Many investors think there are only two options in a market where participants have become overly exuberant, either 'I want in' or 'Get me out.' Our strategies are more nuanced, and we believe fit better with what we expect to transpire.
It used to be that we consulted our favourite market prognosticator—the taxi driver—regarding market tops. When they were touting specific stocks, we knew the end was nigh, but the disruption from Uber and the pandemic has limited our access. Perhaps, in the not-too-distant future, robo-taxis will be equipped to provide stock tips.
From time to time, certain market participants treat the markets as a casino, speculating on outcomes. Others sell at the first sign of market froth as they prefer to be spectators rather than risk exposure to an overdone market. With the ability to perfectly forecast the timing of a recession, one would sell—stepping aside to watch until the bear market ended. Similarly, if one knew a bubble was brewing and could pick the top then aggressively selected positions would benefit most from exuberance. But these scenarios are obviously extraordinarily difficult to predict and fraught with risk. Thankfully, these are not the only options. The point in the cycle, the types of securities being impacted, relative valuations, and other factors play a role in the extent investors should be exposed to stocks when markets are frothy.
The Opposite of Panic
We aren’t sure whether the opposite of panic is complacency, euphoria, or otherwise, but we recognize it when we see it. And we’re witnessing it now. Outright speculation is occurring—IPO shares nearly doubling, on average, on their first day of trading. The IPO boom has now eclipsed that of the dot-com period and many more companies that are unprofitable have gone public than at any point in history. Penny stock trading volume is off-the-charts high too as speculators frantically seek out their next score. And securities trading over-the-counter is being conducted at higher volumes than on the exchanges, which has never before occurred. This certainly can’t end well because most of these companies are early stage, money-losing entities. Trading by individuals has far surpassed the volumes of the dot-com bubble. Margin debt—borrowing to invest—is at an all-time high relative to individuals’ net worth and GDP. So they’re betting using leverage; that’s rarely a good combination.
Meanwhile, short interest is at a record low. The heavily shorted stocks, which usually underperform, are the ones up the most in this recovery and as a group have exceeded any other period over the last 25 years. That has scared off those who typically hedge. Call option purchases have by far exceeded any period historically. Over 90% of market timing newsletters are bullish, invariably a negative sign, and leveraged ETFs are taking on record fund flows.
While we are waiting for herd immunity, the herd seems to be busy playing the stock market.
Too many are buying stocks (or ‘stonks’ in Internet slang) indiscriminately, merely because they're going up. Even worse, by using call options they are making short-term bets, which come at a premium, involve leverage, and expire worthless over 90% of the time.
While there have been specific pockets of speculation, such as electric and autonomous vehicles, anything green-energy related, SPACs, and cannabis stocks, share prices in general are expensive. Overwhelmingly positive sentiment has pushed market participants to overpay for many stocks. Apple's market capitalization is now larger than the entire Canadian S&P/TSX Composite Index with its 221 constituents. Tesla’s market cap alone has surpassed the combined market cap of the top 10 global car manufacturers. Nearly 50% of S&P 500 stocks have forward P/Es above 20x, about twice as much as the average for the last 30 years. And it’s been relatively concentrated. The percentage of stocks in the S&P 500 exceeding the index return is near record lows, only approaching this level in 1973 and 2000, other periods marked by extraordinarily high valuations. Valuation is today’s primary risk.
And it’s not just the stock market. The world is awash in liquidity from stimulus which has flowed into assets of all kind. Mexico, a country that has a currency crisis every few years, issued 50-year bonds at an ultra-low interest rate and the issue was 3 times oversubscribed. The fine art market has had record sales. House bidding wars are the norm. Loose fiscal and monetary policies have propelled assets like gold and cryptocurrencies—bitcoin up 10-fold from its bottom in March last year. And collectibles, such as comic books and sports cards have been excessively bid up. These rises are occurring for the same reason toilet paper was selling out—excessive demand for items that the crowd is chasing.
Investor vs. Speculator
Since day-trading is back in vogue, let’s remind ourselves of the market statistics. Stock markets invariably outperform over multi-year periods with the probabilities, based on history, of gains rising toward 100% over 20-year time frames. But, on a daily basis, the odds of a gain are just over 50%. Day traders are clearly just tossing coins—some traders even behaving like boiler-room brokers, essentially involving themselves in the unsavoury practice of pumping and dumping.
