A High P/E and the DMV
Q4 2017 Investment Commentary
By Benton S. Bragg, CFA, CFP®
Chairman, Investment Committee
“When everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risky.”
My son flunked his driving test at the DMV last month. According to the DMV officer, Carlton (16) ran over the curb as he drove out of the parking lot. Needless to say, his mother was less than impressed with Carlton’s performance and we all enjoyed teasing him to no end when he got home that day. There had been quite a bit of build-up associated with his appointment with the DMV. First, we’d made it clear that Carlton wouldn’t be allowed to get his driver’s license until he had completed his Eagle Scout project. As you might imagine, Carlton waited until his sixteenth birthday was right around the corner to get started on his project and then he wanted to get it done immediately. He soon realized that building a kiosk for the mountain bike trails at Huntersville Elementary was not going to happen overnight. But he kept the pressure on me. “Dad, take me to Lowe’s to buy wood,” and, “Can you pick up eight 80-lb bags of concrete at Home Depot after work?” and, “Will you help me cut the rafters on Saturday?” or, “Can you drive me to the school to work on the project this afternoon?” This fall became quite the fire drill for me as Carlton pushed to complete his project before his birthday. Finally, it was done.
Dad sighed with relief but Mom quickly found herself in the hot seat as Carlton pestered her to take him to the DMV. It was no small task to get the appointment and it fell right in the middle of the busy Christmas holiday season. Alice and Carlton assembled the necessary documents including his learner’s permit, her driver’s license, his log of hours driven, his passport, the registration for the car, his social security card, two pints of blood and my left arm. They arrived at the DMV at 7:45 am and Alice breathed a sigh of relief as Carlton climbed into the car with the instructor. Finally, he’d have his license and this mad scramble would be behind us. Wishful thinking. Little did she know but she’d be right back two weeks later (he did pass on the second try).
Carlton blamed the curb incident on his having to take the driving test in his mother’s Chevy Suburban. “If I didn’t have to drive that big tank, I wouldn’t have run over the curb,” he said. He added, “And that lady was completely unreasonable. It was just one little curb. That’s no reason to flunk me…completely unreasonable.”
Speaking of unreasonable, several commonly used measures of US market valuations currently show that stocks are priced unreasonably high relative to historical norms. Here are two examples in charts:
Price-to-Earnings Ratio (P/E) Using Actual 12-Month Trailing Earnings
Current S&P 500 PE Ratio: 26.21, January 4, 2018. Price-to-earnings ratio, based on trailing twelve month “as reported” earnings. Current PE is estimated from latest reported earnings and current market price. 01/01/1950 through 01/04/2018. Source: Robert Shiller and his book “Irrational Exuberance” for historic S&P 500 PE Ratio. *During and following the financial crisis, S&P 500 earnings were negative.
Price-to-Earnings Ratio Using the Cyclically Adjusted Price-to-Earnings (CAPE)
Current Shiller PE Ratio: 33.06, January 4, 2018. Shiller PE ratio for the S&P 500. Price/earnings ratio is based on average inflation-adjusted earnings from the previous 10 years, known as the Cyclically Adjusted PE Ratio (CAPE Ratio), Shiller PE Ratio, or PE 10. Source: Robert Shiller and his book “Irrational Exuberance” for historic S&P 500 PE Ratio.
Why the exuberance? Are things different this time? We would suggest not. In a properly functioning market, the current value of a corporation (today’s price) is simply the discounted value of all cash flows expected in the future. So what is the market telling us today with the high multiple assigned to most stocks? Here are a few answers that might be helpful.
1) Earnings Growth: In the long run, stock prices are driven by corporate earnings. If the “E” in the P/E ratio increases dramatically, while the “P” remains constant, it follows that the P/E ratio will fall and valuations will look more reasonable. Said another way, earnings will have “grown into their high price.” Investors today have pinned their hopes on a faster-growing economy and higher corporate earnings, resulting from oft-discussed policies and legislation promised by a Republican-controlled White House and Congress. Measurable outcomes at this point are limited but the chart below (S&P 500 Earnings Per Share) shows that earnings have rebounded nicely since the financial crisis. It also shows analysts’ expectations for earnings for the next four quarters. Clearly, expectations are high.
