ClearBridge Investments market commentary for the first quarter ended March 31, 2016.
“Getting to the top is optional. Getting down is mandatory.” — Ed Viesturs
ClearBridge Investments – Climbing Up and Down the Value Mountain
Active investment managers are in the judgment business. There are many permutations for exercising investment judgment, but at a high level it all comes down to assessing the risk and reward of an investment through the prism of price, fundamentals and value. As active valuation managers, we seek to exploit those valuable opportunities where price is materially divorced from underlying fundamentals and value. However, the opportunity set for value varies over time, and a key part of our job is to observe and map the constantly evolving valuation landscape. The market landscape shifted dramatically during the first quarter, which resulted in price volatility that our investment process is designed to take full advantage of. Taking action during episodes of volatility, however, requires both emotional discipline and valuation math. This letter will detail how both came into play during an active quarter.
During one of my favorite business school classes, the great behavioral economist Richard Thaler had us read Jon Krakauer’s Into Thin Air. The book detailed the 1996 disaster that Krakauer’s team endured climbing Mt. Everest. Thaler used the book to detail the compounding effects of bad judgment, when the emotionally and physically demanding environment of the oxygen-deprived “death zone” above 26,000 feet resulted in major decision-making errors and the loss of life. I don’t think Thaler expected any of us to go out and climb Everest, but he did want to highlight the dramatic impact that stressful environments can have on judgment and decision making.
As a boy growing up in New Mexico, mountain climbing was a regular activity, and I still climb annually with a close group of friends who are also professional investors. We have never been tempted by Everest, which seems to present MUCH more risk than reward, but we did climb Mt. Kilimanjaro a few years ago, slept in ice caves last winter, and are venturing to Alaska this spring. These brief excursions are a great escape from regular work stress, and provide the opportunity to share ideas and discuss markets with a great group of investors. However, these trips are not easy: they challenge each one of us to work effectively as a team, push through physical pain, and exercise judgment in sometimes physically and emotionally demanding environments. There are definitely powerful parallels with investing and especially our valuation-driven process. How so?
ClearBridge Investments – Monitoring And Gauging Of The Valuation Cycle
Over the years and in last quarter’s letter we discussed our continual monitoring and gauging of the valuation cycle as measured by valuation spreads. When valuation spreads are rising materially, as they did during the first two months of this year, value-based strategies are generally underperforming as price and value diverge —sometimes violently and quickly. The resulting downside price volatility triggers emotional pain, which the brain doesn’t really distinguish from physical pain. This pain is one of the primary drivers of excess returns from a value premium, as many investors either cannot handle the emotional burden of falling prices or are forced to sell for institutional and risk management reasons. As emotion begets more selling, the math keeps getting richer and richer as price and underlying value diverge. We liken the process of rising valuation spreads to “climbing the value mountain,” which is made incrementally challenging by a thick fog of uncertainty. Unlike a physical mountain, where the summit can be observed and measured with certainty, a market value summit is unknown in timing and magnitude until we actually get there. As a result, we must carefully balance two goals during the climb:
- Making sure we are richly positioned with mispriced stocks that will enjoy full price and value convergence when valuation spreads peak and come down the mountain.
- Making sure we can survive a continued expansion in valuation spreads by managing portfolio-level volatility through portfolio construction, and continually stress testing our holdings.
During the first quarter we started a brisk climb up the value mountain, which kept us laser-focused on both goals. As Exhibit 1 shows, valuation spreads expanded to almost 1.7 standard deviations in mid-February, and then compressed back to 1.0 times by the end of March. We realize standard deviations won’t mean a lot to many people, so I will use a mountain analogy and provide some rough potential return context below.
When valuation spreads get between 1.5 to 2.0 standard deviations, we are getting to Mt. Kilimanjaro territory, which has a summit of 19,341 feet and a historic climber mortality rate well below 0.5%. The lack of oxygen and risks are uncomfortable for most climbers, but broadly very survivable. On the equivalent market scale, this level of spread widening led to a roughly 12% correction for the S&P 500,1 with many value stocks down at least twice this amount, which was also uncomfortable but equally survivable for most investors. At these spread levels, the opportunity from value is getting quite attractive with potential forward returns generally well into the double digits for many value stocks.
