Stick to the Process

Stick to the Process

May 23, 2019

RJ Steinhoff, CFA
Director of Research
Historically, a value approach—buying stocks when prices are low relative to fundamental metrics such as earnings, cash flow, or book value—has outperformed broader markets. Value investing traces its roots to the 1930s works of Irving Fisher, John Burr Williams and Benjamin Graham with work by academics and practitioners over the last thirty years cementing its legitimacy.

However, value has underperformed in the U.S. and globally since the end of the 2008-09 financial crisis, with most of the underperformance coming in the last five years. The table below lists annualized returns for the S&P 500, MSCI All Country World Index (ACWI), and their growth and value style sub-indices through April 30, 2019. Since 1990, the only time the 3 and 5 year annualized return spread between the S&P 500 Growth Index and S&P 500 Value Index has been greater than the recent period was at the height of the dot-com bubble.


Source: Generation Advisors Inc., FactSet

The five largest U.S. large cap value ETFs with more than 10 years of history have all underperformed the S&P 500 over 1, 3, 5, and 10 year periods. The Value Line Geometric Index, an oft-cited value index, and Berkshire Hathaway, run by the highest profile and most prolific value investor of all time, Warren Buffett, have also underperformed the S&P 500 Index.


Source: Generation Advisors Inc., FactSet

As value investors, the recent environment has been as frustrating as riding a bicycle into a strong headwind. Practitioners of any focused investment style must accept these bouts of underperformance. Historically, value and growth have ebbed and flowed, with both underperforming for long stretches of time. After all, if value—or any style or factor—produced steady and consistent outperformance then it would be arbitraged away, never to be seen again.

During frustrating periods, commitment to the investment process must not waver. One might be tempted to chase after what’s working at the moment, as we’ve seen with the rush to cryptocurrencies, cannabis stocks, or any business that labels itself a “disruptor”. A sober, methodical investment process will win out in the long-run. While we’re constantly evaluating and testing new ideas to improve our process, the core of our approach remains unchanged:

  • identify great businesses with high returns on invested capital, solid balance sheets, capable and properly incentivized management, competitive advantages and clear long-term growth drivers
  • estimate the value of these businesses using valuation approaches such as discounted cash flow models or sum-of-the-parts analysis
  • purchase these businesses when they trade at reasonable discounts to our estimates of their fair market values
  • guard against drawdowns using risk management tools, which may include hedges when we believe the business cycle is peaking or market risk is elevated
We have confidence in this approach for the risk-adjusted returns that we seek over the long run. We’re sticking with the process.


DISCLAIMER

The information contained herein is for informational and reference purposes only and shall not be construed to constitute any form of investment advice. Nothing contained herein shall constitute an offer, solicitation, recommendation or endorsement to buy or sell any security or other financial instrument. Investment accounts and funds managed by Generation Advisors Inc. may or may not continue to hold any of the securities mentioned. Generation Advisors Inc., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities mentioned. The information contained herein may change at any time and we have no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation. It should not be assumed that any of the securities transactions or holdings mentioned were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities mentioned. Past performance is no guarantee of future results and future returns are not guaranteed.

The information contained herein does not take into consideration the investment objectives, financial situation or specific needs of any particular person. Generation Advisors Inc. has not taken any steps to ensure that any securities or investment strategies mentioned are suitable for any particular investor. The information contained herein must not be used, or relied upon, for the purposes of any investment decisions, in substitution for the exercise of independent judgment.

The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. We make no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained herein. We expressly disclaim all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained herein.

All products and services provided by Generation Advisors Inc. are subject to the respective agreements and applicable terms governing their use. The investment products and services referred to herein are only available to investors in certain jurisdictions where they may be legally offered and to certain investors who are qualified according to the laws of the applicable jurisdiction. Nothing herein shall constitute an offer or solicitation to anyone in any jurisdiction where such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such a solicitation.