S&P 500 Earnings per Share
Index quarterly operating earnings
Source: Compustat, Standard & Poors, FactSet, JP Morgan
2) Low Interest Rates: Low interest rates have driven prices of risk assets like stocks and real estate higher. Since the value of an asset today reflects the discounted value of all cash flows expected in the future, the interest rate used in the discounting formula is a critical factor. The lower the rate, the higher the present value of the asset. For example, the present value of ten equal annual payments of $50,000 using a discount rate of 2.0% is $449,129. The same stream of payments discounted at a rate of 6.5% is only worth $368,004. The following chart of long-term interest rates may explain why valuations of the last two decades have been persistently above the post-war average.
Nominal and Real 10-Year Treasury Yields
Source: BLS, Federal Reserve, FactSet, J.P. Morgan Asset Management.
3) Investment Alternatives: Another way of stating the previous point regarding low interest rates is simply to say, “Where else will I invest the money? What is a better alternative? With cash yielding close to zero and a ten-year Treasury bond yielding 2.4%, where can I get a better return than in stocks?” This case for stocks being the best alternative is often further bolstered by the use of the “Fed Model” which compares the yield of Treasury bonds to the “yield” of the stock market. The calculation is simply the inverse of the price-to-earnings ratio (P/E) resulting in earnings to price (E/P). The output is the “earnings yield” of the market. When compared to the yield of cash or the yield of a ten-year Treasury, the current “earnings yield” of the market looks more reasonable. See the chart below provided by Ed Yardeni who also introduced the name “Fed Model” for this measure.
S&P 500 Forward Earnings Yield &
Nominal 10-Year Treasury Bond Yield
* Year-ahead forward consensus expected earnings divided by S&P 500 stock price index. Monthly through March 1994, then weekly. ** Monthly through March 1994, then weekly.
Source: Thomson Reuters I/B/E/S, Federal Reserve Board, Yardeni Research 2017.
Over time, when the earnings yield of the market is higher than the earnings yield of Treasury bonds, the market is arguably undervalued. Before getting too excited about this measure, remind yourself that Fed-tightening is underway, albeit at a very measured pace. Interest rates have risen very slowly. Thus far the yield on a ten-year Treasury bond has increased approximately one percentage point (from an all-time low of 1.4% in July of 2016 to 2.4% as of year-end 2017). Unless it really is different this time (and we don’t think it is), this correlation (interest rates and asset prices) will hold in the long term and is therefore very important to the future direction of stock prices.
4) Corporate Tax Cuts: Above-average valuations reflect investors’ expectations that a lower corporate tax rate will immediately increase the net earnings of most US corporations. As you have undoubtedly heard, sweeping changes to the US tax code were signed into law by President Trump in December. The new law reduced the corporate tax rate from 35% to 21%. Estimates for the earnings increase resulting from the lower rate vary from a low of 8% to a high of 12%.
In addition to the direct impact a tax cut will have on corporate earnings, there is the follow-on effect of the lower tax rate. Investors are optimistic that a lower rate will make the US more attractive for business. If more companies choose the US for their headquarters or for the location of their operations, this logically will increase economic activity, which means more jobs and growing earnings. And this takes us all the way back to Point Number 1.
We’ve laid out some possible explanations for today’s seemingly high valuations. Even as we’ve done so, we admittedly scratch our heads a bit as we observe the optimism and the duration of this rally. Valuations don’t appear as unreasonable as Carlton’s DMV instructor but they are a bit hard to understand. Markets don’t run forever. Our fundamental, bottom-up investment process at Queens Road Funds remains steady and true. While this one-way bull market has certainly tried our patience, we remain committed to a clear and time-tested investment process that we believe will work over full market cycles.
Lower Fund Fees: The Queens Road Funds board of directors voted in November to lower the fund fees for the Queens Road Small Cap Value fund from 1.24% to 1.18% effective January 1, 2018. This brings the fund cost to just under the average for small cap value funds according to Morningstar. We are pleased to be able to pass these savings on to our fellow shareholders in the fund.
