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.


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.


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.


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.


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