The S&P 500 rose 2.6% in July. This puts year to date return at 3.7% (including reinvested dividends) compared to FatAlpha at 2.4%. FatAlpha’s two largest gains came from Trinity Industries and Sanmina as they rose 11% and 9% respectively, while the largest losses came from Triple-S at -16% and Insight Enterprises at -10%. Triple-S is a health care provider in Puerto Rico and recent news of a restructuring of local government debt pushed the stock down. I’ll be waiting for earnings and the conference call before making a decision on the stock.
Regarding the market, investors should reduce their potential profit expectations to say the least. This is not based on some theoretical model but on the fact that many stocks are fully valued. The result of this, is that stocks struggle to appreciate even on good earnings. Let’s look at some examples. Apple beat expectations but the stock dropped. Bloomberg and CNBC will tell you it was because the beat wasn’t as large as usually or because the watch only sold 1.9m pieces instead of an expected 3-5m or some other bogus reason. The watch was actually a huge success as it sold more pieces than the original iphone and ipad on launch. The real problem with Apple is the valuation. If we use the 5-year average high of P/S, P/Bk and P/E and apply them to Bloomberg estimates then we get a target price of $131. I can already see some of you shaking your heads and pointing to all the cash flow and the cash on the balance sheet. But even if Apple continues to generate $50bn a year in free cash flow, I put a DCF value at $132 using a 10% discount factor and $146 using a 9% factor. More importantly, we need to ask where does Apple fit in? It’s no longer a value stock as value investors seek much deeper discounts, and it’s questionable as a growth stock. The company is so large right now that it’s difficult to move the needle. Not to mention the reliance on the iphone product will constantly be brought up. Keep in mind that I do love the products and I continue to like the overall story, but a great company is not always a great stock.
Another example in Anthem (ATHM) which also beat but did not appreciate in value. ANTM has been one of my favourite positions of all-time but the valuation is extend both from a historical multiple perspective and DCFwise. A third and final example is Valero Energy (VLO). This refiner has been trending higher and higher with analysts and investors excited, however it is trading way beyond historical multiples and considering fluctuations in cash flows I don’t believe using current cash flows to value the company makes sense. For Valero’s valuation to work it would need either consistent cash flow and/or a multiple re-rating which is not typical of the industry. I had discussed this with my friend Kevin who highlighted that the WSJ agreed with me: “Valero, one of refining’s heavyweights, now trades around 9.6 times earnings, above its 15-year average of about 8.5 times. That average is actually overstated by wild swings in 2009 and 2010 in the aftermath of the financial crisis. Take those out, and the average is just eight times, with the current multiple more than one standard deviation above that.” For the full article look here: http://www.wsj.com/articles/refiners-can-keep-floating-on-cheap-oil-1437495278
Do historical valuations matter? Well apparently they do. As I mentioned in last month’s letter I have been taking a fresh look at backtesting. I’ve been looking at single factors and models and how they drive future performance. Some of the tests have been on historical multiples and it appears that stocks trading at a discount to their historical valuations do outperform stocks that trade at a premium. So not only is it reasonable to look at historical valuations we have empirical proof that it is an important factor. Obviously, not the only one but who said investing was simple?
The study which is mostly complete confirmed previous results and once again highlighted that valuation is the No. 1 driver of future returns. The only result that surprised me was the results from backtesting momentum. It appears that momentum does not add additional return when included with other factors. This needs further study, however I have decided to suspend looking at value momentum candidates (i.e. momentum stocks that are cheap) for the time being. I am not entirely surprised by the result as having executed the FatAlpha strategy for over 3 years now, I have found that many candidates and investments from my pure value models ended up on the value momentum model. So it may make more sense to pick them up early rather than participate in the last leg of the appreciation – which is the case with value momentum.
As I mentioned above with a few examples, several companies are fully valued. In addition, “U.S. equities are being pushed along by the fewest stocks in more than 15 years” (see first article on page 3), the S&P does not perform well following tight ranges (see second article on page 3), and S&P Capital IQ is projecting a year-on-year decline in EPS for both Q2 and Q3 which obviously does not help multiples rise. Furthermore, according to S&P, the majority of times that EPS declines y-o-y, recessions either follow or concurrently occur. While each reason on its own does not mean anything, the list is getting longer and hence my expectation for a difficult environment moving forward. In the meantime, enjoy your summer and keep in touch!
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