We’ve recently been covering money managers’ divergent approaches to historically high U.S. stock prices in what has turned out to be the seventh year of the bull market.
Opinions vary greatly:
- Katie Nixon, chief investment officer of Northern Trust Wealth Management, said July 20 that investors should still buy dividend stocks and high-yield bonds, despite rich valuations in both sectors.
- FBR & Co. Director of Research David Hilal listed 16 dividend stocks to own, even now, because they offer “an attractive yield and potential share appreciation.” That story was published July 18.
- Larry Pitkowsky and Keith Trauner, who manage the GoodHaven Fund GOODX, +0.58% after previously working for the Fairholme Fund FAIRX, +0.21% said in a July 26 story that owning an index fund is a can’t-miss proposition during a bull market, though active management might be a better option during periods of volatility. They listed Barrick Gold Corp. ABX, +3.55% and Staples Inc. SPLS, +0.81% as favorite stock picks.
On July 25, Mark Travis, the founder and CEO of Intrepid Capital Funds, didn’t dwell on perceptions that market valuations are high. When discussing the success of an index fund during this current bull market, he said: “Most investors don’t earn what a fund earns,” because they buy high and sell low. In an interview, he focused on his approach to value investing.
“We can lead you to a higher price without heroic assumptions.”
Travis manages the Intrepid Capital Fund ICMBX, -0.17% which has $340 million in assets, while the company’s total assets are about $900 million. The fund invests in small-cap and mid-cap companies and high-yield bonds.
Citing a study by Dalbar Inc. showing that “over the past 20 years, investors make a much smaller equity return than they would with a blend,” Travis said, “I am trying to help people sleep at night, rather than scare them.”
“On the equity side, we try to figure out what a business would be worth in the private market,” based on price multiples to pretax cash flow, he said. That is an approach that Travis follows whether or not the overall stock market is considered fairly valued. He added that private valuations for companies “seldom” exceed 10 times earnings before interest, taxes, depreciation and amortization (EBITDA).
“We are really short-duration equity investors,” he said. “Meaning the time we have to wait for cash flow to come back to us is shorter than it would be for Amazon, Netflix and Tesla.”
“If you are investing in growth equity that has its cash flows far in the future, you are saying, ‘Let’s see how long I can hold my breath,’ ” he said.
The Intrepid Capital Fund has returned 10.8% this year through July 26, which compares favorably to the 7.4% return for the S&P 500. Like so many actively managed funds, its total returns during the bull market have lagged behind the index over longer periods. Its average annual return over the past five years has been 6.4%, compared with 12.7% for the index. Its average return for 10 years has been 7.7%, in line with the average for the index, according to FactSet.
Morningstar ranks the Intrepid Capital Fund fourth of 915 funds in the “moderate target risk” category, while it ranks in the second-quartile over five years and in the top quartile over 10 years.
Here are three stocks favored by Travis:
- Cubic Corp. CUB, -0.18% provides ticketing and payment services for transit providers, including the Metropolitan Transit Authority, which serves New York City and surrounding areas. ”This is an example of a business where we think it is worth more than where it trades,” Travis said. Cubic’s stock closed at $41.27 on July 26, while Travis said his analysis of the company’s discounted cash flows indicates an intrinsic value of about $50 a share.
- Patterson-UTI Energy Inc. PTEN, +0.80% “has about 240 land-based drilling rigs and also has a frack pumping business,” Travis said. He said that “you can get around $4 billion for the rigs and another $1 billion for the pumping business.” The company’s stock closed at $20.21 on July 26, with a market capitalization of $2.98 billion. That’s a 40% discount to the intrinsic value of the company’s assets, according to Travis, who said the company is also trading at a heavy discount according to his discounted cash flow model. “We can lead you to a higher price without heroic assumptions,” he said.
- Royal Mail PLC RMG, +0.89% is the United Kingdom’s privatized mail delivery service. “What is interesting to me is to compare the typical mail cost in the U.K. compare to here. I think it is about $1 dollar per U.S. mail piece. It is no wonder our mail system is losing money,” Travis said. He emphasized that even though letter volume is declining, package delivery is soaring because of the continued growth of online shopping. He said the company has plenty of unlocked value because it is in the process of selling land in the central business district of London, which the company has been carrying on its books at cost. “Those figures are wildly outdated,” which means investors can expect gains on the sale of the land.
As always, if you find any of the names favored by Travis compelling as individual investments, you need to do your own research and consider whether you believe the company’s strategy will enable it to thrive over the long term.
Another argument for a value approach
Despite all the fear when the S&P 500 sank 10.5% from the end of 2015 through Feb. 11, 2016, the benchmark index is up 7.4% this year. So warnings over the past two years about an overvalued market and the pending end of the seemingly eternal rounds of economic stimulus at home and abroad may have been early. But that’s pretty easy to say in hindsight.
So let’s take a quick look at valuations.
The S&P 500 SPX, +0.25% trades for 18.6 times trailing earnings, according to FactSet. That’s the highest price-to-earnings ratio for the index since April 2004.
Crit Thomas, global market strategist for Touchstone Investments, said in a July 19 interview that there are periods that favor growth or value picks.
“They tend to run in cycles, and there tends to be reversion to the mean,” he said.
Touchstone Investments is based in Cincinnati and oversees $15.2 billion by helping clients select from institutional asset managers.
Thomas pointed out that just considering the price-to-earnings ratio for an index could give the wrong impression because of disruptions in the market. The energy sector is a great example.
“Early this year, the P/E was very, very high, since earnings were wiped out, but it was a great time to buy. Because there are significant cyclical aspects, I tend to avoid P/E for this type of analysis,” Thomas said.
If we look at price-to-book value instead, we see the S&P 500 trading for 2.8 times trailing book value. The index last traded so high in August 2015, and before that October 2007, according to FactSet.
Thomas prefers to compare the valuations of the Russell 1000 Growth RLG, +0.25% and Russell 1000 Value RUI, +0.25% indices when analyzing long-term trends. The growth index is trading for 5.9 times book value, while the value index has a price-to-book ratio of 1.9.
Based on these measures, “value stocks, relative to growth, are cheapest since just before the dot-com bust, in 1999,” he said.