We consider purchases or sales based solely on price action to be speculations; whereas to be an investment, consideration must be given to fundamentals, including business operations, financials, valuation, and associated risks, including liquidity.
Investors should consider overall risk management too. Since the markets are at valuation extremes, we continue to hedge our long positions with short sales of the overall U.S. market (or inverse ETFs in registered or long-only accounts). Initially, we shorted in January 2020 because our Economic Composite suggested a recession could occur at any time. We covered our shorts a couple of days prior to the March market bottom because it appeared the markets had fallen too far too fast. We reinitiated those shorts after a significant rebound because we feared the risks associated with the pandemic (pre vaccines) and assumed the lows would be retested, which normally occurs, but the markets powered ahead. With valuations so high, and investor psychology so ebullient, we remain short because an outsized correction could start at any time. Insiders appear to agree as their selling is high and corporate buybacks have sunk to lows.
We don’t, however, foresee a new bear market. Those prolonged major declines occur during a recession. The current economic cycle is still in its onset and economies around the world are enjoying synchronized global growth which should continue to boost Fair Market Values (FMV).
Other than valuations there don't appear to be any material excesses that should inhibit economic revival in the near term. Some worry about a double-dip recession. We don’t see it. Currently, supply cannot keep up with demand. We’re witnessing this in many areas including housing, semi-conductors, and industrials commodity prices which have shot straight up. The world has experienced a cyclical rebound and is now in a secular growth phase. Without major economic excesses in place, this cycle could last quite some time.
Most importantly, the stock market has a buffer. No competitive alternatives. Cash earns nothing. Government bonds and investment grade corporate bonds yield a pittance. Negative yielding bonds are now at a record $18 trillion. Inflation is muted, meaning these asset classes should continue to provide minimal competition for stocks, especially while earnings and FMVs are rising.
Unemployment in the U.S. has declined back to 6.3%, though there has been a material decline in the participation rate, leaving unemployment heavily understated. Another massive amount of stimulus is coming next month. And likely an infrastructure-spending bill soon too.
Once vaccinations are more pervasive, the back half of this year and well into next should be substantially boosted by pent-up demand and the unleashing of it. One cruise line recently sold out its 2023 around-the-world-in-180-days cruise in just one day. Perhaps those consumers are the same risk takers who were buying GameStop.
A cyclical uptick in inflation could be coming. Central banks are trying to engineer it. However, with such a massive amount of government debt overhanging economies around the world, growth rates and inflation should be restrained in the medium term. This too augers well for relatively high valuations.
Hedging Risks Not Risks of Hedging
Based on our models the markets are sufficiently overvalued to warrant hedging. It is unusual for the markets to be above FMV. The markets typically vacillate between undervalued and fair value. Since implied growth rates are now at all-time highs, these elevated expectations leave markets susceptible to any shock to the system which could take prices back to a discount. In these instances, short selling can be an effective hedge for an overall portfolio.
Most money managers don’t short. Others constantly short to be market neutral. In our view shorting isn’t for all seasons. The math works against shorting. You can theoretically lose an infinite amount and only make 100% if a position goes to zero. Those who don’t short either fear that math, have had poor experiences, or lack the mandate. We see short selling as a useful tool in extreme periods, normally at the onset of a recession. Or, as is the case today, when risk of an outsized correction is extremely high as a result of 100th percentile valuations and sentiment. And we don’t typically short individual stocks. First, because we are interested in hedging a market decline and second, because we fear an undue rise in a specific name (recent headlines have certainly drawn attention to this concern). Shorting individual stocks, as others have, using lots of leverage, where there was no immediate catalyst or potential fraud but simply concern regarding business erosion, where the short exposure was crowded (perhaps even conducted without securing a required borrow of shares to be sold short), made those positions susceptible to shorts being forced to cover as a result of margin calls or outsized losses as prices ran up.
