Fundamental Free Lunch: Update

Periodically, we like to update a back-test that uses a single fundamental factor, EV/EBITDA, to demonstrate how successfully a ultra-simple value portfolio can play out favorably over a number of years.  Now that we’ve crossed the halfway point for 2014, we thought this would be a good time to revisit this back-test and update it with year-to-date numbers.

As in past iterations of the back-test, we begin by ranking all the components of the S&P 500 at the end of each calendar year from 1992 (earliest data) to the present day by EV/EBITDA multiples, taking the 50 cheapest stocks in the S&P 500 and rebalancing on 12/31 each year.  Companies are equal-weighted.  Once a portfolio is set, there’s no trading over the course of the year.  Companies involved in M&A transactions over the course of any given year go out at the takeout price; we do not replace the acquired company with a new position.   Finally, in a new twist, for comparison purposes we use total returns for the S&P 500 benchmark (i.e. include dividends) but exclude dividends for the back-tested portfolio.  Since annual dividend yields for the S&P 500 are generally 2%+, this is a back of the envelope way to account for performance draining factors like slippage, commissions, and other fees.  All data comes via Bloomberg.

Why do we like to do this?  As you’ll see below, a super-simple portfolio using EV/EBITDA multiples for stock selection once per year without any other work produces outsized returns over the index over time.  It’s a powerful reminder that fundamentals work over the long run.  And, it’s a reminder that complexity can be the enemy as well over time.  As an aside, it’s incredibly interesting to go back over the past few decades and look at the names that pop up along the way, many of which no longer exist.

Here are the results through the end of trading today, 7/25/14.  

The back-tested portfolio outperforms the S&P 500 by over 4% annualized during the approximate 21.5-year period.  Because of the power of compounded returns, this is a very big deal.  $1000 invested in the model portfolio using the single valuation factor is worth $15,972 today versus $6,939 for an index tracker.

As we’ve pointed out in the past when conducting this exercise, there is a catch.

Pretend you are a portfolio manager launching this simple value based strategy on 12/31/1992 knowing that value works over the long run.  You invest the portfolio and look like a rock star the first two years.  Then, the value-manager killing late-1990s growthy stock bubble takes off leaving you in the dust for five straight years.  By the end of 1999, you’re losing by over 40% to the index with investors abandoning the portfolio (at the worst possible time, by the way) in droves to chase the newfangled internet stock dreams.  For the next 14½ years post-1999, the portfolio crushes the index, but you may not be there with a product to take advantage.

The moral: true value investing can be incredibly streaky and requires significant patience.  Over the first 21 years of the back-test, the model portfolio underperforms in eight. Though the long-term rewards are substantial, it is enormously difficult for investors, whether individuals or institutional, to stay the course, stick to plan, and take advantage.  Furthermore, it’s easy in hindsight to look at the names that pop up along the way and think that some of the moves were obvious in hindsight.  In real-time, many of the companies included in the portfolios were wounded and down on their luck at the time for rebalancing.  Apple, for instance, shows up in the early 2000s when few gave it much of a chance to do anything.  At the very least, the vast majority of the names included in the portfolio over time were far from being considered the sexist names in the investing universe.

Ultimately the value “free-lunch” continues because no matter how much the collective investor universe understands that value ultimately wins, very few are actually able to exhibit the patience, consistency, and discipline to take advantage.  A pesky thing called emotion intervenes over and over.  Investors can’t help chasing the shiny object, nor can they help ignoring the names that are trading cheaply but happen to carry some baggage. 

