An old adage in the financial markets for seekers of value is ‘follow the misery.’ The concept of misery is subjective and means different things to different people but the basic idea is that disappointed investors bid down prices to eventual bargain levels.
Times of great misery for investors such as March 2009 coincide with terrific buying opportunities for patient, long-term owners of good businesses.
The opposite of misery is exuberance. This is when risk-taking is well-rewarded and the financial markets appear benevolent. Many participants attribute investment success in such an environment to their own special insight. A bubble is when exuberance becomes so pronounced that the seeds of capital destruction are sown due to extreme overvaluation.
In a bubble prices rise to levels that imply perpetually low or negative returns because investors pay too much for future cash flows. High-quality businesses like Microsoft (MSFT), Oracle (ORCL) and Cisco (CSCO) famously reached this level of overvaluation during the dot.com bubble of the late 1990s.
In the first quarter of 2014, valuations for many American stocks reached late 1990s’ bubble levels. Internet names like Twitter (TWTR), Yelp (YELP), LinkedIn (LNKD) and Facebook (FB), and 3D printers like Stratasys (SSYS) and 3D Systems (DDD) represented overvaluation risk in the extreme.
History suggests two things about owning extremely overvalued stocks. First, they can remain expensive for years and warnings against owning them can look foolish. Second, owning them will eventually end in losses as it is impossible to make a timely exit: how does one know if a drop in the share price is simply a “healthy” correction or the beginning of a long misery cycle?
We use numerous metrics to guide us in our search for great businesses selling at good prices. We begin with the overall level of the stock market and with some exception we believe the US market is currently exuberant. How exuberant? Were the US market to rise another 30% without an equal or greater rise in corporate earnings, we believe American stocks would then be classified as being in a bubble.
During the first quarter we made several changes to the Covestor Core International Portfolio. In the US we believe there remain pockets of attractive valuation and therefore added to our position in IBM. We continue to be pleased with our ownership of Cisco (CSCO) and DuPont (DD), the global agriculture and other services giant.
We initiated a new position in Aqua America (WTR), a quality US water firm that we characterize as a predictable growth utility. We also added Baxter International (BAX), the diversified healthcare company with an long term track record of increasing shareholder value through dividend increases and share buybacks.
Most of our activity has been in markets outside the US that are not exuberant by any measure. As a group emerging markets fit into this category given that EM stock prices are lower now than they were 3-years ago.
This misery has created an opportunity in our opinion and we believe a “conservative” way of participating in the emerging markets is through ownership of Chile-based Andina, a Coca-Cola bottler since 1946 with businesses in Chile, Brazil, Paraguay and Argentina. As well, we own Coca-Cola Amatil, an Australian bottler with extensive interests in Indonesia. The Coca-Cola Company has a major ownership stake in both firms.
In the fourth quarter of 2013, we added Singapore-based conglomerate Jardine Matheson (JARD) whose major businesses are focused principally on Asia. They are involved in engineering and construction, transportation services, property investment and development, retailing, restaurants, and agriculture. Their luxury hotel group, Mandarin Oriental, is well-known to most business travelers. The shares are selling at roughly its book value.
In Hong Kong we added Hutchison Whampoa, the ports-to-property conglomerate that is entering a divestiture cycle to enhance shareholder value. Most of Hutchison’s holdings are in Asia, including significant infrastructure assets, but they own Husky Oil in Canada and telecom firms in Europe. The shares trade at a discount to net asset value.
We implemented a new position in growth stock SGS, a Swiss-based global leader in the testing & inspection industry. SGS is profitable and may continue to benefit from globalization and increased outsourcing of testing and inspection services. Finally, we maintain a 15% cash position awaiting good entry points for companies on our shopping list.
In summary, we believe none of the companies in the Core Portfolio is at an exuberant level of valuation and some are even priced for misery.
DISCLAIMER: The investments discussed are held in client accounts as of March 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.