April 22, 2019
Recently Published Articles:
- The Long-Term Case for Disney
- REITs are Getting Expensive
- 3 Great Companies I’d Like to Buy During a Correction
- Brookfield Asset Management: Attractively-Priced Powerhouse
- The Big Mac Index and Russian Tailwinds
- These 2 Foreign Dividend Stocks Offer Good Risk-Adjusted Returns
- Solid Jobs Report Supports Market, Shows Widening Sector Divide
- An Inverted Yield Curve is Driving Market Volatility
- Brexit and European Slowdown Hanging Over International Indices
- Sierra Wireless: Shifting Towards Recurring Revenue
- P/E Ratio: Why Investors Need Better Valuation Metrics
- 3 Growth Stocks to Avoid, and 2 I’m Buying
- 3 Value Stocks I’m Buying, and a Look at 4 Value ETFs
I write articles on a lot of websites and some readers have asked for more frequent updates when I write them, since this newsletter comes out approximately every 6 weeks.
The best way currently is to follow me on Twitter where I link to articles within a day of writing them. Historically I haven’t been very active on Twitter or any social media, but I’m trying to be this year, at least to link to recent articles.
Now let’s get into the newsletter.
I Have Two Significant Market Concerns
Over the past few years, I haven’t been as bearish as some of the popular bearish pundits, nor as bullish as some of the popular bullish pundits. I take advantage of buying opportunities when they come along, and grow a bit more cautious when everything is going well and valuations are high.
In particular, I’ve been paying attention to four growing problems in the United States economy for a while now. Each one of them is manageable, but the greater issue is that they are all inter-linked and could pop around the same time during the next economic slowdown, whenever it comes. The uniting theme with them is that the U.S. middle class is quite fragile compared to most other developed countries and many government promises, ranging from state pensions to federal entitlement programs, are deeply under-funded.
I’m still very long U.S. and international equities, but I maintain defensive elements in my various portfolios as well.
There are a couple other concerns I’ve been discussing in some newsletter issues and articles. These two likely aren’t as systemic as the other four, but they specifically threaten U.S. stock performance if they don’t go well and are therefore worth being aware of.
Concern 1) Big Unprofitable IPOs
Generally when we think of stocks, we think of owning pieces of profitable companies that grow over time and perhaps pay us some dividends along the way. But there is a growing percentage of companies that are unprofitable for very long periods of time.
Not all unprofitable companies are bad. I have small positions in three unprofitable companies myself because I expect upcoming catalysts to make them profitable. If there’s a company with a promising new product or service, it can take some time to reach a scale where it becomes profitable, and therefore the company relies on investor financing to get started and build out the system. That’s fine.
But there’s been a bit of a private equity bubble in Silicon Valley over the past decade. Even Saudi Arabia is pouring money into it as they seek to diversify their economy away from oil over the next decade.
And in recent years, many of those companies have gone public while still unprofitable. The percentage of companies that go public with negative earnings is now above 80% this past year, exceeding the ratio of the Dotcom Bubble from 20 years ago. In other words, private companies are going public while still unprofitable at greater rates than ever before:
Chart Source: CNBC
The unprofitable ride-sharing company Lyft recently went public with about a $20 billion market capitalization and its stock has steadily gone down since it become public. Not only is this company unprofitable, but it doesn’t have any direct route to profitability because its expenses (drivers) scale with its growth.
Its larger competitor Uber is planning to go public as well with a $100 billion valuation, which is about the valuation of GM and Tesla combined.
Another way to put it is that Uber’s market capitalization is greater than the combined market capitalization of the four major U.S. airline companies, even though their combined revenue is over $150 billion with profits while Uber’s revenue is $12 billion and without profits, but with a much faster revenue growth rate.
The social media company Pinterest (PINS) just went public at $19/share, and is now over $24 after its first day of trading for a market capitalization of around $13 billion. The company hasn’t been able to generate a profit yet even though it was founded almost a decade ago. At least its expenses don’t scale directly with growth.