More On the US P/E

Debate over the “Shiller CAPE” normalized P/E ratio, popularized by Nobel Prize winning economist Professor Robert Shiller, has been particularly pointed this year.  As we’ve discussed in the past, this measure takes the average of 10-year trailing earnings for the “E” in the P/E ratio in order to smooth out and eliminate the volatility present in typical expressions of simple trailing 12-month S&P 500 earnings.  Supporters of the widely followed valuation measure correctly point out that future 10-year total index returns have a statistically significant relationship to CAPE valuation levels.  Detractors have leveled a number of charges varying from complaints that 10-year trailing earnings unfairly capture the massive, and in their view highly unusual earnings cliff dive that occurred in ‘08/’09 (but ignoring the fact that earnings were overly inflated ahead of the crisis), to the fact that the supposedly mean reverting ratio has remained above mean for the vast majority of the past two decades undermining the credibility of the indicator.  

A particularly interesting argument against Shiller’s version of the normalized P/E came from a blog by the name of Philosophical Economics back in December.  The blogger pointed out that changes to the treatment of “goodwill impairment” when calculating GAAP earnings had created real problems in terms of the consistency of Shiller’s earnings data over time.  The blogger demonstrated this issue by comparing GAAP earnings since the early 2000s (when the rules changed) with Bloomberg’s S&P 500 earnings calculation of scrubbed non-GAAP earnings from continuing ops and showing that the deviations between the two series since the early 2000s had increased dramatically since the shift.  We thought this was a particularly compelling argument and therefore used the alternate Bloomberg earnings data series in the same manner as the above blogger to reconstruct a historical normalized P/E ratio to create a more consistent measure.  

First, we’ll take care of a few housekeeping items.  Since the Bloomberg pro-forma data only goes back to 1952, and considering that deviations between pro-forma and GAAP are much, much small prior to the goodwill changes, we took a bit of “artistic license” and added Shiller’s publicly available data for the period from 1925 to 1952 so we could get a longer term view incorporating the bubble of the late 1920s and the subsequent depression years.  Now that that’s out of the way, here is the chart:

Now that we’ve addressed inconsistency due to GAAP changes, what do we learn from the current normalized P/E levels using the alternate “pro forma” data?  We see that the real (inflation-adjusted) P/E ratio currently sits at 22x versus the 25x level of the traditional Shiller P/E.  This compares to a long-term average of approximately 17x and a long-term median of 16.5x.  While not as overvalued as the traditional Shiller P/E, we see a market that’s still decently above historical levels.  How does this translate into a prediction for future returns?  The 10-year future annualized return forecast comes in at 3.54% for inflation-adjusted total returns (i.e. with dividends), 6.38% for non-inflation-adjusted total returns, and 4.47% for non-inflation-adjusted returns without dividends.  This compares to historical averages of 5.71%, 8.85%, and 6.63% respectively.  These numbers, therefore, look better going forward than those produced by Professor Shiller’s calculation.  Still, we’d say at current levels, even with the GAAP adjustments, there’s a good chance that market returns over the next 10-years will be substandard relative to historical averages.  

Regarding the criticism by some that the ratio has remained above median for a good part of the past 15 years, we see looking over the future returns streams that the above average P/Es resulted in sub-average returns.  The massive spike associated with the late 90’s tech bubble?  That spike resulted in outright negative 10-year annualized nominal and real returns.  How about those elevated P/E ratios observed in the period from roughly 2003 to 2007?  So far, the 10-year annualized returns that have been realized from 2003 and 2004 onward have been roughly in-line with the sub-par results P/E ratios would have predicted.  Take September/October 2003, for instance, when the normalized P/E was trading at approximately 22x, the current observed level: 10-year future total real returns were 4.5% per annum, over a percent lower than historical averages and nominal total returns were 6.9%, approximately 2% lower per annum than historical average.  The pattern has continued.  And, don’t forget that there was one heckuva wild, dangerous ride during that 10-year period, with the S&P 500 falling over 60% peak to trough at one point during the financial crisis.  

There are some other interesting historical observations worth pointing out, in our opinion.  Look at the Great Depression period and the secular bear market associated with that era.  Leading into the ’29 crash, valuations were extremely elevated.  At the beginning of the Depression, valuations dipped into the single-digits at a velocity similar to the velocity of valuation compression we’ve observed at various points over the past 14 years.  Over the five-year period from 1932 to 1937, however, markets recovered materially and valuations actually pushed back above 20x to a level almost exactly where we currently reside.  Sure enough, a relapse sent markets and valuations tumbling from overstretched highs back towards cycle lows.  