To Hedge or not to Hedge

To Hedge or not to Hedge

April 10, 2019

Randall Abramson, CFA
President & CEO,
Portfolio Manager




This article has been excerpted and edited from our quarterly newsletter to clients dated March 28, 2019.
That is the question. With the worst U.S. stock market performance for the month of December since 1931, who wouldn’t have welcomed some short exposure? Though, after the market then experienced its best January in 30 years, recovering nearly all of its December losses, why bother hedging? The answer for most hedge funds is to smooth out returns—a less bumpy ride. We typically remain unhedged in normal course because we are only interested in shorting, or holding inverse long ETFs, when our macro tools alert us to do so. When the economy is on the rise and corporate earnings and valuations too, we prefer to participate fully and are less concerned about market corrections. In fact, we view those market setbacks as opportunities to deploy cash or switch into better positions.

Our macro tools—Economic Composite (TECTM) and our indicator of momentum (TRIMTM)—are designed as alerts for potential bear markets, i.e., prolonged and severe downturns. When these proprietary tools alert us, we then wish to protect ourselves from declining markets. TECTM, in retrospect, has signaled for a U.S. recession 7 times since the early '60s. A recession followed in each instance, on average, about 290 days later. TRIMTM alerts have invariably followed after the economic warning, over the same time period. The average decline, post TRIMTM alert, was around 24%. As a reminder, there have been only 5 occasions in the last 40 years when the S&P 500 declined by greater than 20% from peak to trough. All were during recessions, other than the '87 Crash which was accompanied by very specific circumstances that led to a massive one-day decline.

Until recently, most economies around the world had not given us TECTM alerts. But Canada triggered on February 20 and the U.S. triggered on March 22. And some U.S. indexes gave TRIMTM warnings in late December. Since these TRIMTM signals unusually occurred prior to an economic signal, we believed they were indicative of a severe correction rather than a prolonged bear market. Therefore, we chose not to react, especially given the extremely oversold market levels in December. However, the probability of a business cycle peak is at its highest in the current cycle. And, many markets around the globe have given TRIMTM sell signals. Since the markets have become overbought again, and with a TECTM signal now in place, we intend to begin hedging via short selling (for accounts that have authorized it) or inverse ETFs which mimics short selling. Though, ironically, the first 6 months after an inversion of the yield curve—the dominant component of our economic composite—are normally in the top decile or two of overall market performance. So we expect to move judiciously with plans to initiate short exposure and increase it over the next several months.

Aside from the indications of our macro tools, we are concerned about rising debt levels, slowing global growth, and political instability. The already high debt throughout the economic system continues to expand. The U.S. budget deficit increased by 17% in its fiscal year ended September 30, at a time in the economic cycle when deficits should be shrinking. Corporate debt is at an alltime high at 46% of GDP. Student loans, auto loans and credit-card debt are all at fresh highs.

And ever-growing pension obligations of state and local governments will bring a heavy future burden. Rising rates may also further impact debt levels as the cost of servicing debt expands. At the same time, central banks are shrinking liquidity which is not a positive for equity markets.

Politically, we had the longest U.S. government shutdown in history and may yet see a repeat performance. Populism is a wave that’s impacting many countries. And, potentially worse for the markets, there are a number of Democratic candidates with socialist policies. Negative sentiment around Brexit persists because of uncertainty surrounding the transition. Chinese growth remains high but is slowing. Its massive trade dispute with the U.S. isn’t helping either. Europe and Japan are barely growing at all. And nations like Venezuela are in complete turmoil.

The leading economic indicators (LEIs) have dipped but are nowhere near negative, which has always been the case prior to a recession. And the ISM Manufacturing index is still in the mid-50s whereas a fall to 45 or below is typical for recessions. The lowering of corporate tax rates to 21% from 35% likely means a boon for the U.S. as corporations shift to the U.S., though this is not an overnight event.

Earnings have generally been ahead of expectations, but there have been some high-profile companies issuing warnings. Apple, Samsung, FedEx, Caterpillar, American Airlines, Nordstrom and Deere are examples. With unemployment at such low levels, the percentage of businesses worrying about labour costs has spiked to a multi-year high—previously a leading indicator of negative economic trends.

Current valuations appear fair. But that can mean a vulnerability back to undervalued levels. Corporate insiders appear to agree, having done a complete about-face—now significant net sellers after doing the opposite at the end of last year.

Unusually, 90% of asset classes had negative returns in '18, the largest such percentage since 1901. As well, sentiment was extremely negative in December as exemplified by the record number of U.S. mutual fund holders redeeming. So we expected a rebound. Seasonality has remained favourable too through April, with an historical record of outperformance which is enhanced by this year being a mid-term election year, where the November to April time frame has not registered a down period since the '40s. But the window is narrowing. And with valuations back up to the 5-year average, it’s not easy to find attractive opportunities to be fully invested.


