Category: Investing Philosophy

Has this ever happened to you? You think of what you would describe as a clever term or phrase only to take to the internet and find out you were beat to the punch (and by more than a day or two).  Recently, I was looking through a long list of marijuana related stocks and it soon became clear that there were just a couple of established businesses scattered among acres of unproven, speculative companies that were more akin to a lottery ticket. Light bulb! I began to wonder which of these will be among the first to become a “green chip” stock.  Google results sadly returned the fact that “green chip” was used here and there for environmentally friendly stocks when they surged in popularity a decade ago. But given how nearly every corporation claims to be in the business of sustaining our environment in some way or the other, I would argue the green chip term should be reserved for those that ultimately gain establishment status as among the Cannabis stocks. Plus, I think it’s more amusing to apply to Mary Jane stocks anyhow – so move over First Solar.

The term blue chip stock has some latitude in its meaning, but generally refers to large, financially sound companies that pay steady dividends. With 19 states having legalized medical use and another 8 for legal recreational use, investor attention has been on the rise (at least anecdotally in my case). Many are eager to strike green gold by identifying one of these future green chips and investing in them now.  I can’t call this crazy thinking at all since it’s only a matter of time for the great plains and southern states to catch up to the rest of the country.

Before a couple more thoughts on the investment aspect, I am curious about how the industry will fit within the notion of “socially responsible investing” or SRI.  Maybe it’s just in these southern and plains states that are dragging their feet on cannabis liberalization, but there will be undoubtedly investors who would prefer not to profit from marijuana.  SRI has been one of the most difficult aspects to investing I’ve encountered. Even with geographically clustered clients, you don’t always find ubiquitous ideals or for how those ideals should be reflected in their investments. Furthermore, even if there were ubiquity, a fiduciary’s responsibility is with all clients’ money so how can one let the ideal of client A, B & C impact D’s portfolio?

To make it even harder (for me anyhow), it’s difficult enough finding the commonality within an issue, let alone having it boiled down to the exact common factors to be considered for an SRI portfolio. Here’s an offbeat example that hopefully highlights the difficulty.

Company A: Peddles annuities onto unsuspecting school teachers, in turn smothering them unknowingly with 3-4% vehicles. Not stopping there, they then strand them to make their own investment selections.

Company B: Manufactures plant based therapies to aid those with cancer from their pain and chemo nausea. That plant just happens to be associated with social taboo.

One is a financial cancer and the other one is fighting real cancer. One recently had it easier to do business in the US and the other is still battled by half the country. Clearly some personal bias shines through this slant – but its particular striking to me because I could find company A in just about any investor portfolio, even if they have a “socially responsible” slant. Rarely, if ever, would you financial stocks in an SRI screen yet I would suspect you would find some resistance somewhere to benefiting from cannabis.

SRI is clearly on the rise but is well beyond my scope and I have more questions than answers. I do fully understand and respect those that wish to have their dollars invested in a way that aligns with their values.  It’s simply not in my personal jurisdiction – other than one last suggestion. Academic research has shown that SRI can lead to positive results, but in two ways. The first: Companies that “do good” tend to “do well”. The second: companies shunned as taboo also tends to do well (just take a quick look at cigarette stocks).   That goes right along with sage advice from one of my investing idols, Howard Marks, to “concentrate on the unloved, less-followed and therefore less-efficient sectors”. If, for some reason, investors drag their feet to get on board – marijuana very well could be an area worthy of more focus. I’m not saying this is the case right now but is certainly a possibility going forward.

Assuming the socially responsible bridge has been crossed, marijuana investments on the other side of that bridge range across many industries such as real estate, growing technologies, farms and of course health care. Health care seems like the obvious path for the first green chip, but we shall see. Please make special note that none of this is a recommendation to put money in that area. FEG’s specialty centers on risk management in the pursuit of balancing risk, return and taxes. That isn’t conducive to putting client dollars towards unproven, speculative plays. But, I would certainly encourage you to not dismiss it as the area isn’t one that should be written off either. It does seem to me at least that there is a rather large disconnect between the fact that we are more than halfway home towards nationwide legality but still in the very early stages of investor interest. Those two will reconcile over time and some will be rewarded with healthy profits on their early investment. If you do somehow find motivation to go fishing for green chips yourself – do use caution and do not buy a stock just because it is in a certain business. A good company does not always make a good stock.  But best of luck for turning your greenbacks into green chips

 

 

And if so, is it time to put them away too?