Of note, the next single-digit valuation low in 1942 proved, though, to be one of the better buy-points of all time.  Buying at the valuation low in 1942 would have produced double-digit annualized returns over the next 25 years.  Further showing how important starting valuation is, buying the market at the height of the Depression in 1932 when valuations hit a modern low produced double digit total returns over the ensuing 33 years until the next valuation peak was reached in 1965.  Similar observations and outcomes arise out of the valuation lows of the 1970s and early 1980s.

What’s the point of all this?  Set expectations appropriately for US returns and make sure you’re keeping your eye open for opportunities elsewhere.  They do exist.  Again, at current valuations, we’re hard-pressed to believe that US returns will be able to approach or exceed long-term historical averages over the next decade.  On the flip side, many other markets overseas hold much more attractive valuations in the low to mid teens.  In fairness, just because US valuations are elevated doesn’t mean that total market Armageddon is around the corner.  There are a lot of breathless, hyperbolic bears out there right now.  But, thinking that a decade of 80’s and 90’s like equity returns are in our future isn’t a very prudent way to approach US markets under current circumstances.

Scattershot Summer Thoughts:

EAFE: Waiting for Godot

As we’ve discussed in the past, since the beginnings of the 2007 to 2009 financial crisis, the MSCI EAFE, an index comprised of developed market companies from Europe to Australia to the rest of Asia, has significantly trailed the performance of US markets.  Of course, the sovereign debt crises spreading across southern Europe from 2010 to 2012 hurt European equity markets and held back performance.  And, Japan has been a multi-year economic mess, though Abe’s moves since late 2012 have ignited strong recent upward moves in Japanese equities.  Looking over the first six or so months of 2014 though presents a similar relative performance picture despite the fact that attitudes towards international equities, and Europe in particular, seem to have perked up considerably.  Through yesterday (7/10), the EAFE total return is 3.79% vs. 7.44% for the S&P 500. 

Long-term relative performance analysis shows that the back and forth battle between US and International stocks has been cyclical in nature, with long periods of EAFE outperformance followed by long-periods of US outperformance.  In the past, major turns in relative performance have occurred when the relative strength ratio between the EAFE and S&P 500 has reached extreme levels, generally either +1 or -1 standard deviations from the average.  We’ve passed that threshold recently, with the EAFE performance relative to the S&P 500 falling below -1 standard deviation from the average in recent weeks for the first time since late 2001 and early 2002.  Here’s a chart of long-term relative strength.

The last time the EAFE crossed this threshold to the downside, the EAFE index outperformed the S&P 500 significantly over subsequent years.  From 12/31/2001 to 12/31/2007, the period roughly corresponding with the minor uptrend in the chart coming after the last threshold breach, the EAFE was up 132% (total) vs. 42% (total) for the S&P 500.  Interestingly, even with all of the economic and political troubles outside the US over the past 13 years, the EAFE has matched S&P 500 performance on a simple basis and actually outperformed the US when taking dividends into account.

Investors like us have been waiting for our international developed brethren to re-take the performance mantle from the US for a few years now.  The above suggests that the winds may shift in coming quarters and that the EAFE may soon become a strong relative performer.

Emerging Markets Emerging?

Speaking of relative performance and downtrends, there’s no denying Emerging Market equities have been performance dogs when compared to the US and even developed Europe and Asia over the past several years, defying all sorts of conventional wisdom coming out of the Great Recession.

Year-to-date, the MSCI Emerging Markets Index has shown some vigor, matching the performance of the S&P 500 for the first time in what feels like ages.  Is this the beginning of another long period of outperformance or another short-term reversal?  The evidence seems mixed at this point.