DISCLAIMER

The information contained herein is for informational and reference purposes only and shall not be construed to constitute any form of investment advice. Nothing contained herein shall constitute an offer, solicitation, recommendation or endorsement to buy or sell any security or other financial instrument. Investment accounts and funds managed by Generation Advisors Inc. may or may not continue to hold any of the securities mentioned. Generation Advisors Inc., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities mentioned. The information contained herein may change at any time and we have no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation. It should not be assumed that any of the securities transactions or holdings mentioned were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities mentioned. Past performance is no guarantee of future results and future returns are not guaranteed.

The information contained herein does not take into consideration the investment objectives, financial situation or specific needs of any particular person. Generation Advisors Inc. has not taken any steps to ensure that any securities or investment strategies mentioned are suitable for any particular investor. The information contained herein must not be used, or relied upon, for the purposes of any investment decisions, in substitution for the exercise of independent judgment.

The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. We make no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained herein. We expressly disclaim all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained herein.

All products and services provided by Generation Advisors Inc. are subject to the respective agreements and applicable terms governing their use. The investment products and services referred to herein are only available to investors in certain jurisdictions where they may be legally offered and to certain investors who are qualified according to the laws of the applicable jurisdiction. Nothing herein shall constitute an offer or solicitation to anyone in any jurisdiction where such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such a solicitation.

S&P 500’s Implied Growth Falls to Cycle Median

S&P 500’s Implied Growth Falls to Cycle Median

December 18, 2018

RJ Steinhoff, CFA
Director of Research
We track implied growth rates for many markets around the world as part of a suite of approaches we utilize to assess overall valuation levels. Calculating implied growth is a simple but effective way to get a quick sense of growth expectations embedded in current prices. Growth expectations above cycle averages might be an indication that market participants have become too ebullient about future growth prospects. Low expectations might identify an opportunity if the consensus outlook is too pessimistic.

The implied growth calculation flips the typical valuation equation (i.e., discounting earnings or cash flows) on its head, setting the valuation at current market prices and then solving for the growth rate. In our approach, we use normalized earnings as a proxy for cash flows. Each company’s cost of equity is calculated using trailing three-year betas and the 10-year Treasury rate for the risk-free rate.

The median implied long-term earnings growth rate for the S&P 500 constituents currently stands at 3.0%, off 90 basis points from this current economic cycle’s peak of 3.9%, hit at the end of 2013 and Q2 2017. Implied growth is now 20 basis points below the cycle median of 3.2%. As shown in the annotated chart below, this current correction marks the third retreat of growth expectations since the cycle started in June 2009.



Many technology stocks like Nvidia and Microsoft have seen declines of more than 15% since September. However, implied growth for the Information Technology sector is still above the cycle median of 4.1%. The real carnage has been in the newer Communication Services sector, home to internet-focused companies like Facebook and Netflix and the traditional media and telecom players like Disney and Verizon. Implied growth has tumbled to negative 0.5%, a steep decline from the 3.5% and 4.2% seen at the end of Q1 and Q2, respectively. At 5.4%, the implied growth spread between the Information Technology and Communication Services sectors is the highest observed since this cycle started.

Financials has been another hard hit sector. Implied growth for Financials stands at 0.4%, trading at one of the biggest gaps to the overall market since 2009. Major global banks like Citigroup and Bank of America have declined on rising market volatility, evidence of slowing consumer loan activity, and a flattening yield curve.

We see the overall market, at 15x forward earnings and a median implied growth rate of 3.0%, as fairly valued. The good news is that the overvaluation seen at the peak of September/October euphoria—marked by Apple achieving a trillion dollar market cap—has been relieved. With implied growth falling back to the cycle median, compelling risk/reward opportunities are emerging, especially in the Communication Services sector.

The critical question facing investors now is whether or not the global economy is on the verge of a recession. We see growth decelerating but do not see any data points, including our own Economic Composite, pointing to a global recession. Therefore, until evidence emerges, we continue to seek out opportunities in undervalued, high quality businesses.