Many of unprofitable IPOs over the past few years trade for 8-12x annual revenue as a baseline, if not more. (In comparison, Amazon now that it’s larger, trades for 4x annual revenue. Netflix still trades for about 10x annual revenue.)
Zoom Video Communications (ZM), a smallish and fast-growing developer of high-quality video conferencing software, also went public last week and they are actually profitable. Their stock soared in its first trading day, and as of this writing now boasts a market cap of just under $16 billion. With $330 million in revenue and $7 million in net income in the past year, their price-to-sales ratio is over 48x, making it one of the highest-valued companies in the market relative to sales. Their price-to-earnings ratio is over 2,000, but that’s not a meaningful number yet when their profit margin is so low at 2%.
Zoom will need to grow huge and fast to justify this valuation. If the company multiplies its revenue by 5x in a few years up to over $1.6 billion, and increases their profit margin fivefold from 2% to 10% during that time, the current market capitalization on those bigger numbers would still be at a 10x price-to-sales ratio and a 100x price-to-earnings ratio.
I think a lot of investors will be disappointed in the forward returns of many of these very high-valued stocks, even though a small subset of them will go on to do very well like Amazon did. Technology analyst Beth Kindig who I collaborate with on FA Trader has been great at filtering which ones are worthwhile and which ones are not.
It’s a good idea to be careful with companies that don’t make money. Be conservative with the valuation you are willing to pay, and manage your position sizes appropriately relative to the risk of the company.
Concern 2) Record Corporate Debt as a % of GDP
Corporate debt as a percentage of GDP follows a clear pattern and has reached an all-time high over the past year (recessions shaded in grey):
Chart Source: Gluskin Sheff
The Federal Reserve and many other central banks in developed countries have kept interest rates very low for over a decade now. Corporations have been able to borrow cheap debt and buy back their own shares at very high rates, boosting per-share metrics and shifting their capital structure towards more debt and less equity.
The typical concerns with this are clear. Eventually leverage gets high enough that corporations need to slow down those share repurchases in line with actual growth of earnings or cash flow, resulting in slower EPS growth, which then puts into question the high valuations that investors are willing to pay for their shares.
I’ve written about corporate debt levels a few times, including here.
The more unique concern this time is just how much corporate debt there is, and how much of it is rated BBB, which is right at the bottom end of investment grade ratings.
The credit rating agencies assign bond credit ratings ranging from “AAA” (the best) down to “C” which are on the verge of default. The better the rating, the lower the risk of default there theoretically is, and the lower interest rates that companies will need to pay on their bonds. However, credit rating agencies performed inaccurately leading up to the subprime mortgage crisis because they assigned very high credit ratings to bad mortgage bundles, so the ratings can’t be taken for granted.
There’s a cutoff line right below the BBB/BBB- level that separates “investment grade” from “non-investment grade”. Non-investment grade bonds are also referred to as “high yield” or “junk” bonds.
Many types of institutions are only allowed to hold investment grade bonds. If a bond gets de-rated and falls to junk status, they need to sell the bond. This happens during every recession; many companies get downgraded and some of them fall from investment grade to junk. Because there are fewer buyers of junk bonds and they are riskier, their interest yields spike to higher levels.
Here’s the problem. The percentage of investment-grade bonds that are comprised of the lowest level within the investment-grade spectrum (BBB+/BBB/BBB-) has increased from just over 30% to nearly 50% during the past decade. In other words, nearly half of all investment-grade bonds are now just one major step away from being classified as junk.
Chart Source: PICTET Asset Management
This next image shows a good snapshot of the overall corporate bond universe. It’s from last year but still accurate. The BBB chunk is particularly big now:
Chart Source: The Economist
Furthermore, credit rating agencies seem to be generous with many of their ratings again. Many BBB companies have debt levels that would have historically put them on the high-end of junk status, like BB or BB-, but are still being given the benefit of the doubt and allowed to remain at the bottom end of investment grade. In particular, perpetually low interest rates have allowed for higher than normal debt levels.
