Change of Seasons - High Dividend Value Approach in the Sweet Spot
Summary of this update:
- We expect our High Dividend Strategy to begin outperforming after a long and frustrating period of underperformance
- We have added to our deep value allocations within the High Dividend strategy again
- Value based investing styles are back in favor
- Index based investing approaches will give way to stock picking and active management
- These events historically correspond to a top in the major stock market averages
- Follow the leadership and keep the rest of your portfolio in cash
Let me start this update by asking you to watch the trailer for The Big Short movie.
You’ve probably already seen the film, but the trailer will bring home the theme of this update. The actor Christian Bale, who plays the math genius Michael Burry, tries to calm his nerves by playing the drums to heavy metal, as he holds his very large bet against (short) the housing market in early 2006. He’s suffering because housing prices were mathematically doomed and yet they continued to rise for almost two years. Of course, in the end, Michael is proven right walks into the sunset making millions while the housing market collapses near the end of 2007.
Holding our bet on value-based investments in our High Dividend model has been our own demon for quite a while, longer than we care to admit. Honestly, we have felt like Christian above, beating our heads and our drums in bewilderment as investors piled billions into companies with ridiculous valuations while ignoring those that offer attractive valuations, strong free cash flows and healthy dividends. It’s been six years of pain for those of us with the discipline to stick with a value approach. Admittedly, our High Dividend strategy has lagged both the market and our objectives for almost as long. We have heard the frustration from our clients, and we feel your pain as we have a lot of our own personal and corporate money invested here as well.
Today, we see enough evidence to suggest that the tide has likely turned.
Value is coming back into favor, and Growth is out— and likely to be a drag on the broad US market.
If we’re right, our High Dividend strategy, betting on undervalued individual stocks, is going to start cranking out long overdue returns to our client accounts in this strategy.
The Shift to Value Happens When Investors Become Risk Averse
When markets very suddenly and passionately, shift preferences from a growth to a value mindset, we know that investors are preparing for a different environment. Specifically, they are choosing to populate their portfolios with individuals’ names that don’t trade at nosebleed levels because, they expect prices to fall in the future. More specifically, they expect prices of overbought, overvalued stuff to fall more-- a lot more— than their value counterparts. As conditions continue to angle toward recession in 2020, we should and do expect investors to shift their preferences toward companies that offer stable cash flows, healthy earnings, low debt, have a history of consistent and growing dividends, and are trading at significant discounts in price.
Sound too good to be true?
Our list of companies with these characteristics is long and diverse across multiple sectors. In fact, we’ve been looking at this for years wondering why these names just continue to fall, get cheaper and underperform the growth side of the market. Classically, we have seen unicorn companies go public in mass with a wave of IPOs, as they seek to dump their shares into a marketplace that doesn’t seem to care about earnings or revenues at all. What a great time for owners of private companies to cash out! Now, we are seeing a more rational side to investor preferences. Now we see companies like We Work cut their valuations by 50% before they even attempt to float shares publicly (We Work will go to zero after they go public – personal opinion). Companies trading at very attractive valuations have simultaneously turned higher and its game on!
How have we positioned High Dividend for success? Glad you asked.
In June of 2019, we had so many options to choose from that we expanded our allocation to deep value stocks in the High Dividend strategy from 25% to 40% of total assets. The remainder of the strategy allocations goes to low cost, stable, dividend paying ETFs. In August, we did the same thing, adding another 10% to the deep value allocation. And last week, we pushed the value allocation up to 60% of total assets. Today, we have 10 individual names with room to add 2-3 more before the pot is filled.
Welcome to the Anti-Index Market
I need to be careful what I say here for several reasons. One, I could be dead wrong, and this commentary will be referenced for years to come. And two, the entire financial system in the US is hooked, treble hooked, into in accepting the notion that one need only buy a slate of zero cost index ETFs, put in a nickel on one end and retrieve a crispy dollar on the other. The last six years has been a historic and statistical anomaly for passive indexes. The US stock market, and associated US stock index investments like the SPY or the QQQ, have put up the highest risk adjusted returns RELATIVE to everything else (mutual funds, hedge funds, other asset classes, gold, etc.) in history. Forever is a long time as Sean Powers likes to say. Anyone doing anything other than buying and holding the S&P 500 stock index in concentrated positions is just plainly not smart, right?
That environment just ended
The move we have seen favoring value is also a move that favors stock pickers and active management styles over passive indexing. In 18 months, we’ll look back on this time and see the results of what I am saying. Unfortunately, as I mentioned above, the indexed market of securities is highly dependent on the welfare of the growth and momentum stock world. When these names buckle, they tend to drag the broad market (and all associated index investments) with them. Bespoke created this chart on Friday showing the last times we saw a rotation from momentum to value. To my point, they tend to happen in the final years of bull markets (1999 and again in late 2007).
Practically, that means that investors should simultaneously follow the trend toward value AND be prepared to cut stock market exposure. Diversification to other asset classes like bonds, is always encouraged but may not be a productive as other cycles.
Here’s a closer look at what has happened in the last ten days. This is a dramatic event to say the least.
Selection is Everything
Truth be told, there are growth names out there trading at very attractive valuations. No one owns them yet, but they are out there. On the other end, we have select consumer staples companies trading at truly outrageous prices and everyone owns them. Traditionally, we might think of consumer staples companies as a “Value” play as in one that does well in tough economic times. Staples are anything but a value play. Let’s play a game of Stock Boxing.
In the Deep Value corner we have:
Seagate Technology Holdings (STX) – a growth stock in the data storage business
Price to earnings ratio: 6.61 – very, very cheap price relative to earnings.
Earnings per share growth rate last quarter: 122% - Wow!
Dividend yield: 2.02% tech doesn’t pay dividends?
Seagate makes $2B in earnings in the last 12 months on $10B in total Sales – Strong!
In the High-Value corner we have:
Proctor & Gamble (PG) – a consumer staples company selling toothpaste and stuff
Price to earnings ratio: 75.62 – wait what?
Earnings per share growth rate last quarter: - 380% Yikes!
Dividend yield: 2.43% Meh for a consumer staples company
P&G earned $3.9B in earnings in the last year on …. $67.7B in total sales – very thin
And yet.. Proctor and Gamble has moved higher and higher this year with historically low volatility. Meanwhile Seagate has been volatile to say the least over the last five years. Here’s a five year total return chart comparing the two with PG in Red and STX in Green.
Any sane investor would look at these charts and pick P & G over Seagate. But, remember, we invest for tomorrow, not the past. If this shift to low value stocks persists, we should be very suspicious of companies like PG, while working to pick up shares of a company like Seagate. STX is one of the holdings in our High Dividend Strategy and is poised for a breakout to all time new highs with the very strong move up in the last few months. Should be a knockout!
There are many more examples, but I’ll leave it at this. We are witnessing a new market environment that favors very selective stock picks, specific styles like small cap value, and certain sectors like basic materials, banks, industrials. This is not a market environment where one can simply own everything in the form of an index and hope for a positive outcome. Follow the leaders strictly and exclusively and remain in cash with the rest of your portfolio. I’ve seen this type of market environment twice in my long history of managing money professionally. It can be simultaneously very rewarding to those who know where to look and devastating for those chasing yesterday’s trends.
Pay close attention to what you own and feel free to reach out to us for a free, no-obligation analysis of your portfolio.
CEO, All Season Financial Advisors, Inc