Popular stock indices are trading significantly above reasonable valuation, exceeding peak levels seen during the tech bubble of 2000 and before the Great Recession of 2008. The degree of over-valuation in some respects is now similar to levels last seen before the Great Crash in 1929. Market internals, as measured by advancing versus declining issues and new highs versus new lows, is showing significant deterioration in recent weeks. I believe popular stocks and indices are primed for material downside as they unwind from the riskiest level seen in our lifetime. The Growth and Income Portfolios are positioned in their most defensive allocations to date, designed to protect and benefit as unbridled investor euphoria returns to a more realistic level.
The Income Portfolio is fully allocated to government and high quality corporate bonds. With continued interest rate increases from central banks, along with the winding down of quantitative easing programs, I expect liquidity to tighten and economic growth to continue slowing across the globe. I expect stock market declines to result in a “flight to quality”, whereby investors will bid up the price of our defensive bonds as they seek safer harbours.
In the Growth Portfolio and Small Cap Value Portfolio, our largest equity holdings are deeply undervalued resource companies. As investors sell off overly-concentrated positions in the most popular stocks, I expect they will reposition capital towards such securities trading at much cheaper valuations with substantial upside potential. Generally speaking, purchasing securities trading at 3-4x cashflow, or under their net asset value, have provided significant profit opportunity with low downside risk. As an additional feature, many of our companies pay high dividends. In simpler terms, imagine being able to purchase a rental property for only 3.5x it’s annual rent, and below the cost it would take to re-construct the property from scratch. In our case, we can raise rent by 5-10% per year. Such conditions make for happy landlords.
Although psychologically it is not easy to buy or hold securities that have seen major price declines, it is precisely the emotionally charged price decline that lowers investment risk. As the price of a stock moves lower, investors pay less for the company in relation to its fair value. This lowers the risk of long term capital loss, and increases the potential of long term gain as the trading price eventually meets fair value. Low prices are what make stocks so initially valuable, and so eventually rewarding.
Coincidentally, the last time resource stocks were this cheap was the peak of the tech bubble. Resource stocks saw significant price appreciation as the rest of the market declined.
In our American Growth Portfolio we’ve seen significant price appreciation over the past years, matching that of the index. The big difference is we’ve done so by purchasing bargain priced securities, instead of chasing expensive stocks higher. Our American Portfolio features more diversity amongst sectors than our Canadian portfolio, but the same deep value principles apply to each stock: low cashflow multiples, discounts to book value, and rich dividends. I believe the deep value characteristics of our companies will allow us to see more upside, even in the face of major declines in the indices.
The evidence shows that value investing tends to underperform the most during the last stage of bull market euphoria as investors abandon fundamental valuation, and common sense. History also shows that value investing sees its greatest degree of outperformance directly after that euphoria phase comes to pass. In consideration of the evidence, I believe we are on the precipice of such a turn today, and it will be one of the largest of the past century.
The different types of investor emotions https://www.collaborativefund.com/blog/concealed-emotions/
Are investors destined to repeat the same mistakes? https://www.collaborativefund.com/blog/fool-me-three-times-and-i-give-up/
Doing your research pays https://www.cnbc.com/2018/03/20/doing-your-homework-does-lead-to-better-investing-returns.html
Ben W. Kizemchuk
Portfolio Manager & Investment Advisor
Wellington-Altus Private Wealth