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 Long/Short Equity Fund had a disappointing quarter, down 1.13% (Class I shares, Accumulating). For the first half of 2019 that puts the Fund up 5.61%, which is a little less than a third of the S&P 500 Index’s 18.54% for the period, about in line with our net exposure during the period (32%). We had a great first quarter in Long/Short Equity but gave our lead back during the second quarter.
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 five 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 five 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 improperly valued companies on both sides of the spectrum. 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 growers, but we do tend to own less “expensive defensives” in our long book than the overall market. On the other side of the book, we saw large positive returns in several of our shorts during the quarter that fall in either the high growth or low volatility camps. These dynamics have weighed on recent performance, but we believe set the portfolio up for great results in the future.
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” supports our forward earnings projections. We see great opportunity today on both sides of the book.
While the short book generated the negative contribution that took our overall result negative for the quarter, our performance there was ok, on a relative basis. Our shorts were up in line with the S&P 500 during the quarter. The real problem was that our longs did not keep up with the market (up 1.5% versus 4.3% for the S&P 500).
While we had strong results in the consumer discretionary sector, other sectors were weak. Consumer staples stocks were our biggest drag on performance, followed by health care, industrials, communications services and information technology.
The long detractors highlighted below, Alkermes and Pure Storage, were an almost 2% drag on results during the quarter. In a big up quarter, these individual positions hurt. That said, we remain convicted in both.
Second-Quarter Top Performers
• Zillow Zillow’s shares responded well to its first-quarter results, which showed accelerating revenue growth from the new Zillow Offers business. Offers is an early-stage venture funded by Zillow’s larger and more established advertising business that allows homeowners to sell their houses directly to Zillow. Homeowners get a fair price for their house and avoid the hassle and uncertainty of selling through traditional means. Once Zillow takes ownership of a home, it aims to resell it within 90 days. Zillow has natural advantages in marketing homes by virtue of having the largest audience of real estate shoppers on its website every day. Currently Zillow Offers is loss making, but we believe Offers will produce healthy profits and returns on capital as it scales up and begins providing higher-margin services, including sellers leads and mortgage origination.
• CarMax 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.
• Foot Locker We believe that Foot Locker, an athletic retailer, is structurally challenged due to declining mall traffic and brands like Nike/adidas selling directly to consumers. Shares of Foot Locker underperformed during the quarter due to weak earnings.
• Sleep Number Sleep Number, a manufacturer of high-end airbed mattresses, missed revenue expectations for its latest quarter. Overall units of just +1% implied same-store sales were negative even as they have been transitioning away from mall-focused stores and had a full quarter of their new 360 mattress line.
• Starbucks Starbucks continued to show strong same-store sales growth in the U.S., reassuring the market that they have found a solution to last year’s slowdown. Store growth continued at a rapid pace in China, which also saw improved same-store sales despite the regional focus on increasing store count. The company is performing well, which reassured the market that Starbucks continues to be a great company even after the departure of long-time CEO and founder Howard Schultz.
Second-Quarter Bottom Performers
• Beyond Meat Beyond Meat is a developer of plant-based protein products, most notably its Beyond Burger. The recent price appreciation against us is due to a combination of a low float, an active short name and headline risk as fast food chains have explored and signed up to sell plant-based burgers from Beyond Meat and its competitor Impossible Burger.
• Alkermes 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.
• Generac Generac is a manufacturer of standby and portable generators. Our thesis centered around the pull forward of demand from a highly active hurricane season, but recent results have continued to be stronger than expected, driven by growth in home standby generators and their commercial segment. The company also announced small acquisitions within energy storage, which could potentially be a future growth driver for the company.
• Boston Beer Company Our thesis on Boston Beer, an alcoholic beverages company, is that the company’s craft beer business is challenged because of low barriers to entry. While the flavored malt beverages business is currently growing, it is susceptible to market share losses due to changing consumer preferences and competitive product launches. Shares of Boston Beer moved higher during the quarter as earnings beat expectations.
• 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, making the setup look increasingly attractive moving forward.
Thank you, as always, for your trust and confidence.
|Crown Holdings, Inc.|
|Alaska Air Group, 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.