Current stock valuations – or cost per unit of economic value – are not something I usually want to devote a lot of space to as they don’t change that significantly month to month and their short run influence is rather limited. This certainly shouldn’t imply that value isn’t high on my list as an investor, because it is.  Further, valuation input is pretty well established and not subject to a ton of disagreement (if you are in the business, just check your twitter stream).   However, as we move from one market environment and calendar year to the next – here are a few thoughts on the topic.

Two Considerations for Expensive Stocks

The view that US stock valuations are elevated is certainly not a new one and merits little dispute. Yet, I am a firm supporter of the notion that stock valuations shouldn’t be analyzed in a vacuum that only considers past stock valuations and ignores other basic factors like interest rates. Most families for whom my role supports need some combination of growth and income to support them during retirement, with our job at the Financial Enhancement Group being to find that best combination. So, it absolutely matters that the lower forward return expectations that accompany high valuations is accompanied by extraordinarily low bond return expectations as well. That is the first notion to consider when using equity valuations as an investment input.

The second notion accompanies what has now probably become the most popular method of looking at stock values; the Shiller cyclically adjusted price-earnings ratio (CAPE).  The CAPE’s concept of not being overly influenced by the booms and busts of a cycle carries a lot of appeal. Applying the concept though to publicly-traded US equities has one big problem: the way we measure earnings was significantly adjusted in 2001.  For a much better explanation, follow this link to a brilliant piece in 2013 by Philosophical Economics: http://www.philosophicaleconomics.com/2013/12/shiller/.  To put the problem simply, before 2001 was apples and post 2001 are oranges.

Proprietary Solution

My answer to both of these notions was taken into account by what I call the “rule of 25”.  It is built on the framework of Shiller’s CAPE but takes into account these two factors of consideration described above. For this post’s purposes, I won’t fully describe the methodology (and thereby give away too many secrets).  What I will tell you is that as we close out this year, this internally calculated measure now suggests a more balanced view of stocks and bonds than we had as late 2013/early 2014. In 2009 and 2010 as the cycle turned upward, the extremely low stock prices produced very cheap valuations that suggested equities should be very heavily over weighted due to a favorable 5 year forward outlook compared to bonds.  As we lifted off those levels, stocks continued to be favored on a 5 year forward basis but not by as much and increasingly because interest rates kept moving lower.  Where we stand today in this internal rule is a more balanced and neutral view of the allocation to stocks (whatever that means to you).  Again – this is only looking discussing valuation and only one part of the investment input.

Deeper view of current valuation levels

Goldman Sachs recently put out a simple, but rich perspective on current valuations.  It was meaningful because they look beyond one or two measures of value and instead compare across 7 as shown in the table below.

Looking at a composite view is very helpful in looking past any anomalies that can skew one indicator or another. In this case, however, the message across the board is pretty clear that stocks are historically expensive. The one holdout on these is free cash flow yield – which in my role as an analyst has a lead role.  While the initial thought is that is a nice silver lining, another perspective merits strong consideration.

One of the main restraints we have seen in the economy over these past few years is a reluctance of corporate America to invest in their future through capital expenditures (chart below).   Keeping Cap-Ex low has been a boost to free cash flow (which keeps free cash flow yields high). If corporate America jumps on board with the current economic optimism and invests their cash flows – this one silver lining goes away. If they don’t, the lack of investment will further restrain their growth. I can’t tell you which one is better for next couple of years’ stock market, but a release of the cash flow would take away the one hold out from the table above and leave a unanimous view of high historic valuations.

Valuation context and what it means for you

Valuations are most helpful (at least to me) when simply thought of in the context of how markets move from point A to B. The move from point A to point B will always comprise of a change in earnings and a change in the price for earnings (P/E) multiple investors are willing to pay for those earnings. For example, the S & P has moved from 1,518 at the end of 2011 to now over 2,200 – an increase of 45%+. Over this time frame, earnings on the index have increased 13% from 77 to 87. Meanwhile, the (P/E) multiple – investors were willing to pay which has moved up from 16.3 to now over 26 (trailing basis). That expansion in P/E to a very high historical level has served as a major tailwind for stocks – a tailwind we should assume is now likely behind us after having accounted for the majority of the move over the last 5 years.  Of course, it can march on higher but it is most wise to assume that any surge to higher valuation levels would not be permanent and likely quite short lived.