The worst-case scenario, which may or may not happen to a severe degree, is that the next recession comes along at some point, hurts corporate earnings as usual, but then several of these corporations with record high debt get downgraded from BBB to junk status, forcing institutions to sell an unusually large amount of them at once. If there aren’t enough buyers of these newly junk bonds, there could be a liquidity issue and a spike in yields for the companies, which makes it hard to refinance and could lead to liquidity problems in the companies themselves. What makes this time different than previous business cycles is the unusually high percentage of bonds sitting right at the bottom edge of investment-grade in BBB status.
My overall opinion is this: Keep an eye on the balance sheets of companies you invest in and ask yourself if the debt would become a problem during a recession if the company’s earnings decline. Pure index investors might consider adding a quality factor to their portfolios to reduce their exposure to high debt companies. I have an example of this in my sample ETF portfolio article.
I have four investment accounts, and I provide updates on my asset allocation and investment selections in each newsletter issue.
These include a primary passive/indexed retirement account, two actively-managed brokerage accounts at Fidelity and Charles Schwab, and the new account specifically for this newsletter at M1 Finance.
I use a free account at Personal Capital to easily keep track of all my accounts and monitor my net worth.
M1 Finance Newsletter Portfolio
I started this account about seven months ago with $10k of new capital, and I put an additional $1k into it before each newsletter issue, totaling $15k.
It’s by far my smallest account, but the goal is for the portfolio to be accessible and to show newsletter readers my best representation of where I think value is in the market.
I chose M1 Finance because their platform is commission-free and allows for a great combo of ETF and individual stock selection with automatic and/or manual rebalancing. It makes for a great model portfolio with high flexibility, and it’s the investment platform I recommend to most people.
After adding $1,000 in fresh capital in April, here’s the portfolio today:
Changes since previous issue:
- I added new positions to the dividend stock portfolio including Unilever (UL), Dollar General (DG), Illinois Tool Works (ITW), Lazard (LAZ), Bank of Nova Scotia (BNS), and Lam Research (LRCX). You can read my thoughts on two of them here.
- I added a small position in Sierra Wireless (SWIR) to the growth stock pie.
- I re-arranged the international equity ETF allocation slightly.
The portfolio’s defensive exposure to dividend stocks, gold, short-term bonds, real estate, and lower-valued international equities protected it from a big chunk of the U.S. stock declines in Q4 of 2018. And I shifted a bit into growth stocks in early January, which helped during the bull market that came in early 2019.
The portfolio is mildly outperforming the S&P 500 so far, and with less volatility. We’ll see how it does over the next few years together.
Here’s the more detailed breakdown of the holdings:
My contact at the company recently pointed out to me that until April 30th, people who transfer existing accounts of $20,000 or more to M1 Finance get a $100 bonus.
Primary Retirement Portfolio
This portfolio is my largest and least active. It purely consists of index funds that automatically rebalance themselves regularly, and I rarely make changes.
Here’s the allocation today:
From 2010 to 2016, this account was aggressively positioned with 90% in equities and enjoyed the long bull market.
Starting in 2017 in order to preserve capital I dialed my equity allocation down to 60% (40% domestic, 20% foreign). This was due to high stock valuations, rising interest rates, and being later in the market cycle more generally. If and when the U.S. economy encounters a recession and significant bear market, I would likely increase equity allocations to upwards of 90% once again.
Related Guide: Tactical Asset Allocation
One reason this is so conservative is that my active portfolios are more concentrated and aggressive, so I consider them together when determining how to allocate assets.
This is an example of a fund that takes a rather hands-off approach but that still makes a tactical adjustment every few years based on market conditions. This employer-based retirement account is limited to a very small number of funds to invest in so my flexibility is limited compared to my other accounts.