DISCLAIMER

The information contained herein is for informational and reference purposes only and shall not be construed to constitute any form of investment advice. Nothing contained herein shall constitute an offer, solicitation, recommendation or endorsement to buy or sell any security or other financial instrument. Investment accounts and funds managed by Generation Advisors Inc. may or may not continue to hold any of the securities mentioned. Generation Advisors Inc., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities mentioned. The information contained herein may change at any time and we have no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation. It should not be assumed that any of the securities transactions or holdings mentioned were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities mentioned. Past performance is no guarantee of future results and future returns are not guaranteed.

The information contained herein does not take into consideration the investment objectives, financial situation or specific needs of any particular person. Generation Advisors Inc. has not taken any steps to ensure that any securities or investment strategies mentioned are suitable for any particular investor. The information contained herein must not be used, or relied upon, for the purposes of any investment decisions, in substitution for the exercise of independent judgment.

The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. We make no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained herein. We expressly disclaim all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained herein.

All products and services provided by Generation Advisors Inc. are subject to the respective agreements and applicable terms governing their use. The investment products and services referred to herein are only available to investors in certain jurisdictions where they may be legally offered and to certain investors who are qualified according to the laws of the applicable jurisdiction. Nothing herein shall constitute an offer or solicitation to anyone in any jurisdiction where such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such a solicitation.

Changes

Changes

December 13, 2018

Randall Abramson, CFA
President & CEO,
Portfolio Manager




This article has been excerpted and edited from our quarterly newsletter to clients dated November 16, 2018.
Everybody handles change differently. Some embrace it, rolling with the punches. Many even seek change because they require new or additional stimuli. Others can’t cope with the slightest change, becoming anxious or frightened from non-life altering unexpected change, like flight cancellations.

Finance professionals must be equipped to cope with an ever-changing world. To assess whether changes are material and analyze any possible impact on markets or a security’s value. And to react to news (fake or otherwise), in order to determine whether to buy, sell or hold. Is an event temporary? Or perhaps, where there’s smoke is there fire? Has the market already discounted these changes or are investors in denial?

Often the market anticipates change. For companies, information from competitors, suppliers or customers may become apparent prior to a corporate report. So prices may have already reacted when news hits. Hence the adage, “Buy on the rumour, sell on the news.” Business schools have a more formal name for this—the Efficient Market Hypothesis, in its strongest form where all information is reflected in share prices at all times.

Because, periodically, events do come out of the blue, meaning they are completely unanticipated, we diversify. And, furthermore, we strive to find investments where the businesses are more predictable, to minimize the impact from exogenous factors.

As value investors, we do not believe the market is entirely efficient and we embrace change. First, because it’s the price fluctuations that provide the bargains we seek. Second, because we know changes are inevitable and we must be ready to react to the ebbs and flows of businesses, the business cycle, and newsflow.

SOME THINGS NEVER CHANGE

Earnings, along with their multiples and growth rates, are key determinants to stock market levels. Looking back in time, some periods were characterized by lofty multiples and high growth rates and others by the opposite. Current multiples are now slightly below average for the S&P 500 and have some room to expand as long as interest rates remain relatively low. Earnings growth has been robust but should be under pressure from higher interest rates (both from higher interest expenses and the dampening effect of higher rates on housing and auto sales), rising labour costs, new tariffs and a strong U.S. dollar, while the boost from lower tax rates has already annualized. We expect more volatility as the economic cycle advances. However, we still believe we are in a bull market because in the absence of a recession, earnings should continue to rise boosting corporate valuations and consequently share prices too.

October lived up to its scary reputation—the S&P 500 falling in the month by the largest amount in the last 40 years, the only worse Octobers being '08 and the Crash of '87. For perspective, there have been only 5 occasions in those 40 years when the S&P 500 declined by greater than 20% from peak to trough. Other than the '87 Crash, all were during recessions. There were 17 other instances, over the same time frame, when the market fell by over 10% but less than 20%. Furthermore, this is the 18th correction of 5% or more since the current bull market started in March '09. Corrections are the norm. They can be healthy as they often undo market complacency—overbought levels—potentially allowing the market to base and move even higher.