The behavioral and judgment challenge is that value opportunities are born on real economic and market stress, as shown by the coinciding recession bars in the exhibit. In addition, there is no concise way to estimate the magnitude of potential stress and the ultimate size of the value opportunity when it is ongoing: are you climbing Kilimanjaro or Everest? This makes a huge difference in both contexts. The real Everest is 29,029 feet, roughly 10,000 feet more than Kilimanjaro, but the mortality rate jumps over 15 fold to an astounding 6.5%. In a similar and partially non-linear scale, when valuation spreads get above 3 standard deviations, the overall market is typically down over 20% and value stocks are down considerably more, with many facing going concern issues. These big value events occur roughly once every decade, and the immense pain and dislocation leads to a return opportunity typically well above 100% for the value stocks that survive. Unfortunately, with big value opportunities there truly is no gain without the pain: this is simple math and the source material of an enduring behaviorally-driven opportunity.
So which mountain did we figure we were climbing in the first quarter? From a U.S. perspective, we figured we were climbing Mt. Kilimanjaro, and that valuation spreads likely peaked in February at 1.7 standard deviations. This judgment call was primarily driven by the continued health of the U.S. consumer, who is supported by continued job growth, modest wage acceleration, improved housing values, lower commodity prices, and much improved balance sheets. This consumer-driven resiliency kept our odds of a 2016 U.S. recession at 20% to 25%, with the key risk being a major crisis in China that could lead to a major devaluation in their currency, which would effectively act like a deflationary bomb for the global economy. The really important thing to ponder here is how valuation spreads got to these levels without a U.S. recession? This would be the first value event of this kind, and we will entertain and assign odds to three scenarios to explain it:
- Structural Market Changes (70% probability): Whether you blame Central Bank activity, the massive shift to passive investing, or new asset allocation approaches like Smart Beta, there has been a big shift in the market landscape in how capital is allocated. In particular, there has been a dramatic shift away from pricing assets at the individual security layer, which has untethered individual security price from fundamentals and value. This increasing lack of interest in individual securities, combined with crowding at the asset allocation layer, is creating liquidity challenges and immense volatility in security prices. This landscape change is creating immense challenges for portfolio construction, which I will discuss in a bit, but at the same time it is enhancing the long-term opportunity for active stock picking. Fewer and fewer investors want anything to do with volatility-driven pain, which is keeping them far away from any value mountain. Instead, we have more than $7 trillion in assets in global government bonds earning negative yields. This locking in of a guaranteed loss of capital is also unprecedented at this scale, and is like hanging out at the Dead Sea of returns. The real Dead Sea has an elevation of negative 1,407 feet. Nothing ventured, certainly nothing gained.
- Shallow U.S. Recession (10% probability): We are certainly in a global manufacturing recession, which has led to several quarters of contraction in U.S. manufacturing on top of the massive contraction in energy-related capital spending. In a very low nominal growth environment, it may not take much to tip the U.S. economy into a shallow recession. In this scenario, we may have effectively seen recessionary stress which resulted in wider credit and value spreads. We assign a low probability here, as the U.S. economy is still driven by consumption, and we don’t see enough signs of contagion across the broad U.S. economy.
- Crisis Delayed (20% probability): This is the false summit scenario. With excess capacity and the last decade’s explosion in debt, China could still cause a global crisis that could push spreads up to Everest levels. In this scenario, China could devalue the RMB in excess of 10%, which would cause a major deflationary tsunami in a highly indebted world. This would set off a wave of bankruptcies and freeze global credit markets. Such a scenario would certainly be enough to trigger a U.S. recession. However, the U.S. would still be much better prepared than almost any other part of the world given the relative strength of the U.S. consumer, and the capital and liquidity strength of our banking system. In fact, the repudiation of debt would probably create a fully-stocked menu of financials and commodity stocks way below book value and current prices.
In Exhibit 2 we show annualized turnover and valuation spreads since we have been directly responsible for the portfolio, and not surprisingly when price volatility kicks up and value spreads widen, it translates into action. This was very true during the first quarter, with annualized turnover above 50%, a tenure-high for this team with the exception of the third quarter of 2010 when we were first responsible for the portfolio. This turnover was directly driven by our twin goals of: 1) taking advantage of widening price-to-value gaps and 2) ensuring we have stocks that will survive and converge as part of a widely-diversified portfolio of valuation opportunities. Given the robustness of our valuation process and the experience of the team, finding mispriced stocks is never a challenge for us — especially when valuation spreads are elevated. However, we have faced challenges satisfying the second goal with our portfolio construction, and not from a lack of trying. We will briefly diagnose these challenges and detail a few specific portfolio changes that we think satisfy both goals.