Please contact John Bragg if you have any questions or want to schedule time for an update call with portfolio manager Steve Scruggs, CFA. We thank you for your continued investment in our Queens Road Funds and look forward to serving you.
Market and Economy
By Matt DeVries, CFA
Analyst, Queens Road Small Cap Value Fund
A strong fourth quarter closed out a remarkably good year for stocks. The S&P 500 rose every single month for the year—a first in the history of the index. The S&P 500’s 21.8% return outpaced solid returns in small- and mid-cap stocks with the Russell 2000 Small-Cap Index up 14.7% and the Russell Mid-Cap Index up 18.5%.
Foreign stocks had an even better year as foreign currencies strengthened relative to the US dollar. The MSCI All-Country World Index excluding the US rose 27.8%. Foreign markets face less uncertainty today than a year ago as potentially disruptive elections in France, Netherlands, Germany, and Japan largely resulted in votes for the status quo.
|Index||4th Quarter||2017||3 Years||5 Years||10 Years|
|S&P 500 (US Large Cap)||6.6%||21.8%||11.4%||15.8%||8.5%|
|Russell Midcap (US Mid Cap)||6.1%||18.5%||9.6%||15.0%||9.1%|
|Russell 2000 (US Small Cap)||3.3%||14.7%||10.0%||14.1%||8.7%|
|MSCI ACWI X-US IMI Net (Foreign Equity)||5.2%||27.8%||8.4%||7.2%||2.2%|
|MSCI EM (Foreign Emerging)||7.4%||37.3%||9.1%||4.4%||1.7%|
|Barclays Aggregate Bond||0.4%||3.5%||2.2%||2.%||4.0%|
|Barclays Muni Bond||0.8%||5.5%||3.0%||3.0%||4.5%|
Past performance is not an indication of future performance.
It’s all about taxes
President Trump signed his much-promised tax bill into law before Christmas. The new law reduced the corporate tax rate from 35% to 21%. With the new bill in place, Factset is projecting S&P 500 earnings will grow by 11.8% in 2018. That would come on the heels of an estimated 9.6% growth in S&P 500 earnings in 2017. Given the strong performance of the market in 2017, it appears 2018 earnings growth may already be baked into today’s market prices. Capital Group, which manages the American Funds, estimates that the tax cut could also lead to the repatriation of $1.5 trillion in corporate cash that heretofore has been held offshore.
If the tax cuts can stimulate economic growth as expected, inflation may pick up, forcing the Federal Reserve to reconsider the current path. Right now, the Fed is expected to raise rates by 0.25% three or four times in 2018. The Fed, however, will soon be under new management as the top three positions are about to be filled with new people. Chairwoman Janet Yellen will be replaced by Jerome Powell on February 3rd. Replacements for Vice Chairman Stanley Fischer and New York Fed Chief William Dudley have yet to be named. We assume the new Fed will operate much the same but it is hard to know for sure right now.
Late stages of the business cycle
As we look ahead to 2018, it appears that the economy still has some room to run, but a case can be made that we are in the later stages of the business cycle. Late in the business cycle, we typically see the Fed raising short-term interest rates. Usually the Fed raises rates to manage accelerating inflation but that isn’t the case this time around as core inflation has been just 1.7% over the last two months leading up to December. The Fed instead has been doing so to return to a more normal monetary policy in order to have arrows in the quiver for when the next recession does hit.
Long-term Treasury yields actually fell in 2017 as short-term rates rose. Stocks have actually done quite well historically when 10-year Treasury yields were less than half a percent more than 2-year yields. We ended 2017 with the 10-year yielding 2.40% and the 2-year at 1.89%, so they are almost into that sweet spot. The tricky part is that every single recession over the past 50 years has been preceded by 10-year Treasury yields falling below 2-year yields. The narrowing of the spread we are currently seeing usually happens late in the business cycle but it can persist for multiple years while the bull market rolls on, so it isn’t a great indicator of how close we are to the top.