In the short term, markets clearly can fluctuate quite a bit. Headlines of the day sway sentiment which in turn impacts quarterly earnings estimates and growth rate expectations. In September the markets were setting all-time highs. The complacency was exemplified by the record number of IPOs hitting the market with net income losses, higher than in 1999; consumer confidence stats that reached record highs; and through August, there had only been 52 days in '18 when the S&P 500 closed up or down more than 0.3%—the fewest in any previous year. The markets were extended, not necessarily in terms of valuation but with respect to the speed of the advance and the level of optimism and therefore were vulnerable to a setback.

To be sure, there are areas of concern—rising interest rates, slowing global growth and the effect of recently imposed tariffs. Though, even if these are temporary issues, of greater concern is the high levels of debt throughout the economic system. The U.S. budget deficit increased by 17% in its fiscal year ended September 30, at a time in the economic cycle when deficits should be shrinking. Corporate debt is high too. And ever-growing pension obligations of state and local governments will bring a heavy future burden. Rising rates are further impacting debt levels as the cost of servicing debt expands. At the same time, central banks are shrinking liquidity which is not a positive for equity markets.

On the political front, populism is making its way into many nations. This may be problematic too as global capitalism is being somewhat rejected and is the reason we are seeing policies which embrace nationalism and are anti-immigration, trade and foreign investment.

A WELCOME CHANGE

At the recent lows, complacency was replaced by pessimism. The markets became sufficiently oversold to spur a rally and sentiment gauges were measuring fear among retail investors at levels that were more fearful than the correction trough in January '18 and, amazingly, that measured at the bottom in March '09.

Not only has the U.S. stock market been correcting, other markets around the world and other asset classes have suffered even worse year to date. Bonds (government and corporate), international equities, emerging markets and commodities have all fared worse.

We are constantly watching our Economic Composite, which still has not triggered a negative signal for the U.S. As a reminder, our Economic Composite is a melding of the yield curve—looking for inversion, when short rates eclipse long rates—unemployment and other key economic statistics. Its core component is the yield curve because the lead time from an inversion to a stock market peak is generally just shy of one year. An inversion though is not expected for at least another year. But, we are in an aging cycle and will continue to carefully watch for negative alerts. The Conference Board's LEI (leading economic index) remains healthily positive too. A recession does not appear likely in the near term.

At the same time, we are looking for the typical late cycle behaviour, where commodities outperform and stock markets tend to spike higher. In fact, market tops do not normally occur merely at points of complacency or overbought levels. When the market is peaking, those features are accompanied by euphoria—a state which has been absent thus far.

The positives continue to be numerous. GDP for Q3 grew at a robust 3.5% in the U.S.—consumer spending running at a healthy 4%. Earnings growth for U.S. corporations remains high and ahead of expectations. Core inflation (the PCE deflator) is contained at 2.0%, meeting the Fed’s objective—though wage pressures are appearing with the most recent figures showing more than a 3% rise. Job openings continue to exceed the number of unemployed workers looking for jobs by a record amount—a sign of buoyancy. Insider buying has also picked up and share buybacks too.

We are also optimistic in the short term because seasonality is now highly favourable. The November to April period has a record of outperformance. It’s even enhanced in mid-term election years, where it has not registered a down period since WWII—the median return being 15% since the '30s compared to low single digits in all other similar time frames.

The value of a company at any point in time is the present value of all its future free cash flows. In its simplest form, it’s calculated by discounting cash flow by the discount rate; adjusted by the expected growth rate. Using a 9% discount rate and about 3% long term (GDP based) growth rate, for an adjusted 6% rate, translates into a 16.5x P/E multiple—which happens to be in line with the last 5-year average forward multiple for the S&P 500 of 16.4x. The current forward P/E ratio is below 16x. So barring a recession, the market appears slightly undervalued, which is corroborated by our bottom up analysis using TVMTM (our valuation model) on the stocks that compose the major indexes.

OUR STRATEGY

Though there are cautionary flags, such as rising debt levels, inflation and interest rates, as well as a flattening yield curve, we are still confident in being fully invested because valuations are not extreme and a near-term global recession seems unlikely.

With somewhat higher volatility we have been uncovering more large cap bargains—quality companies with favourable earnings outlooks trading at wide enough discounts to our estimates of their Fair Market Values (FMV). We sold some positions in October on TRACTM sell signals and were able to replace a few at the next floors. We continue to add large cap positions to our All Cap portfolios and look to add more when our current smaller cap positions are sold once they rise close to our FMV estimates.

