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.
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.
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.
Sources: etfdb.com, 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 re-emerged from its restructuring in 2016, which helps explain how it has escaped the ETF dragnet to date. Irrespective, we believe the latest iteration of the branded snacks maker that includes Twinkies, Hostess Cakes, Snoballs, Mini-muffins, Zingers, Ding-Dongs, et al—is no cupcake. Rather, we see a lean (headcount reduced from 22,000 to 1,170 post-bankruptcy), automated, low-overhead, mostly non-union enterprise that is now flexing its muscles in a competitive market. We see Hostess’s recent success as a one-two punch through its strong brand and newly reduced cost structure. Take for consideration that Hostess has quickly obtained number two market share (17%) after being completely shut out of the market for 8 months during its bankruptcy. Today Hostess only trails the undisputed category leader Little Debbie, but also while pricing its snacks at an 80% premium to Little Debbie, and a 30% premium to the overall category. We believe the price premiums are a signpost of “brand equity,” where customers willfully pay higher prices for a given product (i.e., Coca-Cola is a good example), which represents a strong competitive advantage. More specifically, this dynamic translates into a powerful value proposition to retailers as the profit margin that retailers collect on Hostess sales exceeds the total selling price of Little Debbie snack cakes. Perhaps most importantly, Little Debbie’s own strong command of the marketplace, through its powerful brand and impressive cost structure provides a steadfast deterrent towards new competition (including private labels) entering to challenge Little Debbie or Hostess as the market leaders. In the years to come we believe Hostess can drive further business (and earnings growth) by exploiting its brand power through newly released products, including frozen treats as a recent example.
Our second stock, the Ontex Group not only has a low profile with investors, but also sells rather discrete products. Based in Belgium, the Ontex Group is a manufacturer of both private label and branded baby diapers and hygienic pads. What we find worth mentioning about Ontex however is that we believe its potential earnings and cash flow stream can grow at a low-double-digit rate over the coming years compared to an estimated industry growth of 3.6%. While it is included in the rather anonymous ETF for Belgian listed firms (ticker: EWK), we believe it remains far removed from the ETF mainstream. Trading at an estimated 13.8x EPS and 9.9x cash flow, we believe Ontex’s valuation multiples represent a material discount to global peers such as Kimberly Clarke’s estimated P/E of 18.4x (Ontex trades at 25% discount) or the category median estimated P/E of 21.0x (Ontex trades at 34% discount). Likewise, we find it no surprise that the Consumer Staples SPDR ETF (ticker:XLP) containing most of Ontex’s key competitors (P&G, Kimberly Clarke) trades at 21.4x EPS. One of the more compelling aspects that we anticipate in the Ontex earnings stream is its combination of secular demand trends in both the developed and developing markets. Prior to 2015, the firm was more squarely centered on Europe for its revenue stream, but with its back-to-back acquisitions of key producers in both Mexico (Grupo Mabe) and Brazil (Hypermarcas Diaper Division), Ontex significantly increased its exposure to higher growth emerging markets demand. Counterintuitively, we believe Europe also presents a healthy longer-term growth market given two separate factors. First, we believe there is a wide-ranging acceptance and market penetration of retailer brands (Ontex’s European production is primarily focused on private label). Second, we also believe the European markets possess growing demand for incontinence products—due to ageing demographics—where Ontex has a strong presence (in addition to baby diapers, and other hygienic pads). For instance, by 2030 25% of Europe’s population is expected to be age 65 or older, compared to the current global average of 8.5%. Putting these emerging and developed growth trends together represents a barbell effect in our opinion, i.e., combining the ageing populations of Europe and significantly higher birth rates in the emerging markets of Mexico and Brazil. Finally, given the firm’s recent equity raise (and subsequent debt paydown) in early 2017, we believe Ontex’s balance sheet is now attractively deleveraged and back in line with industry averages. In our opinion, this deleveraging paves the way for additional future acquisitions in higher growth markets or, even possible future dividend increases on the back of higher forecasted earnings growth in the years to come.
To summarize the above, we believe that for investors willing to seek bargains and therefore, eschew what is most popular there are still opportunities available in businesses that have become somewhat neglected by the broader markets. Finally, we also believe that locating opportunities not yet discovered by the wider audience of investors is one of the primary methods that successful investors can distinguish their returns in a positive manner.
Lauren C. Templeton