This article is authored by MOI Global instructor Ben Claremon, Principal and Portfolio Manager at Cove Street Capital, based in El Segundo, California.
We don’t spend a lot of time going out of our way to get ideas from other people. This is especially true when it comes to individual securities. We don’t read a lot of sell side research; we don’t talk to analysts; and we certainly don’t buy a stock simply because some hedge fund guy buys a stake and presents a well-articulated investment premise.
It is not because we are arrogant. We are most certainly open to other people’s views of our companies and, in fact, we follow an internal research process that ensures divergent opinions are heard. But, in general, we would rather do our own research, come to our own conclusions, and then test our hypotheses in every way possible.
One exception to the above-mentioned “rule” is that from time to time we will read high level pieces about market valuation and long-term macroeconomic drivers. For the most part, we are in the weeds focusing on Business, Value, and People. But, at times we believe it pays to stick our heads above the tall grass and try to take the pulse of the market. What we see—looking from the bottom-up—is that stocks appear expensive, as multiples in a number of industries have expanded meaningfully.
In a lot of cases it even occurs to us that investors haven’t seen a true down cycle in certain industries for so long that they have virtually forgotten that cyclicality is ever-present. A good way to lose a lot of money is to pay a high multiple of peak earnings because you thought the industry wasn’t cyclical any longer. Time will tell if people are indeed overestimating the stability of valuation multiples and cash flows, but we recently read a couple of interesting thought pieces that indicate our general sense of caution is warranted.
The first is from Jim Paulsen of the Leuthold Group. What intrigued us about the piece is that Jim and his colleagues have tried to create a metric that is like a factory’s capacity utilization but that measures the stock market.
For those who don’t spend all of their days reading about manufacturing businesses, capacity utilization simply represents the percentage of your total production capacity that you are currently using. If your factory can make 1,000 widgets a month and you are making 800, then your utilization rate is 80%. And then once you get to 100%, you can’t generate incremental growth. Nothing too fancy.
The Leuthold model is a little more complicated in that the authors combine a number of factors—including P/E multiples, Treasury rates, and the unemployment rate—to try to determine how close we are to full capacity in the S&P 500. In other words, they are trying to measure just how much more return we can squeeze out of the market. I will skip the gory details and get to the punchline: the market is just a touch below the record high utilization set in late 2017.
Now, Paulsen admits that this is not a timing tool but points out that bull markets usually start when capacity utilization is low and market tops coincide with high utilization rates. Most importantly:
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The opinions expressed herein are those of Cove Street Capital, LLC (CSC) and are subject to change without notice. Past performance is not a guarantee or indicator of future results. Consider the investment objectives, risks and expenses before investing. You should not consider the information in this letter as a recommendation to buy or sell any particular security and should not be considered as investment advice of any kind. You should not assume that any of the securities discussed in this report are or will be profitable, or that recommendations we make in the future will be profitable or equal the performance of the securities listed in this letter. Recommendations made during the past twelve months are available upon request. These securities may not be in an account’s portfolio by the time this report is received, or may have been repurchased for an account’s portfolio. These securities do not represent an entire account’s portfolio and may represent only a small percentage of the account’s portfolio. Partners, employees or their family members may have a position in securities mentioned herein.