We continue to have an overweighting in resources via our oil & gas and gold positions. We expect a rebound in gold prices which have fallen too near industry average all-in sustaining costs (normally there’s about a 40% premium) and bearishness toward the sector remains near record highs. Gold could also act as a hedge against rising global inflation and debt levels. We expect oil prices to move higher especially after the recent downdraft that appears to be related to oil’s paper market (futures) not the physical market (actual oil transactions). Inventories have fallen and we expect them to decline further which should benefit a supply/demand balance that’s already in deficit. Furthermore, the equities we hold in these sectors appear to be at unusual discounts to our estimates of their net asset value.

In general, we continue to seek holdings that possess competitive advantages and consistently growing earnings streams. We screen, analyze, and patiently await investments that are both undervalued and high quality. Yet, if our outlook for the overall economy or stock market turns negative, we intend to raise cash and/or short the market (where authorized by accounts) in order to protect our accounts.


DISCLAIMER

The information contained herein is for informational and reference purposes only and shall not be construed to constitute any form of investment advice. Nothing contained herein shall constitute an offer, solicitation, recommendation or endorsement to buy or sell any security or other financial instrument. Investment accounts and funds managed by Generation Advisors Inc. may or may not continue to hold any of the securities mentioned. Generation Advisors Inc., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities mentioned. The information contained herein may change at any time and we have no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation. It should not be assumed that any of the securities transactions or holdings mentioned were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities mentioned. Past performance is no guarantee of future results and future returns are not guaranteed.

The information contained herein does not take into consideration the investment objectives, financial situation or specific needs of any particular person. Generation Advisors Inc. has not taken any steps to ensure that any securities or investment strategies mentioned are suitable for any particular investor. The information contained herein must not be used, or relied upon, for the purposes of any investment decisions, in substitution for the exercise of independent judgment.

The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. We make no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained herein. We expressly disclaim all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained herein.

All products and services provided by Generation Advisors Inc. are subject to the respective agreements and applicable terms governing their use. The investment products and services referred to herein are only available to investors in certain jurisdictions where they may be legally offered and to certain investors who are qualified according to the laws of the applicable jurisdiction. Nothing herein shall constitute an offer or solicitation to anyone in any jurisdiction where such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such a solicitation.

The Quality Quandary

The Quality Quandary

November 30, 2018

Randall Abramson, CFA
President & CEO,
Portfolio Manager




This article has been excerpted and edited from our quarterly newsletter to clients dated September 7, 2018.
As value investors, we are always on the lookout for bargains—stocks or bonds that are trading at prices below our estimate of Fair Market Value (FMV). Both research and common sense dictate that the greater the discrepancy between price and FMV, the better—it provides a higher possible margin of safety and implied upside. However, securities are often detached from their FMVs because the business is suffering, leaving investors to figure out whether the issues at hand will be minor and temporary or debilitating and permanent.

Buying the most statistically undervalued companies can be quite lucrative but can also expose investors to deteriorating businesses—some are clearly cheap for a reason. On the other end of the spectrum, the highest quality businesses tend to be fully priced—some unduly, due to their popularity—so high quality investment opportunities can be scarce. Hence, the quality quandary.

Investors generally fall into two camps. Value investors usually dwell in the bargain basement bin. In the other camp, which comprises most investors, are growth or momentum investors, who tend to gloss over valuation work as they prize business metrics over all else. Our philosophy requires both—a high quality business at an attractive valuation. Simply stated but not easily executed, because it requires additional analysis to determine a company’s lasting competitive advantages and the patience to await a price sufficiently below our FMV estimate to justify a potential outsized rate of return.

Our own philosophy has evolved. In years past, we emphasized the more undervalued opportunities, still preferring good businesses but valuation was a key driver. In emphasizing undervaluation, we held some less predictable businesses. Our migration toward higher quality businesses was motivated by our desire to have fewer clunkers—to lower the number of losers and to shrink the size of the losses.

We aim for more winners than losers. Who wouldn’t? And, to maximize the gains from our winners while minimizing the losses from our losers. But, again, simple to say, harder to achieve.