My accounts at Fidelity and Schwab are mainly for individual stock selection, single-country ETFs, and selling options:
Changes since previous issue:
- I sold June covered calls on my Brazil ETF to extract some more income from it. Brazil’s market outpaced the United States market in late 2018 and leading into 2019, and started to get overheated, so I sold some out-of-the-money covered calls on it last month. Since then, the ETF is down to more attractive levels in my opinion.
I didn’t put any new capital into my Schwab/Fidelity accounts over this past six weeks. Instead, I used $10k in fresh capital to create a second M1 Finance account as a one-time investment towards the end of March. Unlike my newsletter model portfolio above, this one will be a static portfolio that doesn’t get new contributions over time, which will make it easier to track some performance metrics with and is why I created it. It will mirror my newsletter portfolio.
Final Thoughts: 2019 International Report
Many investors give little thought to investing in foreign equities and are heavily allocated to stocks in their own country. If they invest in foreign stocks at all, they’re often highly concentrated by market capitalization into a few of the biggest countries.
Regular readers may know that this chart from Meb Faber is one of my favorite charts:
Chart Source: Meb Faber, Cambria Investment Management
What the chart shows is that investors who consistently invested in the cheapest 25% of countries each year based on the low-CAPE ratio (orange line) dramatically outperformed the S&P 500 (dark blue line) since 1993. To be more specific, it was about 14% annual returns vs 9% annual returns, resulting in 3 times as much money for the low-CAPE strategy by the end.
Star Capital shows similar results for investors that consistently bought countries with low price-to-book ratios from 1979 to 2015:
Chart Source: Star Capital
Star Capital looked at 17 countries in total and found that when investors bought when the price-to-book ratio was below 1, average forward returns over the next 10-15 years were 14.1% per year compared to only 0.6% when the price-to-book ratio was over 3.
There’s a linear correlation: the cheaper you buy, the better your investments usually perform. They showed that this is also true for CAPE ratio, normal P/E ratio, dividend yield, and other valuation metrics to varying degrees. Buying a basket of cheaply-valued countries historically does very well over the long-term.
Right now, the cheapest countries by CAPE are Russia, Turkey, Poland, South Korea, Singapore, Spain, and Malaysia.
Often (but not always) when a country ranks cheap based on one metric, it ranks cheap on other metrics too. Russia, South Korea, Turkey, Singapore, China, Poland, and Italy are some of the cheapest countries based on the price-to-book value metric.
International Opportunities in 2019
Last year in June, I published the “2018 International Opportunities Report” as a special feature that ranked 29 countries for their suitability as investments based on a combination of valuation, growth, debt, political stability, and currency strength.
In the ten months since then, the stock indices of the three countries that I gave the highest ranking to outperformed the bottom 3 countries by an average of about 13% in dollar terms.
That’s not likely to happen every year because I don’t target 1-year returns for the report, but it’s a nice start to the system.
Perhaps more importantly, the report provides a lot of facts of what the various strengths and weaknesses of each country are, so that investors can be more informed and comfortable with the international allocation of their portfolio whether it consists of one fund or a complex mix of several investments.
Multiple studies show that when you buy international market index funds while they are cheap, they historically do quite well over the next decade if you have the patience to hold. However, I like to go beyond pure valuation, and focus on a combination of value, growth, debt, stability, and currency fundamentals.
For example, one of my top 3 countries last year was India, even though that was and still is one of the more expensive countries by many metrics. Over the past year, it outperformed emerging markets as a whole by over 13%, and outperformed the all-country index by over 4%, in dollar terms.
It has been one of the best-performing countries over the past two decades despite never being among the cheapest because it has various elements that justify fairly high valuations up to a point.
What matters for a country like India is to buy it when it is cheap compared to its fundamentals. It never is in the top ten cheapest countries and yet historically gives some of the best long-term returns as long as it’s not bought during its occasional bubbles like in 2007.
Chart Source: MSCI
As of today, the new 2019 version of the report is available, and it ranks 30 countries with updated information, and it’s available here.
The next newsletter is planned for early/mid June. Normally I would aim for June 3rd but due to a vacation it’ll probably be June 10th.