April 27, Dear Client:

Transcription

1 Dear Client: 565 Fifth Avenue Suite 2101 New York, NY Fax Tamiami Trail North Suite 206 Naples, FL Fax Our January letter outlined our case for mid single digit S&P 500 returns for Admittedly, that projection looked overly optimistic after the market s swoon through the first six weeks of the year. However, the big snapback in equity prices since mid February has been nothing short of impressive, particularly the Russell 2000 s +20% bounce off the bottom as we write. Our tepid forecast was derived from a framework of sluggish nominal GDP and revenue growth combined with flat or modestly declining margins, resulting in modest at best profit gains. Moreover, the most conventional valuation metric, the price/earnings ratio of the popular stock market averages, was not particularly compelling, and still isn t, as the S&P 500 is selling for 17.4x 2016 earnings while the median market P/E is 20x despite the relative underperformance of the Russell 2000 and Value Line Index (Chart I). Sluggish profit growth combined with average valuations define the neutral to negative market outlook of most investment strategists and institutional investors. CHART I THE BEARISH VIEW We are quality value investors. We focus on companies with strong fundamentals, priced at a discount to their peers. We believe these companies will deliver superior returns over a market cycle. Source: BCA Research But valuations look more compelling when one uses Free Cash Flow (cash flow less capital expenditures) metrics and contrasts them to fixed income alternatives. Chart II, provided by Empirical Research Partners, tracks the relationship between free cash flow yields (FCF/P) and interest rates. From 1960 through 2001 it took a free cash flow yield of 7.5% to rank in the market s top quintile of that metric while the 10 year Treasury bond yield averaged 7.3%. From 2001 through 2009, the comparable readings were 7.9% and 3.4%. Since 2010, the top quintile of free cash flow yields has remained at a high level of 7.8% while Treasury yields have averaged only 2.9%. Consequently, the best 20% of free cash flow yields have been stable at close

2 Page 2 to 8% for over 50 years while bond yields have fallen steadily since While stocks look cheap versus fixed income alternatives when using price/earnings even at these levels they look very attractive when using free cash flow yields as the valuation measure. CHART II STOCKS LOOK CHEAP VS. FIXED INCOME ON FCF Free cash flow margins (FCF/sales) have spiked since the end of the recession at the turn of this century and have remained high, particularly when excluding commodity industries. The high and sustained level of free cash flow margins has perpetuated the elevated free cash flow yields despite the substantial increase in stock prices. It speaks volumes about the outstanding profit performance of corporate America. CHART III FREE CASH FLOW MARGINS REMAIN HIGH

3 Page 3 U.S. equities do not look cheap on a price/earnings basis relative to many foreign stock markets but look more attractive when employing free cash flow metrics. Much of this is a direct result of the superior profitability and free cash flow margins of U.S. corporations. CHART IV U.S. FCF MARGINS SUPERIOR TO REST OF WORLD Many equity investor skeptics are waiting for the completion of the cyclical bear in the major market averages, conventionally defined as a 20% correction. We would argue that we ve had the cyclical bear and then some when one views the market in a broader context. In 2015, the typical stock declined by 20 to 28% in most of the broader market indexes. For example, the Value Line Arithmetic Composite, a very good measure of the average stock performance, fell by 25% from April 27 th last year to January 20 th of this year. Consequently, valuation spreads the spread between the most highly valued stocks and the lowest widened substantially by mid March. In other words, cheap stocks were very cheap relative to those with the highest valuations. CHART V VALUATION SPREADS HAVE WIDENED SUBSTANTIALLY

4 Page 4 Wide valuation spreads usually define a very good environment for stock picking and value driven strategies given the subsequent superior returns of the cheapest quintile of stocks. And what a bounce we ve had as the Value Line Arithmetic Index has roared back by +25% since its January 20 th low, led by value stocks which registered one of their best relative returns of the past 40 years. Consequently, valuation spreads have been halved but are still almost one standard deviation above their mean. CHART VI VALUE HAS HAD A BIG MOVE And this dramatic change in leadership from Growth to Value has typically been followed by further superior performance of value strategies: CHART VII BODES WELL FOR FUTURE VALUE STRATEGY RETURNS

5 Page 5 Growth strategies have outperformed value six times since 1945 this most recent period of dominance being the sixth. And each such period of growth strategy dominance has been followed by a long interval of value outperformance. CHART VIII GROWTH VS. VALUE CYCLES Source: Euclidean Technologies Most equity investors have been extremely risk averse, pouring huge sums into stocks with perceived stable earnings growth and low price volatility. Consequently, these stocks have significantly outperformed the market and are now over loved and over valued and have played a large role in creating the current environment of very wide valuation spreads.

6 Page 6 CHART IX LOW BETA STOCKS DOMINATE Corporate America is generating a lot of excess capital. Their internal reinvestment rates now exceed the required level of capital spending necessary to achieve realistic growth opportunities. Chart X exemplifies the excess capital generation as free cash flow margins have exceeded revenue growth since the end of the Great Recession and are now about 600 basis points higher. CHART X FCF MARGINS EXCEED SALES GROWTH

7 Page 7 Importantly, the majority of managements have been very disciplined and have not attempted to chase elusive revenue dreams. Instead, they have increasingly returned their excess capital generation to shareholders through growing or originating dividend payouts and share repurchases. And given the expected sustained slow growth in global and domestic nominal GDP, rapid revenue growth opportunities will remain elusive. So, we believe we re in for a long period of excess capital generation. Hopefully, corporate managements capital allocation strategies will continue to emphasize returning a significant amount to their shareholders. Successful investors strive to narrow the universe of investment possibilities by systematically employing strategies that have proven to deliver superior results. Much of this letter has been about free cash flow generation. And we have discussed the success of valuation strategies employing free cash flow in many of our past letters. More importantly, they have continued to produce market besting returns despite investors increasing awareness of their effectiveness. No surprise, we continue to employ free cash flow liberally in our valuation strategies. The shares of companies returning a significant amount of capital to their shareholders have typically generated excess returns. We screened the Russell 3000 universe of stocks over the past 30 years and confirmed that the quintile of companies returning the largest percentage of their excess capital through dividends and share repurchases, relative to their market values, outperformed the Index by about 200 basis points annually. Moreover, the penalty for owning stocks returning very little to shareholders was severe. The 20% returning the most to shareholders outperformed the 20% returning the least by 750 basis points annually. TABLE I RETURNS BY QUINTILE DIVIDEND AND SHARE REPURCHASE 5/31/86 3/31/16 Q1 Q2 Q3 Q4 Q5 Russell 3000 CAGR Mean Median % GREATER THAN RUSSELL % 67% 77% 47% 33% Source: Dalton, Greiner, Hartman, Maher & Co. Buying the shares of either companies selling at a high ratio of free cash flow to market or enterprise value or those returning a substantial portion of excess capital to shareholders is a reliable predictor of future superior returns. Combining the two is even better. Best regards, Timothy G. Dalton, Jr. Chairman