies (growth stocks) versus well run cash-flowing companies (value stocks). But markets move in cycles. There is the overall economic and business cycle as well as the cycles that play out within them; value versus growth being a classic example. Emerging from the wide array of sources we use to create the mosaic for our portfolios is our belief that small-cap value stocks may become the rewarded stocks over the next five to ten years. We believe that prospective success will be the result of valuation reversion and investor positioning.
Recently, several small-cap value managers have stressed to us that many of the companies in their investment universe are trading in the bottom third quartile of their historical valuation bands, while yielding dividends that are considerably higher than the S&P 500. At a time when the S&P 500 is trading in its highest quartile of historical valuations, active managers of small-cap value are seeing plentiful opportunities. Investor Michael Burry (of “The Big Short” fame) recently contacted Bloomberg to weigh in on a few issues. Burry told Bloomberg:
The bubble in passive investing through ETFs and index funds as well as the trend to very large size among asset managers has orphaned smaller value-type securities globally ... There is all this opportunity, but so few active managers looking to take advantage.
The potential bubble in passive investing is a topic we can save for another day, but we believe Burry is correct. There are still good stocks out there that can offer strong absolute returns over the foreseeable future.
Another small-cap-manager we invest with recently said something that goes to the core of CWC’s fundamental and decades-long belief structure about value. To paraphrase, he said:
When investing in stocks, you should ask yourself; is this a price an informed Industrialist would pay if s/he was buying the entire company?
Investor positioning in growth stocks may have reached its peak. The canary in the coal mine may be the Initial Public Offering (“IPO”) market. IPOs of profitless companies are now at their highest level since the late-90’s Tech Bubble. Most of these IPO companies came into existence during this ten-year bull market. Venture capital and private equity are generally reliant on “exits.” Many of these growth companies are not producing cash flow and so rely on going public to create an exit opportunity that monetizes their asset. We are now seeing signs that the markets are not terribly excited by these companies being brought to market, apparently viewing them as overpriced.
The share price of IPOs like Uber and Lyft have been cut in half since going public. WeWork was one of the most hotly anticipated IPOs of 2019. That changed when their business model was abruptly called into question, thereby scuttling their IPO and significantly reducing the company’s pre-IPO valuation. Many of these companies are not likely to be profitable or generate free cash flow until after the next recession. It appears the market is finally starting to take this likelihood into account. Money tends to dry up in a hurry once “exits” stop working at high valuations, turning the “virtuous cycle” into the “vicious cycle.”
And it is not just recent IPOs. Shopify, another E-commerce platform (that has yet to navigate its way through a recession), recently issued new shares at a price-to-earnings ratio (“P/E”) well in excess of 400 to 1 in an effort to strengthen its balance sheet, and provide flexibility to fund its growth strategies. By issuing stock, Shopify is choosing to dilute current equity holders of the already meager earnings they make. We are all for companies growing. But this leaves us wondering “why not take advantage of historically low interest rates and raise debt instead?” The decision to issue stock seems to be an admission that they are overvalued. Shopify may prove itself a formidable company in time, but Amazon, Facebook, and Netflix experienced pullbacks in their public infancy of 95%, 60%, and 82% respectively. It is possible the current market landscape might deliver the same baptism by fire to Shopify and other stocks like them.
J.P. Morgan’s Global Head of Macro Quantitative and Derivatives Strategy team Marko Kolanovic believes markets may be set to move back to small cap value. In July, Kolanovic alerted investors that the underperformance of value stocks, relative to low volatility and momentum stocks, was worse than any historical factor divergence, even during the late-90’s Tech Bubble. He said:
We think that the unprecedented divergence between various market segments offers a once in a decade opportunity to position for convergence.
In September, he went on to say:
Given that the S&P 500 is heavy in bond proxies and secular growth, we would expect higher upside potential in small-caps, cyclicals, value, and emerging market stocks than the broad S&P 500.
As a tidal wave of money flowing into large-cap U.S. stocks reaches its tenth year, we see the love for an over-priced asset class beginning to recede. We believe this positions the underappreciated asset classes we have targeted to better brave the elements.
As we said before, we aggregate our findings to codify the mosaic that underpin our portfolios. As we seek to build the best and most appropriate portfolios for our clients, we also apply the tenets of CWC’s investment approach: valuations and market cycles matter, diversification is a means to drive returns, protecting the downside results in better outcomes, and calculating expected results helps quantify risks. (For more information about CWC’s investment approach, speak to any member of the CWC Advisory Team.)
We genuinely enjoy the intellectual challenge and opportunity to build value for the people who have put all or a piece of their financial well-being in our hands. In addition to wishing you a Happy Holidays and a healthy, prosperous New Year, we leave you with some words of wisdom from which we take guidance:
Identify the paradigm you’re in, examine if and how it is unsustainable, and visualize how the paradigm shift will transpire when that which is unsustainable stops.
- Ray Dalio, Bridgewater Associates
It’s not enough to be different – you also need to be correct.
- Howard Marks, Oaktree Capital
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