Like the EAFE/S&P 500 comparison above, Emerging Markets performance relative to US stocks has been just as cyclical.  The recent underperformance comes after a long period of outperformance following extremes similar to extremes observed above in the EAFE chart.  Even with underperformance over the past 3 or 4 years, relative strength is stuck in the middle of the 2 ½ decade range as seen below:

Using relative valuation, Emerging Markets are clearly undervalued on a long-term basis, with various CAPE P/E ratios hovering in the low-teens versus the low-20s for US equities.  At some point, those wide valuation differentials will converge.  When though?  We also look at the 200-day moving average for the relative strength ratio between the S&P 500 ETF, the SPY, and its Emerging Market counterpart, the EEM.

At this point, the downtrend remains in place as shown below:

At IronHorse, we’re seeing more and more emerging-market stocks pop-up as targets for consideration; we’ve even added a small amount of single-stock emerging markets exposure in recent months.  We’ll become more comfortable, however, with large amounts of emerging markets exposure when the above trend starts moving the other way.

Sentiment:  The Song Remains the Same

The past few years, we haven’t ceased to be amazed by the quickness with which broader market sentiment deteriorates at the first hint of correction.  This is a very good thing in our estimation.  Take recent market action.  Granted, the S&P 500 and global markets have pulled back in recent sessions.  Nonetheless, the S&P 500 is still slightly up for the month of July at this writing and the MSCI World is down less than 1% for the month.

What’s happened to various sentiment indicators?  Fear has jumped.  It’s not extreme, but the jumps higher for fear gauges seem disproportional relative to the magnitude of actual equity market moves, a condition that’s persisted for much of this equity market cycle.  For example, the put/call ratio has jumped from a roughly neutral level to approximately 0.6 standard deviations above the long-term average.  The 10-day average for the ISES option indicator has fallen from an extended level over 1 standard deviation above the norm to a neutral level over the past two weeks.  Meanwhile, individual investor sentiment as represented by the AAII bull/bear/neutral survey remains below long-term averages.

As we mentioned a few weeks ago, there seem to be several pockets of serious complacency out there, but nothing that warrants deep pessimism.  Corrections, minor or not-so-minor, are healthy recalibration agents for up markets.  Investors broadly seem to still think, though, that every little hiccup is the beginning of the end of days.  Until this behavior changes significantly, we’ll remain encouraged.

Inflation: Little Sound, Little Fury

This week, the back and forth continued among various Fed officials, Fed watchers, and market gurus about the future path of inflation, and hence Fed rates.  Some of this back and forth has contributed to some of the recent market hiccups.  James Bullard, St. Louis Fed President, suggested this week that the Fed Funds rate could increase sooner than the markets expect. 

Of course, there remain a number of pundits and analysts out there sounding the inflation warning signals, as they’ve been doing for five years now.  To this, we say, “Where’s the Beef?”  Looking at 5-year and 10-year TIPS/Treasury spreads, a way to gauge the broader market’s expectations for future inflation, inflation expectations remain well grounded at this point and have barely budged in recent months, even with improving labor market numbers and other indications that economic growth has regained its footing.  The following charts provide a visual representation of this benign pattern:

 

Furthermore, it seems to us that the biggest driver of sustained inflation problems in the past (take the mid to late 1970s for instance) has been strong increases in unit labor costs.  At this point, there’s no sustainable evidence that unit labor costs are increasing materially in the US.

Look at the below chart showing year over year unit labor cost moves.  As you can see, the green line, the 24-month moving average for year-over-year unit labor costs, began increasing in 1967 and didn’t stop until Volcker broke inflation’s back over a decade later.  Of course during this time period, Americans experienced the infamous double-digit inflation that affects attitudes to this day.  What’s happening now?  Actually not much.  There’s always statistical noise in this series.  Focus on the 24-month moving average which remains in a downtrend.  Wage data in the recent strong employment reports remains unremarkable.  We’ll begin to worry about long-term inflation trends when labor costs begin to uptick in a meaningful and sustained way.