The S&P 500 Index returned 4.30% during the second quarter, with low volatility stocks leading the way, growth stocks just behind and value stocks lagging. The Thornburg Value Fund had a disappointing quarter, up just 1.59% (I shares). For the first half of 2019 that puts the fund up 15.84%, a good absolute return, though trailing the index return of 18.54%.
What We See
The two most interesting things we see today are the wild outperformance of low volatility stocks, especially over the last year, and the associated underperformance of value stocks.
Chart 1 is a look at the valuations of companies that are expensive versus cheap, on a trailing P/E basis.
Chart 2 shows the forward P/E spread of the S&P 500 Value Index stocks versus the overall market (as represented by the S&P 500).
Chart 3 shows the valuation of low volatility stocks versus the overall market. Notice how tight valuations were back in 2013.
To frame the current environment, we must discuss interest rates. As of this writing, the U.S. 10-year Treasury sits just above 2%, down from 3.25% last fall. Globally, record amounts are invested in negative yielding bonds today (approximately USD 13 trillion). By one measure, global interest rates are at 5,000 year lows.1
Many investors use discounted cash flow (DCF) or dividend discount models (DDM) to value their equity investments. Both are highly dependent on two variables, the projected constant growth rate in perpetuity and constant cost of equity capital. As the risk-free rate declines, so does the cost of equity capital. Funny things begin to happen as investors apply forever low risk-free rates into their valuation models. The implied P/E valuation for businesses that are projected to grow, forever, can go almost parabolic. This may explain some of the valuation discrepancy that we’re seeing in growth and low volatility companies relative to the rest of the market.
Interestingly, as the discount rate declines, the portion of valuation driven by cash flows further out in the future increases. From the AllianceBernstein research report Global Quantitative Strategy: Has Value Met Its Waterloo?,2 “If the overall discount rate (WACC*) falls from 10% to 5% in a very simple DCF then the proportion of the net present value accounted for by cash flows more than 5 years in the future rises from 70% to 95%.” AllianceBernstein takes pleasure in highlighting that, based on their data, “people are really bad at forecasting anything 5 years ahead.”
Investors, especially factor ETF investors, seem to be using a shortcut to figure out which companies will grow fast, forever. They have been plowing money into S&P 500 low volatility ETFs, which simply track the performance for the 100 least volatile stocks in the S&P 500 Index as measured by trailing 12-month standard deviation. It also happens that these ETFs have performed well, of late, and according to Empirical Research Partners report Stock Selection: Research and Results June 2019,3 “Most of the flows that go into ETFs each month are directed into products that rank in the highest two quintiles of three-month past performance.” So perhaps that’s what’s going on? Empirical Research Partners further points out that since 2011, there has been a nearly 2% annualized difference between the dollar weighted return in low volatility ETFs and the buy and hold results in the very same ETFs. Investors seem to be very bad at timing their purchases and sales of low volatility ETFs.
Either way, we think the valuation dispersion is misguided, and has left many companies with great prospects looking very cheap. We’ve long said that defensives look expensive to us—and now, even more so. We work hard to invest in a balanced portfolio and have a large component of stable and consistent businesses, but we do tend to own less “expensive defensives” than the overall market. This has weighed on performance recently, but we believe it sets the portfolio up well looking ahead.
We also tend not to focus on DCF or DDM valuation approaches in our valuation work. We rely more heavily on tying our adjusted earnings forecasts to the free-cash-flow generation capability of a business and calculating price targets based on a multiple of adjusted earnings a year or two into the future. We award higher multiples to businesses that we think will grow earnings faster or where we believe the earnings stream is more predictable (i.e. less cyclical). The work that we do on “reason for being” and “competitive dynamics” support our forward earnings projections. On our work, our portfolio of investments looks as attractive as ever vs. the S&P 500 Index, while maintaining a healthy allocation to Consistent Earning businesses that should hold up better in a downturn.
Sector allocation, overall, didn’t impact relative performance materially during the quarter. Though our overweight allocation to financials helped, our underweight to information technology, our cash position and our overweight to energy investments were each a drag on relative performance.