The better the business, the more predictable are its earnings. The more predictable the earnings, the easier it is to estimate the value with relative confidence. Companies that are less susceptible to competitive threats, with higher returns on capital and efficient balance sheets, are usually the steady growers. Therefore, these companies are more likely to have consistently rising FMVs. While certain companies trade at low valuation multiples, appearing undervalued, and can provide tremendous upside should the business improve, the risk of erring in our analysis, we believe, is substantially increased when the business has less predictability. That’s the reason we often invest in companies trading at 20% discounts to our FMV appraisals, rather than those trading at perhaps larger discounts, as high quality companies typically don’t detach too far from intrinsic value.

In between unanalyzable companies—the impossible ones to predict—and the highly predictable ones, lie most businesses, a wide swath for whose trajectory is less certain. These companies often have too many moving parts, too many competitors, are too levered—both financially and operationally (from high fixed cost structures)—and therefore are overly vulnerable to sudden changes in the landscape (i.e., new entrants, falling demand, higher interest rates, or regulatory changes). For these reasons we find ourselves mostly passing over opportunities which are potentially high reward but equally, if not more so, high risk.

Even though, in the last few years, the markets have been much less volatile, there are still enough instances where the shares of high quality companies fall to at least a 20% discount, allowing us to build a diversified portfolio. Usually, a 20% discount is as good as it gets for high quality companies. Only at the depths of bear markets, when everything’s on sale, can one normally find superb companies at larger discounts.



DISCLAIMER

The information contained herein is for informational and reference purposes only and shall not be construed to constitute any form of investment advice. Nothing contained herein shall constitute an offer, solicitation, recommendation or endorsement to buy or sell any security or other financial instrument. Investment accounts and funds managed by Generation Advisors Inc. may or may not continue to hold any of the securities mentioned. Generation Advisors Inc., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities mentioned. The information contained herein may change at any time and we have no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation. It should not be assumed that any of the securities transactions or holdings mentioned were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities mentioned. Past performance is no guarantee of future results and future returns are not guaranteed.

The information contained herein does not take into consideration the investment objectives, financial situation or specific needs of any particular person. Generation Advisors Inc. has not taken any steps to ensure that any securities or investment strategies mentioned are suitable for any particular investor. The information contained herein must not be used, or relied upon, for the purposes of any investment decisions, in substitution for the exercise of independent judgment.

The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. We make no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained herein. We expressly disclaim all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained herein.

All products and services provided by Generation Advisors Inc. are subject to the respective agreements and applicable terms governing their use. The investment products and services referred to herein are only available to investors in certain jurisdictions where they may be legally offered and to certain investors who are qualified according to the laws of the applicable jurisdiction. Nothing herein shall constitute an offer or solicitation to anyone in any jurisdiction where such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such a solicitation.

Myths and Misconceptions

Myths and Misconceptions

November 30, 2018

Randall Abramson, CFA
President & CEO,
Portfolio Manager




This article has been excerpted and edited from our quarterly newsletter to clients dated September 20, 2017.
VALUE VS. UNDERVALUED

We don't buy value stocks per se. We buy undervalued stocks. There’s a difference. Value stocks are generally understood to be those that trade at low multiples of earnings or book value. And many investors practice their trade by purchasing what they believe to be cheap stocks by finding those that are trading at relatively lower multiples than the market or industry peers. We prefer a stricter approach, analyzing companies and arriving at appraisals of fair value such that we have an absolute (as opposed to relative) view of the company’s price with respect to our fair value estimate. We believe this approach offers a better margin of safety and provides us with the ability to have appropriate targets—fair market values (FMVs) where we look to exit positions. Most stocks trade between undervaluation and fair value. Once fair value is achieved, the best one can hope for is to track a company’s growth rate but the stock becomes more susceptible to a downturn from any overall change in the expected growth rate or other factors impacting its value.

GROWTH VS. VALUE

Observers also like to distinguish between growth and value stocks. Generally, growth stocks are those that trade at high multiples and whose earnings are expected to grow at a fast clip, whereas the opposite view is held for value stocks. Again, here, we have a different opinion. Most of the time, a company must be growing, and at a decent pace, to justify it being good value—though a company can have flat or declining earnings and still be undervalued, if its price is too far below the expected future free cash flows of the business. However, normally it’s a value trap—a company that appears undervalued but whose fundamentals are deteriorating, in turn eroding fair market value along with its share price. We seek to own companies whose FMVs are growing up and to the right—companies whose earnings are ever-advancing but for various reasons, usually a recent setback, the share price has declined or remained flat while our view of underlying FMV remains higher.

