Flawed Relative Value Analysis in U.S. Financial Markets

In June, the Federal Reserve raised the federal funds rate 25 basis points to a range of 1.00-1.25%. The Fed also unveiled preliminary plans designed to slowly shrink its $4.5 trillion balance sheet by not reinvesting a portion of the principal received each month from maturing Treasury and mortgage-backed securities. We suspect maturing principal that is not reinvested will be returned to the U.S. Treasury, effectively eliminating all debt service costs of debt held by the Fed. As previously discussed, the massive quantitative easing program has effectively monetized $2.5 trillion in national debt that will never need to be repaid by our government. Although this might seem like a magic bullet needed to reduce our national debt, we find the concept of printing money to pay off your obligations to be morally wrong and expect the process to result in numerous long-term consequences.

U.S. equity markets rose in the second quarter of 2017, marking the 7th consecutive quarter of positive performance for the S&P 500. Large-cap companies were slight outperformers during the quarter and extended their lead over small-caps for 2017. Growth companies again outpaced value companies in Q2 and have dramatically outperformed in 2017 as investors continue to pay a high multiple of current earnings in anticipation of future growth. From a sector standpoint, healthcare, real estate, and financials were the top performing sectors while energy, consumer staples, and utility stocks all lagged. In fixed income, the yield curve continued to flatten as long-term interest rates declined even after the Fed raised short-term rates. In commodities, gold prices ended the quarter largely unchanged while oil prices retreated. We have recently spent more time researching energy companies, replicating our playbook from 2015 as we search for unlevered companies trading at a sharp discount to their owned asset bases.

As U.S. equity indices continue to surpass all-time highs, investors frequently ask us about the attractiveness of the equity markets and the likelihood that the market is overvalued. With the S&P 500 trading at a trailing price/earnings ratio above 24x and a price/book ratio above 3x, we consider the equity markets to be extended both on an absolute basis and a relative basis. We subscribe to the view that people (and markets) are rationale in nature and thus the question becomes why rational investors would ever overpay for assets. Utilizing our discounted cash flow analysis as a framework, we have identified three primary reasons why an investor would appear to overpay for an asset, including using too low of a discount rate, overestimating future cash flows, and potentially receiving some unseen utility or benefit in addition to the expected cash flows from the asset.

In our view, the most likely reason for the potential overvaluation of the U.S. equity market is the utilization of an excessively low discount rate to value expected future cash flows. While a common counterargument suggests that stock valuations are justified given historically low bond yields, we contend that central bank intervention has reduced bond yields to unnaturally low levels. Relative value analysis is particularly dangerous when the asset on which you are basing your analysis appears to be trading at bubble-like levels. We have heard multiple investors point out that stocks and high-yield debt appear attractive compared to what can be earned in an FDIC-insured savings account. This flawed relative value analysis is being conducted both by individuals and also by institutional investors including insurance companies and pensions funds seeking nominal yield targets. We are concerned this type of analysis has reduced required returns for risky assets without sufficient compensation for the potential of loss of principal that accompanies risky investments. Although interest rates are exceedingly difficult to project, we find it much more likely that interest rates and the equity cost of capital will move higher over time, which would result in capital losses for investors all else being equal.

Predicting future cash flows for most companies is a challenging activity. Economies and markets have always been subject to cycles, and that is unlikely to change despite the efforts of central bankers. While we have little to no ability to predict what macro events hold, we would note that the United States has experienced seven consecutive years of economic growth and our country’s 4.3% unemployment rate is at the lowest level since 2007. While timing remains uncertain, a return to more historical averages can likely be expected. We would also note that humans tend to be overly optimistic in their forecasts, which is reflected in earnings estimates for the S&P 500 consistently being revised lower as the year progresses. A reduction in the U.S. corporate tax rate has the potential to have a large positive impact on after-tax cash flows, but thus far the implementation of corporate tax reform has proved elusive.

Finally, we find that some investors receive a utility or benefit in addition to the cash flows they receive from owning an asset. For certain real assets (such as a piece of office artwork), the owner might receive some level of personal fulfillment from owning and displaying an asset that others would not recognize. Similarly, investors might also get enjoyment simply by saying they are investors in an asset class such as venture capital or hedge funds. On the other end of the spectrum, the massive rotation of capital into passive investment vehicles might also fall into this category. With the support of modern portfolio theory, institutional investors could be incentivized to reduce the potential career risk associated with underperforming the market by simply purchasing index funds. While it is impossible to fully understand the incentives driving other market participants, it can be helpful to identify reasons why some investors might be motivated to purchase an asset or asset class beyond the expected future cash flows.

In the event U.S. equity markets do retreat from current price levels, it will be challenging for our long-only U.S. equity portfolio to escape unscathed. However, we have taken a number of steps to attempt to mitigate potential losses that could occur due to the factors we described earlier. We continue to utilize discount rates between 12.5% and 15.0% when conducting our discounted cash flow analysis. By doing so, we maintain the same high standards for inclusion within our portfolio regardless of the interest rate environment. Our portfolio companies are all deep- value companies that are not dependent on earnings growth to justify their current valuation. Our portfolio companies also have pristine balance sheets and owned real assets that provide a margin of safety in case our cash flow forecasts are overly optimistic. Our portfolio companies also all have pristine balance sheets and owned real assets that provide a margin of safety in the event that our cash flow forecasts are overly optimistic. Finally, we attempt to maintain a contrarian mindset and purchase companies that are out of style. In this way, we avoid purchasing popular companies or sectors that may be prone to sharp reversals if the equity market sells off (whether the sell-off is caused by active or passive investors).

This post has been excerpted from a letter of Gate City Capital Management.

Performance for the period from September 2011 through August 2014 has undergone an Examination by Spicer Jeffries LLP. Performance for the period from September 2014 through December 2016 has undergone an Audit by Spicer Jeffries LLP. Performance for 2017 is unaudited. The performance results presented above reflect the reinvestment of interest, dividends and capital gains. The Fund did not charge any fees prior to September 2014.The results shown prior to September 2014 do not reflect the deduction of costs, including management fees, that would have been payable to manage the portfolio and that would have reduced the portfolio’s returns. Actual performance results will be reduced by fees including, but not limited to, investment management fees and other costs such as custodial, reporting, evaluation and advisory services. The net compounded impact of the deduction of such fees over time will be affected by the amount of the fees, the time period and investment performance. Specific calculations of net of fees performance can be provided upon request.