All of our short-term relative underperformance during the quarter was driven by stock selection within sectors. While stock selection aided returns in the energy and consumer discretionary sectors, poor short-term stock performance in the information technology, communication services and health care sectors were a drag on relative returns. Our top and bottom performers list will highlight many of the individual drivers—though our weakest individual contributor during the quarter, Pure Storage, was up a lot (35%) during the first quarter of the year.
Second-Quarter Top Performers
- JP Morgan and Citigroup
JPMorgan and Citigroup showed strength in the second quarter, as financials bounced back from weakness during previous quarters.
- Thermo Fisher Scientific
Thermo Fisher Scientific’s fundamentals remain strong as demand from biopharma research continues. The company has been executing on its plan—organic revenue growth, margin improvement and smart capital allocation.
- Crown Holdings
Crown noted that the metal beverage can industry is seeing increased demand from new products as some companies rethink plastic bottles, allowing them to increase pricing/margins in certain geographies. Crown has demonstrated consistent operating income and cashflow generation over the years in its beverage can business, and we believe the stock should re-rate closer to peers as results come through.
CarMax saw better-than-expected same-store sales while continuing to hold their profit per car sold at a steady, above-industry-average level. The rollout of their new omni-channel strategy, which allows potential buyers to purchase a car in-person or online, is progressing rapidly and should be accessible in most of their markets much sooner than anticipated. This is expected to contribute to both long-term growth and margin improvements.
Second-Quarter Bottom Performers
- Cognizant Technologies
Cognizant reset growth expectations for 2019 in the first quarter under a new CEO, sending near-term earnings expectations and the stock price lower.
- Capri Holdings
Capri noted a continuation of weak sales trends at its core Michael Kors brand, and the stock sold off despite management reiterating their FY20-FY22 earnings targets as the targets now appear more difficult to achieve. The stock currently trades at just 7.0x FY20 consensus earnings per share.
In addition to the ongoing drone of regulatory worries out of Washington, Alphabet disclosed a slower-than-usual revenue growth rate during their first quarter report. While the lack of segment revenue detail makes it harder to discern the cause of the slowdown, we expect continued strong growth from the company’s mix of dominant businesses.
- Pure Storage
Pure Storage narrowly missed revenue expectations against the backdrop of a slowing industry in their first quarter report, sending shares lower. We would note, however, that revenues still grew 28% year over year, making them a significant share gainer, and the stock now trades at just 1.8x EV/sales value to sales, making the setup look increasingly attractive moving forward.
Alkermes has been a very weak stock for us of late. The potential for government action on drug prices has depressed stock prices across the space. More than that, Alkermes management is struggling from a lack of investor confidence. While we had very little expectation that their large opportunity depression drug would make it to approval, the FDA rejection of their application in February still weighs on sentiment. During the first quarter, Alkermes reported what appears to be a very short-term inventory related hiccup in Aristada sales. Given sentiment, many investors are not giving the company the benefit of the doubt on this most recent setback.
Thank you, as always, for your trust and confidence.
|Crown Holdings, Inc.|
|Capri Holdings Ltd.|
1. Speech by Mr. Andrew G Haldane, Executive Director and Chief Economist of the Bank of England, at the University of East Anglia, Norwich, 17 February 2016.
2. Inigo Fraser-Jenkins, Mark Diver, Alla Harmsworth, Sarah McCarthy, CFA, Global Quantitative Strategy: Has Value Met Its Waterloo?, AllianceBernstein research, 19 June 2019.
3. Rochester Cahan, Yu Bai, Stock Selection: Research and Results, Small-Caps Versus Large-Caps: Give the Little Guy a Chance? Defensive ETF Flows Reveal Extreme Pessimism, February 2019.
Performance data shown represents past performance and is no guarantee of future results. Investment return and principal value will fluctuate so shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than quoted. For performance current to the most recent month end, see the mutual funds performance page or call 877-215-1330. The maximum sales charge for the Fund’s A shares is 4.50%.