In that sense, it may be helpful to think about the market as a 4 engine plane.  Sure, the “multiples engine” is probably gone – but that doesn’t mean the plane is destined to crash. One of the biggest mistakes I’ve seen investors make (speaking from experience here) is avoiding equities under the risk that stock prices could fall and return valuations to normal. High valuations, in isolation, shouldn’t mean you drop equities all together.  Valuations can just simply hold here near these levels through the rest of this cycle. If we couple that scenario with something like steady 4-6% growth stemming from earnings growth through the rest of the cycle….is that the worst outcome?

At the same time, we have to recognize that we are clearly running with less power with the “multiples engine” offline. If storms pop up (which, for us, include other pieces of our risk barometer), the valuation piece means we have less engine power to get around those storms.  Our sell signals need to be closer by under nosebleed valuations. If we lose another engine – that’s when we are looking for an emergency landing. High valuations will be corrected, but it’s foolish to think we can know how or when.

“Common sense” when carefully applied can be a useful tool in an often overly complicated world, and sometimes we downright crave a healthy dose. Case in point: Dustin Johnson at this year’s U.S. Open. Now, I come from a golfing family, have played the game most of my life and continue to play any opportunity the family calendar provides.  Yet, I will be the first to say the game of golf represents a reluctance to progress in the worst kind of way.  Many golfing establishments still care what you wear on their course (after perhaps shelling out $100) right down to the point they require your upper garment to be affixed with a collar.  After all, it would be quite a shame for more of your neck to be exposed in public! That sort of nonsense sheds light on how the game would make possible the treatment – completely void of any common sense – Dustin Johnson received at the U.S. Open.  For anyone who didn’t see it, the guy was penalized when ball rolled all of 2 dimples worth clearly due to natural causes.  Fortunately, it did not cost him a major championship, but did send millions of golf fans screaming from mountain tops their pleas for the application of common sense. It could have been a very ugly situation had the match finished closer. (You can check out the clip here if you wish:  https://youtu.be/OUxeuWyFUco)

Danaher spinoff

All of that digression on golf is to say that while we so often want the world around us to just use some common sense, it can often be a detriment to investors. One small example of that can be seen from a long-time portfolio holding of ours, Danaher (DHR).  Danaher has done very well over the years with a successful track record of buying up companies across a number of different industries and making them better. Last year, Danaher management decided that owning all these various businesses under one stock umbrella was restraining their stock price from further appreciation. The belief is/was that the company was relatively more priced for the slower growing industries in its portfolio than for its faster growing ones. Subsequently, by breaking them apart, the market could more easily reward the overall stock price for the faster growth holdings. This playbook has worked very well in several instances over this market cycle.

This past July, Danaher investors had their holding broken into two prices. One stock (still called Danaher) holds the faster growing businesses with popular theses. The other, now called Fortive, holds more of the old school and slow-growing businesses. Common sense suggests that investors hold onto the more appealing stuff that drove investors to Danaher in the first place.

Out of the gate

This was largely the case during the first month for Fortive, where after hitting an intraday high of $54.34 on trading day #1, shares spent most of the time languishing between $48 and $50 while Danaher steadily appreciated. However, as things have since settled, it is the Fortive shares that have outperformed and taken off.

These were the group of assets thought to be left for dead. As with so many things in investing, it’s not just the quality that matters, it’s the price you pay for that quality.  We still have work to do in mapping our strategy for managing the Danaher / Fortive positon, but we knew we weren’t going to just automatically defer to the “more attractive” assets.

Broader significance

This Danaher spin-off is just one small and perhaps temporary example, but the notion of not just defaulting to common sense can be broadly applied to investing.  The European and Japanese movement to take short-term interest rates negative was supposed to lead to increased spending and investment as it discouraged people and companies from just parking the money at the bank. However, savings rates in both European and Japanese cases have been on the move up, not down, in savings rates.  In my opinion, this unintended consequence will be a big deal in the global thinking on monetary policy and its importance from here.

Another significant and recent example was the Brexit vote.  I had a client tell me in early August how she wished she could have somehow gotten advance feedback in late June from a friend “on the ground” in London and in turn clued us in to the ultimate outcome of the vote.  Of course, she was surprised to learn when I explained that even if we could have had that (assumed accurate) information ahead of time – it likely would have worked to our disadvantage as markets shrugged off the initial sell off with a rebound at breathtaking speed. Common sense could easily have sent us running for the hills. Instead, we relied on data and our process and were actually able to take advantage of the Brexit sell off. Herein lies the lesson:  Use common sense when teaching kids, using your computer, or just having some fun on the golf course.  But, rely heavily on the data (whatever your data set may be) whenever possible when investing money.

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer.