Blue Light Special – Q4 2020 Newsletter

Stocks are trading at all-time highs and stocks of unprofitable companies seem to earn the largest gains. Technology, momentum, and growth are the order of the day. Is bargain hunting in such an environment a fool’s errand?

Even with all the froth in the market today, there are still some segments of the stock market trading at rock bottom valuations. It is likely some of them will be big winners in the years to come.

Around the office we have been referring to these market segments as Blue Light Specials. As in “attention K-Mart shoppers…”

I don’t like to admit it, but back in high school I worked at K-Mart one summer. The pay was $6 per hour and all the pride I could swallow. It wasn’t the best job, but I vividly remember the Blue Light Specials. The store actually had a flashing blue light that one of the store associates would haul over to signal the monumental bargain being offered. There was also an announcement over the store’s PA system in case anyone missed the big flashing blue light.

Unfortunately, in the stock market there is no announcement and no flashing blue light to point out the cheapest stocks, but among the hot IPOs and soaring tech stocks, there is an opportunity that could help protect capital and also generate significant returns in the decade to come.

These strategies still involve risk and concentrating in them is unconventional. The order of the day is to buy the biggest technology stocks, such as Apple, Microsoft, Google, etc. That is the easy trade. They are solid companies with strong growth profiles. Their historical returns have been stellar, and these stocks earn glowing headlines in the media on almost a daily basis. The problem is, they likely cannot continue to provide this same level of returns going forward.

The alternative though is to buy Blue Light Specials, such as value stocks, that have struggled to keep pace with the overall stock market the past several years. They are also in non-flashy industries, or industries that may face future regulatory headwinds, like energy or financials. However, many of these stocks now trade at such attractive levels, that regardless of future headwinds, it seems the stocks almost can’t help but outperform in the coming decade.

But note, there’s that pesky issue of timing. While it seems obvious that a shift from growth to value will occur, no one knows precisely when. It could be starting now, or it could take several more years. If it takes longer than anticipated, that perceived unconventional failing can result in a lot of pressure to make changes at precisely the wrong moment. This can result in permanent damage to a portfolio.

And, even if we’re right, there could be some bumps along the way. Market rotations historically have been accompanied by severe downturns. Today’s cyclically-adjusted price/earnings or CAPE ratio for the S&P 500 is the second highest ever recorded, behind only the Dot Com Boom of the 1990s. Prior CAPE peaks have been followed by significant market declines, such as in 1929 and 2000. These have also marked changes in market leadership away from growth and toward more value-oriented stocks.

Of course, we can’t say for sure that this market rally will end with a bust. Though, even without a big stock market decline, the data is quite clear that high valuations today lead to low future returns. Forward ten-year returns for the S&P 500 have been at most 6% annualized, and at worst negative when starting valuations have been as high as they are currently. Many forecasters expect anemic or even zero returns for stocks for the coming decade.

This “lost decade” scenario is not without precedent. It happened in the 2000s when the point-to-point return for the S&P 500 was less than 1%. Often during these periods, poor performance for stocks has been somewhat offset by stronger returns for bonds. However, we recently read a paper published by investment firm GMO that shows six periods ranging from seven years to 19 years in length where a 60% stock and 40% bond portfolio generated flat or losing returns. Their data goes back to 1900, but four of these dead money periods occurred during the post-war era.

GMO points out that each of these periods was preceded by either stocks or bonds being overvalued. Today we have the dubious distinction of an era with both stocks and bonds in historical valuation territory. Not only is the CAPE ratio the second highest on record, but interest rates are as low as they have ever been. This will likely result in long-run bond returns of around 1% annualized.

If these forecasts are correct, the high returns we have enjoyed from both stocks and bonds in the past are unlikely to persist. However, institutional and individual investors’ needs won’t change as a result of the coming shift in returns. So, something needs to be done within portfolios.

Our solution has been to focus on Blue Light Specials. Value stocks globally are trading at valuations as low as they have ever been relative to growth stocks. Emerging market stocks and small-cap international stocks also sport very low valuations. While these market segments are not without risk, we expect they will hold up better than the overall stock market in a downturn and should rebound more quickly.

Value stocks were already cheap compared with growth stocks prior to the COVID downturn. However, the gap widened even further as the economy shut down, which punished cyclical stocks and rewarded growth stocks in the technology sector. This valuation gap cannot be justified by differences in fundamentals, as the least profitable companies have been the best performing stocks lately. Thus, value stocks now offer a rare chance to buy good assets at great prices. In fact, famous value investor Warren Buffet has earned his best returns during periods when value stocks were cheap, and today’s environment is the cheapest ever.

Similarly, international stocks have underperformed the U.S. market for a long time now. International economies have largely lagged behind the GDP growth rate in the U.S., so much of this underperformance has been justified. But there are international market segments that are super-cheap currently, such as emerging market stocks, small-cap international stocks, or for those with an even larger risk tolerance, emerging market value stocks. These all trade at rock-bottom price/earnings ratios and below their book value. As a comparison, the S&P 500 is over two times more expensive on a P/E basis and trades at more than three times its book value.

While these market segments can be volatile, it is also risky to pile into overvalued growth stocks today, even though that might be a well-accepted approach based on recent historical returns. But for those with a higher risk tolerance and an appetite to deviate from the norm in search of higher returns, the Blue Light Specials seem particularly attractive.

To Download the complete Newsletter please click below.