While this may sound academic (i.e., too technical), it’s an important distinction. It has led us to focus on the type of securities we prefer to own. Research over many years has shown that owning value stocks over growth stocks leads to market-beating results. We have always embraced that research. However, we try to focus on companies that aren’t just undervalued but also have steady earnings growth rates, generally higher quality businesses that are strong operationally and financially, in an effort to also mitigate losses.

FULLY INVESTED VS. HEDGE?

It’s generally believed that one should be fully invested at all times. The reasoning is simple. If stocks are the highest returning asset class and if market downturns are difficult to predict—there’s always some prognosticator calling for doom and gloom—then one should ignore the noise and remain “in it to win it.” Here too we differ. In spirit we agree—one should be fully invested most of the time—because over two-thirds of the time we are in a bull market. If, on the other hand, one could forecast the timing of the other third—the bear market—one could avoid the drawdowns. Something business schools teach can’t be done—to have our cake and eat it too.

We don’t like drawdowns and our clients detest them. And, simply put, when FMVs are falling, so are share prices. When are most company values declining? In a recession. So we developed an Economic Composite to alert us to recessions both in the U.S. and abroad. Similarly, we developed a market momentum indicator (TRIM™) to alert us to bear markets—those that decline by more than 20%. And, in periods when our alerts aren’t triggering, like today, we should have even more confidence to be fully invested. Though, one key caveat now, we still need to be able to find enough investment opportunities that meet our criteria—currently not an easy task. In our large cap only portfolios we have held an outsized cash position which has restrained our returns. Not because we have been bearish, but for lack of our ability to find enough attractive opportunities, not for lack of looking.

PASSIVE VS. ACTIVE?

At the bottom of the market, passive investing can make a lot of sense. When bargains abound it can pay to invest broadly—to have exposure to everything and limit the risk of a few holdings preventing outsized returns. However, when valuations are full, or markets are overpriced, then caveat emptor (buyer beware) as broad exposure can be riskier than holding a better mix of undervalued stocks.

Because the markets are fully valued and growth rates are low, the U.S. market is exhibiting the lowest prospect of long-term returns in years. The Value Line appreciation potential index, which has been remarkably accurate over the years, is forecasting a 5-year return of only about 6% per year—in the bottom decile since the late '60s. And a 60/40 asset mix (60% S&P 500 stocks, 40% U.S. 10-year bonds) which before fees has returned 8% per year since 1880, half of which came from bond yields, looks like wishful thinking today given a 2% government bond yield, a fully-priced stock market and the lowest economic recovery rate of the last several economic cycles.


DISCLAIMER

The information contained herein is for informational and reference purposes only and shall not be construed to constitute any form of investment advice. Nothing contained herein shall constitute an offer, solicitation, recommendation or endorsement to buy or sell any security or other financial instrument. Investment accounts and funds managed by Generation Advisors Inc. may or may not continue to hold any of the securities mentioned. Generation Advisors Inc., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities mentioned. The information contained herein may change at any time and we have no obligation to update the information contained herein and may make investment decisions that are inconsistent with the views expressed in this presentation. It should not be assumed that any of the securities transactions or holdings mentioned were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities mentioned. Past performance is no guarantee of future results and future returns are not guaranteed.

The information contained herein does not take into consideration the investment objectives, financial situation or specific needs of any particular person. Generation Advisors Inc. has not taken any steps to ensure that any securities or investment strategies mentioned are suitable for any particular investor. The information contained herein must not be used, or relied upon, for the purposes of any investment decisions, in substitution for the exercise of independent judgment.

The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. We make no representation or warranties as to the accuracy, completeness or timeliness of the information, text, graphics or other items contained herein. We expressly disclaim all liability for errors or omissions in, or the misuse or misinterpretation of, any information contained herein.

All products and services provided by Generation Advisors Inc. are subject to the respective agreements and applicable terms governing their use. The investment products and services referred to herein are only available to investors in certain jurisdictions where they may be legally offered and to certain investors who are qualified according to the laws of the applicable jurisdiction. Nothing herein shall constitute an offer or solicitation to anyone in any jurisdiction where such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such a solicitation.