While the overall market is elevated, growth stocks have grossly outperformed. They have been market darlings for an extended period causing most to be rather overvalued. These stocks are particularly vulnerable to a correction. Last year, the Russell 1000 Growth Index outperformed the Value Index by its widest margin on record. Value stocks are as cheap now on a relative basis to growth stocks as they were in 2000, before coming back into favour for many years. The differential between the most expensive stocks and the cheapest ones is rarely this wide.
Other risks should be noted too. The economic growth rate normally peaks 12 months after the bottom of recession, so growth rates could slow soon, especially if pent-up demand has yet to kick in. The virus could worsen but it’s already everywhere. In the U.S., there has been at least one case in every single one of the over 3,000 counties, even the furthest reaches of Hawaii and Alaska. Cases are dropping, and with vaccine distribution about to meaningfully pick up, there is finally an end in sight to the pandemic. Vaccine take-up should be a concern though. We were unnerved by the poll showing about 20% of Americans won’t get vaccinated while 35% were unsure.
We are pleased to hold our long positions looking forward to continuing economic recovery but prefer to be hedged in case the market has an outsized correction. Even if our long positions sell off in unison, we believe they’ll only temporarily further detach from our rising FMV estimates. In a true bubble, markets can rise rapidly as a blow-off phase is often more dramatic than one can imagine. Monetary tightening bursts bubbles but that does not appear to be coming any time soon. If the market keeps rising, the near-term risk is that we would earn less on the upside as a result of our hedges. That’s a risk we’re prepared to take.
We don’t chase stocks. It’s not in our makeup to buy stocks at 52-week highs—that’s a game for others. Though, we are quite enamoured with buying stocks when they’re suffering from misconceptions, at a significant discount to our estimated appraisals, with economic tailwinds, when most appear to be overpaying for stocks in general.
The following descriptions of the holdings in our managed accounts are intended only to explain the reasons that we have made, and continue to hold, these investments in the accounts we manage for you and are not intended as advice or recommendations with respect to purchasing, selling or holding the securities described. Below, we discuss each of our new holdings and updates on key holdings if there have been material developments.
All Cap Portfolios—Recent Developments for Key Holdings
Our All Cap portfolios combine selections from our large cap strategy (Global Insight) with our best small and medium cap ideas. We generally prefer large cap companies for their superior liquidity and lower volatility. Importantly, they tend to recover back to their fair values much faster than smaller stocks, so they can be traded more frequently for enhanced returns. The smaller cap positions are less liquid holdings which are potentially more volatile; however, we hold these positions because they are cheaper, trading far below our FMV estimates making their risk/reward profiles favourable.
Orca Energy Group completed another substantial issuer bid, repurchasing about 32% of its Class B shares at $6.50. While we still see considerable value in the shares with an estimated FMV around $12, we tendered our full position and therefore sold 32% of holdings to the bid. Orca’s free cash flow going forward should be substantial and we expect dividend increases as well as further buybacks. However, we held too much of this position especially given the lack of progress with extending the company’s lease beyond 2026 and the ongoing risks related to the Tanzanian government.
All Cap Portfolios—Changes
In the last few months, we made several changes within our large cap positions all summarized in the Global Insight section below.
Global Insight (Large Cap) Portfolios—Recent Developments for Key Holdings
Global Insight represents our large cap model (typically with market caps over $5 billion at the time of purchase but may include those in the $2-5 billion range) where portfolios are managed Long/Short or Long only. A complete description of the Global Insight Model is available on our website. Our target for our large cap positions is more than a 20% return per year over a 2-year period, though some may rise toward our FMV estimates sooner should the market react to more quickly reduce their undervaluations. Or, some may be eliminated if they decline and breach TRAC™ floors. At an average of about 74 cents-on-the-dollar versus our FMV estimates, our Global Insight holdings appear cheaper, in aggregate, than the overall market.
There were no recent material developments for our key holdings.
Global Insight (Large Cap) Portfolios—Changes
In the last few months, we made several changes within our large cap positions. We bought Ping An Healthcare and Technology, Alibaba Group, Alibaba Health Information Technology, Intel, Facebook and Wells Fargo. We sold Citigroup, Palo Alto Networks, Viacom International, American Eagle Outfitters, Millicom International Cellular and U.S. Bancorp as they were close to our FMV estimates or inflected down from TRAC™ ceilings.
