FPA Capital Q3 Commentary
Introduction Is the market finally correcting the recent excesses of stock valuations, particularly in the small-mid-cap area? The admittedly arbitrary definition of a stock market correction is when an index declines 10% or more from its recent level. Based on this, the Russell 2000 (R2000) recently fell into correction territory while the S&P 500 has declined 9% over the past month (as of 10/14/14). Moreover, the Russell Microcap Index is down more than 17% from its high earlier this year, with microcap technology stocks down nearly 25% since March. Thus, small-cap stock valuations, relative to large-cap valuations, are in the process of reverting back toward historical averages. In some ways, the smaller decline in the S&P 500 has masked the broader correction for a number of industry sectors. Besides those mentioned above, large-cap automotive stocks are down 18% since July, and energy stocks are also getting hit with the S&P Oil & Gas Exploration & Production index down 25% since this past summer. While your portfolio is not immune to this correction, we believe the companies we own have strong balance sheets, providing management teams an ability to take advantage of any good opportunities to buy assets on the cheap – should any opportunities present themselves. We have managed this strategy through a number of corrections and each time, while we take temporary hits to capital, we have been able to take advantage of opportunities that present themselves during these periods of dislocation. Our strategy’s three-decades of history shows that we can deploy capital very rapidly when valuations are depressed and when fear and uncertainty are high. On the other hand, we have exhibited tremendous patience in holding higher than normal levels of liquidity when valuations are rich. The last couple of years tested our patience, but we were fortunate to have discovered stocks that still met our stringent investment criteria and deployed some of your capital into these new investment opportunities. In recent weeks we deployed incremental capital as selling pressure accelerated. If the current volatility continues, we fully expect that we will be more aggressive in deploying your capital as valuations become even more attractive.
Over the past year or so, we have been asked a number of times, “What does the current market remind you of?” Our response has been that it reminds us of the late 1990s, when there was a large valuation difference between large-cap stocks and small-cap value stocks, except that this time small-caps have been more expensive. At the end of 1999, the S&P 500 traded at 32x earnings per share, while the R2000 value traded at 17x earnings, a 15 point spread. Earlier this year, the R2000 traded at ~37x earnings versus roughly 19x earnings for the S&P 500, an 18 point differential. Lately, this gap has narrowed to 14 points as small-cap stocks have declined more than larger-cap stocks, we expect the gap to narrow further (rationale is highlighted below).
It is impossible, at least for us, to predict exactly how wide a valuation spread between two different indices might become or when this spread will peak and then contract. However, over the past year or so, we have expressed our view both verbally and in writing that we believe small and mid-cap stocks in general were, and still are, overvalued. For example, if we assume that the R2000 is one large conglomerate with two thousand subsidiaries, and roll up each of the individual company’s net income to get an aggregate net income, the R2000 would actually trade at 61x earnings at the end of September. It is striking that nearly one-third of the companies in the Russell 2000 have lost money over the past twelve months.
The reasons for the difference in the stated P/E of 32x versus 61x based on the method above is that Russell correctly uses a weighted average market-cap method but incorrectly in our opinion, typically excludes companies with negative P/E ratios. By not fully incorporating companies with negative earnings
into the calculations, Russell unfortunately biases the index’s P/E lower. Nonetheless, even at 32x and 26x earnings, respectively, both the Russell 2000 and 2500 are excessively priced, in our opinion.
Going forward, we believe earnings for small-mid-cap companies will need to experience accelerated growth to support their elevated valuations, or valuations will likely continue to decline toward more historical levels. However, we could be wrong and the market may continue the positive trend of the last few years despite anemic earnings growth. That is, investors may not care as much about earnings growth and continue to buy stocks because of no better alternative for their capital.
Perhaps the market’s attitude of the past couple of years is similar to the recent Silicon Valley approach to investing and buying into other companies. Larry Page, Google’s CEO, has coined the term “the Toothbrush Test”1 for deciding whether to acquire another business. The Toothbrush Test is simply a determination of whether companies possess a product or service that is used once or more a day, and makes your life better. Apparently, Mr. Page believes this test is superior to diligently analyzing the financial statements and valuation of a targeted company, which may explain Google’s recent acquisition of Nest, a thermostat company, for $3.2 billion, or Facebook’s purchase of WhatsApp for $19 billion.
Google, Apple, Facebook and other Silicon Valley companies are now often by-passing investment banks and relying on their own internal business development teams to scrutinize merger & acquisition deals. The frumpy banks tend to use old-school valuation metrics to help assess the merits of a deal, and thus are losing out on lucrative M&A deal fees. Sadly, the banks have not invested enough in training their key personnel, who can assiduously measure whether “The Toothbrush Test” is passed by a targeted company! Undoubtedly, the Harvard Business School will need to add a new class to their curriculum if they expect their future graduates to be hired by these leading global banks.
Over the past few years, we have favored the economic “slow-growth” view, but not the more pessimistic “recession camp”. While we continue to believe the growth trajectory of the U.S. economy over the next year will average 2% or so, we think the recent dollar strength highlights how poor some of our global trading partners’ economies are performing – particularly in Europe. Yet, we cannot rule out a much slower U.S. growth scenario, or even a recession, if Europe deteriorates even more from its current malaise.
The U.S. dollar has rallied from roughly 1.40 to 1.25 against the Euro over the past six months, and from 94 to 1.10 against the Japanese Yen since June 2013. We believe these foreign currencies are declining because their respective Central Banks are trying to stimulate their mercantilist economies by keeping sovereign interest rates lower than those of U.S. Treasuries for similar maturities. All else equal, lower government interest rates normally imply weaker currencies. And lower currencies make export products more competitive in the global market place in relation to goods produced in a stronger-currency country.
Japan, which started depreciating its currency earlier than the ECB, has recently experienced more robust exports and a rising stock market. We think the Europeans are playing catch up to