Something else usually seen late in the business cycle is widespread optimism. There’s definitely no shortage of optimism for Bitcoin but the cryptocurrency isn’t large enough yet to be a major risk to the global financial system. While it is debatable whether or not stocks have run too far and are overvalued, we lean slightly towards the overvalued side in our opinion as you see in Benton’s commentary.
One way to look at the overvalued debate is to look at the valuations of market leaders relative to historical valuations. For example, many of the “Nifty Fifty” stocks in the ’60s and ’70s traded at more than 50 times earnings and during the technology bubble of the late ’90s, “dot-com” stocks had astronomical valuations while having little to no earnings or assets.
As of today, the five largest companies in the S&P 500 are the tech giants Apple, Alphabet (Google), Microsoft, Amazon, and Facebook. These five stocks averaged a staggering 46% return in 2017 and added over $1 trillion in market cap. By comparison, the next five largest companies (Berkshire Hathaway, Johnson & Johnson, JPMorgan, Exxon Mobil, and Bank of America) averaged a 21% return and added just over $300 billion in market cap.
Although optimism appears overly high, immediate downside risk is moderated by the fact that consumer and business debt levels are relatively low due to years of deleveraging following the financial crisis. Since 2012, US consumers have been and still are spending less of their after-tax income on debt payments than at any other point since 1980. US businesses are in a similar position. US non-financial companies’ cash holdings were expected to rise to $1.9 trillion in the fourth quarter of 2017 according to Moody’s. That’s over 10% of our 2016 GDP.
Household Debt Service Payments as a Percent of Disposable Personal Income
Shaded areas indicate US recession. Source: Board of Governors of the Federal Reserve System (US)
With Washington providing the new tax bill, regulation reform, and potential new infrastructure spending, we could see consumers and businesses having even more cash available over the next couple years. What percentage of that is spent will be a big factor for how fast and for how long this nine-year bull market can continue to run. 2017’s strong gains, however, will be a tough act to follow in 2018.
Queens Road Small Cap Value Fund Performance Update
By Steven H. Scruggs, CFA
Portfolio Manager, Queens Road Funds
The Queens Road Small Cap Value fund returned 3.76% vs. 2.05% for the Russell 2000 Value Index for the fourth quarter of 2017. For the calendar year, the fund returned 5.86% vs. 7.84% for the index. The Russell 2000 Growth Index finished the year up 22.2% far outpacing value stocks as investor optimism continued to grow, fueled by the passage of the Trump tax cuts.
Performance Summary: December 31, 2017
|YTD||12 Months||Avg. Annual 3-Year Return*||Avg. Annual 5-Year Return*||Avg. Annual 10-Year Return*||Avg. Annual 15-Year Return*||Since Inception*||Lifetime Cumulative|
|Russell 2000 Value Index||7.84%||7.84%||9.55%||13.01%||8.17%||10.66%||9.12%||288.51%|
Performance as of December 31, 2017; gross annual operating expenses 1.18%
*Performance annualized. Fund inception June 2002.
Important Performance and Expense Information
All performance information reflects past performance, is presented on a total return basis and reflects the reinvestment of distributions. Past performance is no guarantee of future results. Current performance may be higher or lower than performance quoted. Returns as of the recent month-end may be obtained by calling (888) 353‑0261.
Investment return and principal value will fluctuate, so that shares may be worth more or less than their original cost when redeemed. There can be no assurance that the fund will meet any of its objectives.
From inception to 12/31/2004 the Fund’s manager and its affiliates voluntarily absorbed certain expenses of the fund and voluntarily waived its management fee. Had the Fund’s manager not done this, returns would have been lower during that period. The Fund’s manager and its affiliates do not intend to absorb any expenses or waive its management fee in the future.
The Queens Road Small Cap Value fund invests primarily in small-cap companies which may involve considerably more risk than investing in larger-cap stocks.
Companies remain expensive. As outlined earlier in this commentary, market valuations are in record territory based on historical averages. As of January 4th, 2018, the 12-month trailing P/E Ratio for the S&P 500 Index was 26.21 as compared with the long-term average of 15.69. The Shiller CAPE Ratio (10-year inflation-adjusted average earnings) or P/E10 has climbed to 32. The CAPE Ratio reached a level of 32 or above only twice in the last 100 years; in 1929 as markets peaked before the Great Depression, and again in the late 1990s during the tech bubble.
