Globescan Capital was founded on the principle that investing in high quality companies at attractive prices is the best and most consistent strategy to achieve long-run risk adjusted performance. This remains as true today as it has ever been. Regardless of the recent market movements we maintain the same disciplined adherence to that principle.
What happened during 2018?
2018 was the worst year for the S&P 500 since 2008. Q4 was the worst quarter since 2008, with a -13% return. The S&P 500 finished the year in total -4.5%. For the worst year in a decade to be only a -4.5% is still a very good decade. Bear in mind that the 2008 return was -39%. Since 1980, the S&P has risen in absolute terms in 3 out of every four calendar years.
It is important to put this -4.5% return into context. At the nadir on March 9th 2009 the S&P 500 stood at 677 on a PE of 10.3x. Since then, the index has risen to 2,507 and stands on a PE of 14.4x. That is a gain of 271% in price terms. Looking more recently, the only real decline we have seen during the last decade was 2016, when the S&P fell 12%. Since then, in just three years the market is up 30%, even accounting for the decline in 2018. As such, whilst the Q4 downturn was sharp, most investors have still enjoyed very substantial returns over the last few years.
Aside from equity markets, we also saw oil markets post their first calendar year loss in 3 years, with both Brent and WTI down more than 20%. As a result, we have already seen some scale- back of planned activity for 2019. Despite this, the EIA still expects US output for 2019 to rise to 12.1m bpd, up from 10.9m bpd.
In fixed income markets, we have seen the progression of interest rate hikes by the Fed- faster than many (including President Trump) would like, along with a near inversion of the yield curve. One of the concerns coming into 2018- inflation- is arguably less of a concern now, both because interest rates are higher and because oil prices have come down so much. One area to be wary of is the flattening of the yield curve- this is often cited as a warning sign of market distress and a precursor to recessions. Looking historically, on average the yield curve inverts 14 months ahead of a recession, but bear in mind that the yield curve has in the past inverted without any ensuing recession at all. As such, we need to be wary of it as a warning sign (particularly for banks- who struggle in this sort of environment), but not necessarily rely on it as a recession predictor.
Why was the stock market down during 2018?
The reasons quoted for the sharp decline in the S&P 500 during Q4 were numerous, and often spurious. It was always interesting to look at different newspapers or channels on days when the S&P was down more than 2%; each claiming different reasons for the fall. Some blamed it on China/ US trade deals, some blamed it on Brexit, or Italy, or valuations, or oil price movements. The reason that each news source differed so much in their reasoning comes back to why we do not attempt to time markets in the short term- because short term moves are random, and as such cannot be reliably and consistently predicted.
One possible longer-term reason for the sell off in equity markets is related to the distortion created by Quantitative Easing (QE) and historically low interest rates. Monetary easing has resulted in some investors being forced up the risk spectrum in order to search for returns. This has meant some investors have had to increase their equity exposures above historic levels. During 2018, interest rates began to rise and therefore the returns available on cash and bonds rose also- meaning some investors have been able to sell down their ‘excess’ equity balances and reinvest into fixed income assets. This flow of funds is hard to track as it is often swamped by new money entering financial markets, but could also have been partly responsible for some of the recent downside in equity markets.
Does the decline continue from here?
The first thing to say here is to repeat the last comment of the previous paragraph- that trying to predict short term market movements is akin to gambling. The thoughtful long-term investor instead looks at the market to determine whether or not it offers good long-term value, and on that basis makes investment decisions.
Determining whether or not equity markets offer good long-term value is a subjective decision, involving an assessment not just of absolute value, but also of relative value- i.e. accounting for potential returns available in other asset classes at the same time. In order to simplify things, investors often use a straight PE ratio as a guide to overall equity market valuation levels. (Reminder: the PE ratio is the ‘Price/ Earnings’ ratio: calculated by dividing the company’s share price by its earnings per share). A few things to bear in mind when looking at PE ratios:
PE ratios do not account for different capital structures– e.g. a company with a large amount of cash on their balance sheet will look ‘expensive’ compared to a company that is instead highly levered. This can be misleading. Take Apple which trades on a PE of 14x, yet has $66bn in cash. Accounting for this cash brings the ‘real’ PE down to only 9x.