Ping An Healthcare and Technology is the largest online healthcare service provider in China. Its services and app are designed as a comprehensive one-stop-shop for healthcare services and products. China’s ever-growing economy, aging population (those older than 60 set to double over the next 30 years), and medical resources supply and demand gap are providing secular growth drivers. The government is highly supportive for multiple reasons, not the least of which is doctor shortages—60% fewer physicians per capita than in the U.S. and 80% fewer family doctors. Though China has built more hospitals per person than in the U.S., most doctor visits are at hospitals where appointment wait times average 3 hours while consultation time is limited to just a few minutes. The company is busy helping to create a more efficient system. It has the largest end-to-end smart healthcare platform with e-health profiles and health management plans. It aims to provide every family with a family doctor while overseeing appointments, providing 24/7 online consultations, treatment plans, specialist referrals, and hospital registrations. And everything is integrated with thousands of hospitals, check-up centres, pharmacies, and dental clinics. The company is run by a management team focused on maximizing user engagement to cultivate its increasing competitive advantage derived from its brand, scale, network effects, and switching costs. Despite execution, competitive, and regulatory risks, its growing ecosystem should enable it to thrive and remain one of the largest online healthcare companies in China. Our FMV estimate is HK$450 without factoring in a considerable number of early-stage ventures.
Alibaba Group is often referred to as the Amazon of China. It’s the largest Internet company in the country with a collection of leading e-commerce, logistics, cloud computing, and media businesses that form a massive digital ecosystem of consumers and businesses around its technology platform. Digital consumption has accelerated since the onset of the virus, thus Alibaba’s market and monetization rate continues to trend upward as it pursues a massive and still relatively underpenetrated e-commerce market. Alibaba’s under-monetized cloud-computing business is also benefitting from an accelerated digital transition as businesses are now increasingly moving their operations online. Recent regulatory actions by the government appear to be aimed at improving oversight and control of data, as well as laying a solid regulatory foundation for the development of technology in the country. We took advantage of the related rumours, including Jack Ma being missing, to purchase shares at a substantial discount to our FMV estimate of $395. We foresee years of growth ahead for this behemoth, though competition remains fierce in the Chinese tech space and disruption is an ongoing threat.
Alibaba Health Information Technology is the largest consumer facing e-commerce healthcare products company in China providing products and services to meet customers’ diverse needs. It operates the number one online pharmacy in an enormous market where over 75% of prescriptions are still filled at hospitals versus 30% in more developed countries. AliHealth offers comprehensive Internet healthcare to enhance quality, efficiency, and convenience. Services include healthcare procurement for items such as prescription drugs, over-the-counter drugs, supplements, medical devices, contact lenses, skincare and many other products that serve online customers directly as well as thousands of pharmacists. The company is well positioned to participate in the shift to online healthcare spending. Its health-tech division is poised to upgrade China’s healthcare infrastructure by connecting patients with doctors, expedite hospital registrations, payments, consultations, and health screening. Though it already has around 200 million users, many of AliHealth’s services are under monetized, with margins currently at depressed levels given management’s decision to delay profits while capturing market dominance. The company should be able to manage execution, competitive and regulatory risks in this rapidly evolving market. Our FMV estimate is HK$60, with upside from many initiatives too early to value.
Intel generated a record $21 billion of free cash flow in 2020, boosted by strong PC demand as businesses and individuals transitioned to work-from-home settings. However, underneath the surface, not all was well. The company faced a series of production woes, opening the door for competitors AMD and Nvidia. Perhaps distracted by a series of acquisitions intended to address new markets, Intel’s manufacturing capabilities lagged behind TSMC and Samsung. Intel tapped its former CTO, Pat Gelsinger, as CEO to reignite engineering and operational excellence. We see this CEO change as a critical step for the company’s turnaround. A high-profile activist investor has accumulated a large stake which should help keep Gelsinger on track. The turnaround will not occur quickly, but we see little downside considering its ample free cash flow and strong balance sheet. With upside to our FMV estimate of $65 and beyond should turnaround efforts bear fruit, we felt Intel had a highly attractive risk/reward profile.