Our analysis of the companies in the Russell 2000 Value Index shows similar elevated prices when compared with current earnings. In general, many well-managed companies have seen their earnings increase by 50-100% since the mid-2000s before the financial crisis. However, their stock prices have increased by 200-300% over that same period. In our view, the disconnect of earnings to price is simply not sustainable. At some point, fundamentals will matter again.
Good Company or Misery Loves Company?
At the end of third quarter 2017, Berkshire Hathaway held a record cash stake of over $100 billion. This is five times the normal $20 billion that Berkshire keeps on hand for opportunities. There has been much speculation over how or when Warren Buffett might invest this record cash hoard. A Bloomberg study shows that over the past 20 years, Buffett has tended to let cash build during more bullish climates and then spent aggressively when markets turned more bearish. In a world when most investors are obsessed with short-term performance, Buffett has achieved superior results by taking a much longer-term view.
“Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
–Warren Buffett, Berkshire Hathaway 2008 Annual Shareholder Letter
At Queens Road, we use a Graham and Dodd-based valuation approach, similar to what Warren Buffett uses to identify opportunities for Berkshire Hathaway. And like Mr. Buffett, we are finding very few companies in the bargain bin. Our bottom-up, fundamental approach pays close attention to what we pay for a company. We continue to turn over rocks looking for opportunities and are finding many wonderful, well-managed companies, but we are hesitant to make investments at these elevated prices. Our cash stake stands at 22% of the portfolio. As a reminder, cash is not a call on the market. It is simply a reflection of the lack of opportunities that we are finding today. We look forward to putting our cash to work when valuations become more attractive. Below is another quote from Warren Buffett that appeared in the 2017 Berkshire annual shareholder letter.
“Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons.”
–Warren Buffett, Berkshire Hathaway 2017 Annual Shareholder Letter
Markets remain calm. Low volatility was the defining characteristic of the equity markets during 2017. The CBOE Volatility Index or VIX, a commonly used measure of market fear, recorded some of the lowest levels of volatility since its inception in 1990. According to Hamish Preston of the S&P Dow Jones Indices, the VIX recorded 47 of the lowest 56 closing VIX levels during the 2017 year. It was also the first year in history in which the S&P 500 Index did not decline from high to low by at least 3% during the year. Judging by the record low levels of volatility or worry, investors seem to see little risk in the equity markets. I am reminded of two statements made by legendary value investment manager Howard Marks in his book The Most Important Thing:
“When everyone believes something is risky, their unwillingness to buy usually reduces the price to the point where it’s not risky.”
“When everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risky.”
Judging by the record-level of calm in the markets, investors are nearing that point described by Marks when they believe the markets carry no risk. If we have reached that point, according to Marks, the markets are actually enormously risky. Time will tell. Meanwhile, we will remain disciplined and patient with our process.
Investments that Helped Performance
- LB Foster rose 100% during the year. LB Foster makes and distributes products and services for the transportation and energy sectors including rail lines, bridge materials and piping. We began purchasing LB Foster during 2016 following two very turbulent years for the company. A major lawsuit and a poorly timed acquisition negatively impacted short term profitability and the company’s stock price was punished. Since then, management has done a commendable job of getting back on track and focused on profitable growth. The company has been winning new contracts and adding to its backlog of business as rail traffic and oil prices have improved. Given its current valuation and future prospects we believe LB Foster remains a compelling value.
- Orbital ATK gained 51% during 2017. Orbital makes aerospace, defense and aviation products for the US government, allied nations and private companies. In September of 2017 Northrop Grumman offered to acquire Orbital ATK for $134.50 per share, a premium of 22 percent to the previous day’s close. The deal was subsequently approved by shareholders and is expected to close in July of 2018.
- Oshkosh Corp. was up 42% for the year. The maker of military trucks, commercial vehicles and access equipment continued its recent run of strong performance. Each of the company’s four business segments showed increased revenues and all but the defense segment reported higher backlogs during the most recent quarter. Management continues to focus on expense rationalization and process simplification. The results are beginning to show up in their financials and is a trend that is expected to continue. As one of our largest and oldest holdings, we remain confident in the company’s long term prospects.