PE ratios use only 12 months of earnings in order to derive valuation. Using a short-term earnings number to assess value in a long-term asset is arguably very insufficient. It also does not account for the future expected growth rate. This is particularly an issue in companies that are growing their earnings very quickly, which will appear expensive on a PE basis. For example, S&P 500 earnings are expected to grow by around 8%, and the S&P 500 trades on a PE of 14.4x (based on next year’s earnings expectations). Mastercard looks expensive on a PE of 29x, but it is expected to grow its earnings by around 21%. So, with Mastercard you get more than double the growth rate of the market, but have to pay less than double the valuation- as such, it is arguably not expensive at all. There is also an argument for the sustainability of earnings- those companies with very secure and non- cyclical revenue streams (such as Air Products, American Tower etc) typically trade at elevated valuations as the market gives them credit (rightly so) for the fact that their earnings remain very resilient even in recessions.
The ‘E’ element of PE ratios can be skewed by a number of factors such as buybacks, or indeed the recent corporate tax cuts, which were an immediate and possibly not sustainable benefit to the ‘E’ within the equation. Such a boost to the denominator of the equation brings down the PE ratio overall- making stocks appear better value.
This is not to say that PE ratios are useless as a tool for determining value- only that one needs to be aware of their shortcomings and ensure that they are only one of a number of valuation methodologies used when making investment decisions. Be wary of news commentators, pundits or anyone else who relies solely or heavily on PE ratios.
However, using this somewhat blunt tool as a basic guide, markets six months ago were not excessively expensive (certainly compared to previous market peaks). Halfway through 2018 the S&P was trading on a PE of around 16-17x, only just above the long term (25 year) average of 16.1x, the peak PE during 2018 was only just above 18x, far less than the 24x we saw in the late 1990s. At today’s level of 14.4x, we stand around half a standard deviation below the 25-year average. This crudely indicates that equities represent reasonable value, given historic valuation levels. We must however be wary of the ‘E’ element of the equation- the tax cuts implemented by President Trump have resulted in an immediate earnings boost. S&P 500 companies grew earnings by c20% during 2018, but more than half of that was through margin expansion alone- much of which was down to a simple reduction in tax rate rather than genuine expansion.
How have we reacted to this move?
One thing we have been actively doing in portfolio’s is taking advantage of weakness by adding to positions we feel have been excessively punished in this recent downturn. I’m sure many of you have heard the phrase ‘a rising tide lifts all boats’- meaning a rising market benefits most stocks- good and bad. The opposite is true of falling markets- good companies can be unfairly punished in market downturns, thus offering great opportunities. Here a few select examples of purchases we have been making over the last few months:
CarMax- the stock is down 22% from its peak, yet its earnings outlook has not changed. They will continue to open 12-15 new stores per year, which translates to double digit earnings growth over the next few years. The company carries very little debt and produces so much cash it has been increasing its buyback to around 20% of all of the outstanding shares.
Facebook- has been in the news a huge amount for data and privacy issues. Facebook now has over 1.5billion users daily across a variety of platforms. WhatsApp and Instagram are both in the billions alone, yet FB has not even really begun to monetize these platforms at all. Their runway for growth remains enormous but the company has suffered with negative short-term press. Facebook has grown its revenue at a compound annual rate of over 50% for the last five years, yet trades on only a PE of 17x.
International Flavors & Fragrances- a reasonably recent purchase for us, we have been adding to positions following the weakness. The flavors and fragrances industry offers an outstanding profile for long term investors. Flavors and fragrances are typically only 1-2% of the cost of a product, but a key differentiator involving substantial intellectual property that is very hard to replicate. As such IFF competes in a stable and rational oligopoly with consistently high margins (EBITDA margins typically in excess of 20%) and a very good growth outlook following their acquisition of Frutarom: a substantial competitor in emerging markets.
As always, we have no way of knowing how markets will move during the next few months- nor do we try to predict them. We shall maintain our focus on prudent long term growth and continue to selectively add to positions where we think valuations have become increasingly attractive.
*Note: in all our equity market comparisons, we always use the S&P 500 rather than the Dow Jones which is a more useful and representative index. The Dow is not representative of the overall economy or market conditions, as it contains only 30 companies and does not include every sector. The S&P 500 is much more diverse- encompassing the 500 largest US listed companies. The Dow Jones is also flawed in its calculation methodology- it is a price weighted index, meaning that a high priced stock impacts the index more than a low priced stock- take Caterpillar as an example, it has a 25% larger weighting in the Dow than Chevron due to its higher share price (which is an arbitrary number dependent on how many shares are in issue), despite being less than half the size. In contrast, the S&P 500 is market capitalization weighted- such that the index performance is weighted by overall company size- this therefore gives a more accurate representation of actual stock market performance.
As always, please get in touch with any questions you may have.