The second goal of managing portfolio-level volatility has been an acute challenge for valuation managers, because declining stocks, regardless of value, are the essence of risk in the current market landscape. When any global macro storms and deflationary winds blow, the crowd quickly runs down the mountain, and any potential value-driven return argument fall on ears deafened by panic. This behavior has resulted in a much higher level of correlation in individual stocks, as stocks increasingly move in a monolithic fashion. This was on full display during the first quarter, when the entire S&P 500 reached record high correlation levels with the price of oil as shown in Exhibit 3. This broad correlation simply reflected that most underlying value sectors, especially financials, traded just like stressed energy stocks. The value trade became the energy trade, which is a frustrating reality of the current market structure. In addition, defensive and low-volatility stocks look historically expensive to us. This means directly diversifying portfolio-level volatility with defensive stocks is relatively expensive in terms of lost potential expected returns: a negative defensive premium cancels out the positive value premium.
Philosophically, we look at challenges as opportunities, and the very nature of capitalism is that long-term return potential rises as existing players fail or flee and capital exits. The increased volatility, especially within value stocks, is driving out active value-based capital and increasing the return potential for surviving value managers accordingly. Our goal is to survive any structural and cyclical climb up the mountain by embracing stocks that may be volatile in price, but enjoy relatively stable business models and cash flows that support an enduring and growing business value well in excess of price. These mispriced opportunities, and a culling of existing stocks that were either more fairly priced or did not make the cut on survivability, drove the first quarter turnover.
ClearBridge Investments – Portfolio Review
Not surprisingly, a lot of turnover occurred in the financial sector where many of the stocks fully reflect long-term global stagnation and deflationary risks. We purchased stocks like Discover Financial and Ameriprise that are currently generating very high returns well in excess of their costs of capital, but were discounting an imminent U.S. consumer recession. To fund these names, we sold JPMorgan Chase close to our assessment of fair value, and sold what turned out to be a long-term value trap in Genworth Financial. We held on to Genworth for too long, but we handled this value trap by not adding any capital as the stock declined. In general, where we have struggled in financials is where returns are low and below the cost of capital, and the only remedy to these low returns are higher interest rates. Higher rates will come someday, but these stocks carry a huge amount of macro risk that was driving a lot of volatility. With these changes we lowered portfolio volatility, enhanced business-level returns materially and kept the upside potential from deep-value financials fully intact.
Outside of the restructuring of our financials holdings, we initiated a position in C.H. Robinson that had fallen to the low end of its historic range on valuation and well below business value, but gives us a low volatility stock that should actually do fairly well in either an economic boom or bust. This effective straddle on macro risk, acquired at a discount to intrinsic value, directly addresses our portfolio construction challenge without sacrificing much value premium.
We also continue to see great opportunities in the power sector and added Exelon, a hybrid utility with regulated and non-regulated power businesses. The core value proposition with Exelon is that it has tremendous leverage to potentially higher natural gas and power prices, but the market is valuing the stock below peers and embedding a large discount to its non-regulated merchant power business. Despite these value attributes, Exelon stock has near-zero correlation with the current portfolio and very low price volatility, which adds materially to our portfolio construction goals.
These portfolio changes have helped us to dampen some of the portfolio-level volatility we did not want, but without having to change the long-term value-driven return profile of the portfolio. It also allowed us to buy more traditional value names like CBS and QUALCOMM during the quarter, at what we deem are very attractive prices relative to value. A quick note on QUALCOMM: our team vetted the stock on two previous occasions over the past couple of years at higher valuations and passed, which shows the constant discipline of our process.
Just as mountain climbing is not for everyone, these days value investing is clearly not for everyone. However, like great mountains, active value investing will endure as long as human behavior arcs between fear and greed. Recent market fear is giving us a large value opportunity as evidenced by elevated valuation spreads. Outside of our appreciation of a constantly evolving market landscape, our biggest advantage is that in a world increasingly focused on and driven by price, we remain fully focused on value. This focus would not be possible without our long-term shareholders. Thanks for your confidence as we climb the value mountain together.