Facebook’s shares underperformed its technology peers after it sold off from recent highs. We believe shares lagged due to concerns about Apple’s efforts to provide iPhone users with more transparency and choices around the way apps use and collect data. Without access to user data, Facebook will struggle to personalize ads based on history or interests, hurting advertising ROI. But, as one of the world’s largest advertising platforms that spans multiple apps and demographics, advertisers will continue to heavily utilize Facebook’s properties. Outside of advertising, Facebook is accelerating the growth of shopping, messaging, and payments to raise its average revenue per user. Our FMV estimate is $300.
Wells Fargo traces its roots to 1852 when Henry Wells and William Fargo founded the company. From its first location in San Francisco at the height of the gold rush, Wells Fargo rapidly expanded North and East, eventually building the largest U.S. branch network with close to 6,000 locations. In 2016, over a hundred years of hard-earned customer goodwill was extirpated when it was revealed that 1.5 million fake deposit accounts and 500,000 phony credit cards were created without customer permission. Investigations at the bank’s Wealth and Investment Management and mortgage origination units uncovered more wrongdoing. In early 2020, Wells Fargo agreed to pay $3 billion to settle criminal charges. With these problems and restrictions on its ability to grow its assets, we resisted investing despite a belief that shares were undervalued. However, we now see meaningful changes at the bank. New CEO, Charles Scharf, has invested in risk and control infrastructure. At the same time, over $8 billion of savings has been identified which should boost return on tangible common equity to 15% over the next five years. Our FMV estimate, which conservatively understates management’s objectives, is $40. Should the company achieve its goals, FMV could rise to $60.
While corporate defaults in the U.S. have been climbing, high-yield credit spreads have fallen. They should be rising. But with the economy recovering and government rates so low, high‑yield corporate bond yields have dropped to an all-time low of 4.1%. In this environment, much as in the stock market, finding attractively valued high-yield bonds is not easy. We made no recent purchases though have been pleased with the recovery of our holdings along with the general economy and markets.
Our income holdings have an average current annual yield (income we receive as a percent of current market value of income securities held) of about 6%. Most of our income holdings—bonds, preferred shares, REITs, and income funds—trade below our FMV estimates and we expect the gap to steadily close as economic recovery takes place. Though a correction in the overall markets could also put pressure on our income holdings, we believe they should act more like defensive positions, holding their value, in a market correction which isn’t accompanied by an economic decline.
Neither a Spectator Nor a Speculator Be
Investors should not take either of these extreme stances. Without a crystal ball, it’s extraordinarily difficult to time tops or bottoms. Speculation is accompanied by too much risk—outsized declines can arrive at any time. Sitting in cash and waiting for a better entry point can have the opposite effect as business valuations generally ascend with the march of time—so most returns are made from being fully invested to benefit from the lift in underlying security values.
Every so often the markets behave like the wild west. Normally animal spirits run wild at the end of cycles when excesses abound. So the markets’ run-up and the piling-in behaviour we are witnessing now, at the onset of an economic recovery, is unusual. Right now, the only material excess in the market to worry about is the market. Which is the reason we believe it will likely result in an outsized correction or lengthy consolidation phase rather than a prolonged market downturn, until value catches up.
It might be fun to guess at what the future may hold and postulate about extreme positioning. However, it makes more sense to us, especially during an economic recovery, to stick with our investments and continue to execute our process—buying undervalued out-of-favour companies, selling them when they reach FMV or our opinion changes, all while shorting the overheated market, just in case.
Randall Abramson, CFA
Generation PMCA Corp.
February 18, 2021
All investments involve risk, including loss of principal. This document provides information not intended to meet objectives or suitability requirements of any specific individual. This information is provided for educational or discussion purposes only and should not be considered investment advice or a solicitation to buy or sell securities. The information contained herein has been drawn from sources which we believe to be reliable; however, its accuracy or completeness is not guaranteed. This report is not to be construed as an offer, solicitation or recommendation to buy or sell any of the securities herein named. We may or may not continue to hold any of the securities mentioned. Generation PMCA Corp., its affiliates and/or their respective officers, directors, employees or shareholders may from time to time acquire, hold or sell securities named in this report. It should not be assumed that any of the securities transactions or holdings discussed were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein. E.&O.E.