Investments that Hurt Performance
- Owens & Minor fell 44% in 2017. Owens & Minor provides distribution and logistics services to healthcare providers and manufacturers. The company also sources and assembles procedure kits for manufacturers and providers. Both areas have seen increased competition resulting in deteriorating operating margins. To make matters worse, Amazon recently announced it has received pharmacy licenses in several states. Amazon has stated that it does not intend to enter the prescription drug segment. This has been interpreted by most to mean they are getting into the health care products business which will compete directly with Owens & Minor. This will only serve to increase pricing pressure on the company.The company also announced two acquisitions during the year. The company purchased home healthcare solutions provider, Byram Healthcare, in August and announced it would acquire the surgical and infection prevention business of Halyard Health during the fourth quarter of 2017. The Halyard business will complement and add additional products to the company’s proprietary line of MediChoice products.After increasing its debt burden to fund acquisitions and in the face of stagnant top line growth and operating margin pressures, the company raised its dividend for the 20th consecutive year and currently yields over 4.5%. We aren’t convinced the company’s balance sheet and operating results warrants such a high payout ratio, currently at over 55%. We have trimmed this holding and are continue to monitor it closely.
- Synaptics Inc. fell 32% during the period. Synaptics continues to struggle as the market for the company’s smart phone components has experienced slowing growth and increasing competition. Synaptics makes touchpads and thumbprint sensors for a wide variety of applications. While the company continues to generate the bulk of its revenue from smart phone products, it has increased its focus on its Automotive and Internet of Things applications. To that end, the company announced it was purchasing Marvell Technology’s Systems multimedia solutions business, Conexant.Conexant is most known for supplying microphones to the Amazon Echo but additionally owns a portfolio of over 500 patents relating to audio processing. We are monitoring the company closely, focusing on any pickup in its recently released smart phone display drivers and management’s execution of the Conexant acquisition.
- Fabrinet dropped 29% during the year. Fabrinet manufactures components used in optical communications, industrial lasers and automotive sensors. The optical segment is the largest at roughly 75% of revenue. The optical communication market has grown rapidly as increasing global bandwidth demand has encouraged the adoption of optical networks. As the industry ramped up for increased production, inventories at Fabrinet grew too quickly which came back to haunt them during 2017.We are confident that as the inventory balance is corrected, this segment’s performance will improve. Additionally, the company is entering new markets and pursuing new business in its automotive segment which manufactures pressure, temperature, and safety sensors. We see the struggles of 2017 as a normal process of a growing company competing in dynamic markets. We have recently added to our position in the company.
Top-Ten Holdings as of December 31, 2017
|Security||% of Total Net Assets|
|Vishay Intertechnology, Inc.||3.59%|
|Orbital ATK, Inc.||3.41%|
|Deckers Outdoor Corp.||3.31%|
|Tech Data Corp.||2.90%|
The thoughts expressed in this piece concerning recent market movements and future prospects for small company stocks are solely the opinion of Queens Road Funds at December 31, 2017, and, of course, historical market trends are not necessarily indicative of future market movements. Statements regarding the future prospects for particular securities held in the Funds’ portfolios and Queens Road Funds’ investment intentions with respect to those securities reflect the portfolio manager’s opinions as of December 31, 2017, and are subject to change at any time without notice. There can be no assurance that securities mentioned above will be included in any Queens Road Fund-managed portfolio in the future.
This material is not authorized for distribution unless preceded or accompanied by a current prospectus. The prospectus contains important information on the Fund’s investment objectives, risks, and charges and expenses. Please read the prospectus carefully before investing or sending money. The Fund invests primarily in small-cap stocks which may involve considerably more risk than investing in larger-cap stocks. (Please see “Primary Risks for Fund Investors” in the prospectus.) As of 12/31/2017, the Fund held a limited number of stocks, which may involve considerably more risk than a less concentrated portfolio because a decline in the value of any one of these stocks would cause the Fund’s overall value to decline to a greater degree.