Value Investing

The Crowd

As you likely know, the equity markets have responded well in 2017 to the global recovery in corporate earnings. However, during the past several weeks we have finally seen a modest uptick in share price volatility spurred by hurricanes in the U.S. and an off-kilter North Korean dictator. With that said, the minor volatility that resulted has created a window for us to initiate some previously anticipated rebalancing towards new positions.

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To begin, our research has shown that many of the stocks we find attractive in today’s market tend to not be widely held among the 8,592 ETFs that now populate the market. This stands to reason as the rapid growth in ETFs as an investment vehicle has led these fund vehicles to herd into many of the same large and popular securities as they search for easily tradeable, liquid holdings. We believe this effect has created a self-fulfilling prophecy for many passive strategies as the success of ETFs has not only led to incremental ETF demand, but also to incremental demand for the same commonly held securities (that must be purchased to satisfy new ETF subscriptions). This coupled demand drives both the ETFs and the underlying stocks higher in price through a self-reinforcing effect. For the fully-committed, long-term, buy and hold passive ETF investor; this is not necessarily a problem. Based on our observations over time though, investors are rarely fully-committed, long-term, buy and hold, except when prices rise. When prices fall, we tend to observe a sudden change of heart. We find the evidence supporting this change in heart both reliable and timeless. We believe the best single illustration of this phenomenon can be seen from data presented annually by Blackrock and Dalbar that measures the annualized return for the average investor over a 20-year period compared to various assets classes.

Templeton And Phillips Capital Management

Source: Blackrock, Dalbar

Arithmetically, we believe the most probable way an investor produces returns as dismal as the data above suggests is to faithfully buy high and sell low. As we return our discussion to ETFs and the self-reinforcing relationships we described earlier, we recommend investors create a permanent imprint in their mind’s eye of the illustration above.

Our recommendation is based on our belief that the self-reinforcing behavior that has propelled ETFs and passive strategies to rise faster will eventually conspire to make them fall faster too as share prices decline. As Sir John Templeton once said, “The people who have gotten rich quickly, are also the ones who get poor quickly.” Our reasoning is supported by two observations related to risk among these securities.

Our first observation is that the shares most commonly held among ETFs are materially overpriced relative to the market index. To understand the effect of ETFs herding into a rather narrow basket of equities, we looked at the average valuation for the 150 most commonly held stocks among ETFs to observe if these stocks traded at a premium to the rest of the market. Indeed, we found that the top 150 stocks held among ETFs trade at an average P/E of 29.6x compared with 15.9x in the MSCI ACWI Total Return Index for global stocks.

Templeton And Phillips Capital Management

Sources:, Templeton and Phillips Capital Management, LLC

We believe our second observation on risk in these investment vehicles walks hand-in-hand with our first observation. We see the second risk component that investors are overlooking as a thinly veiled correlation among the majority of ETFs. Given the rapidly growing number of ETFs in the market, these funds tend to increasingly hold the same set of stocks in common. Let us take Apple as an example. As you know, Apple is one of the largest tech companies, and to clarify, one that we generally view favorably for a long-term investor. However, by our count, Apple is now held by 155 ETFs. Notably, among these ETFs we find some odd-couple strategies cohabitating Apple that contradict each other. For instance, Apple is held by six value ETFs, five momentum ETFs, and ten growth ETFs. While we can argue that a growth company like Apple can fall out of favor and become a value, the contrast between value and momentum is too stark. We suspect if investors in the Deep Value ETF (DVP) knew they were commingling in a stock with the Powershares Momentum Portfolio (PDP), they might take issue. This raises the important question, why are these disparate buyers trafficking in the same stocks? The answer we believe is liquidity. ETFs must find highly liquid stocks that make the purchase and redemption of shares-in-kind a fluid process for the ETF manager. This helps explains to us why the Catholic Values ETF (CATH) also owns Apple, even though Apple has historically been linked to child labor in the cobalt mines within its supply chain. We believe CATH, like all other ETFs needs liquid stocks in its portfolio, forcing it to make concessions on its investment mandate and hold stocks that are much like, if not the same as its ETF brethren. We believe when enough ETFs crowd into the same stocks, the ETF investor innocently picks up correlation across their portfolio (which undercuts the benefit of diversification). This erosion can occur irrespective of the ETF’s name, or its purported strategy. Interestingly, these risk-correlation circumstances surrounding ETFs seem mindful of investor complacency leading up to 2008, as it related to CDOs and other debt instruments. Back then, we believe investors became complacent to underlying risk following years of rising asset prices. At that time, the individual debt positions these instruments held was often mislabeled and increasingly correlated due to the extreme loosening of credit standards across the board. This risk dynamic flourished and spread as investors were either not paying attention to, or did not understand the underlying risk. To be sure, we are not “against” ETFs in principal but rather, we see their popularity creating an unrecognized risk in the market. Putting it all together, we see potential danger for these investors as we suspect they are unknowingly herding into a rather narrow band of commonly held stocks that appear inflated in price. Most importantly, and above all else, when the market eventually corrects, we also believe that these same stocks most commonly held among ETFs will represent a fertile hunting ground for the most attractive bargains.

With all of that said, we see it as only a matter of common sense that the best potential bargain stocks lie outside of these major ETF holdings. Bearing that in mind, we thought we would conclude our discussion with a few examples of potential bargains that are not widely held, if at all, among ETFs.

Trading at 1.3x its book value and 9.9x its cash flow, Hostess Brands represents a noticeable discount to its peer group’s median price to book of 3.0x (57% discount), and median price to cash flow of 13.8x (28% discount). If the Hostess name sounds somewhat familiar, you may recall it as the baked goods manufacturer best known for its iconic “Twinkie” snack cake. You may also recall that Hostess filed for bankruptcy in 2012, and only