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,