The markets sold off for the fourth consecutive week, though the lows from two weeks ago weren't violated. Here is how the models look as of 8/19:
Top 20 had arough week. While the S&P 500 declined 4.63%, the model lost 6.2%. During the week, we had 5 stocks off more than 10%. The damage in August has been severe, with the S&P 500 declining almost 13%. Worse, the Russell 2000, a benchmark for small stocks, has lost over 18% Our poor performance is primarily related to exposure to smaller stocks. Our speculative biotech stock, which is our smallest position by far, has led the way (-41%), but our natural gas producer has lost over 1/3 of its value (from spiked levels following a run-up due to a competitor being acquired) as gas prices have plunged.
I have been reducing my targets for almost all of the stocks in the model to account for likely lower future earnings than had been previously forecast. Still, earnings are expected to grow, just at a slower rate. Clearly, the overall market seems to be projecting a recession, which I continue to find unlikely (see market outlook below). Still, it's important to understand the sensitivity of the portfolio to this type of shock. Of our 20 stocks, 15 have more cash than debt. Of the remainder, none have more than 40% net debt to capital. Two of the ones carrying debt are Large-Caps with very strong franchises that didn't lose money in the last downturn in a single quarter. Only one company (the gas producer) concerns me. I am rethinking this position, but I would note that we have very little Energy exposure. This company has several favorable attributes, including a major position in Eagle Ford shale that should boost its oil production, and I think that the company is a likely acquisition candidate.
Another overall favorable attribute is our valuation profile. On a PE basis, any of our stocks are trading below 10X and most are trading below 15X. The ones with higher multiples tend to have issues that suggest using a different metric (like excess cash on the balance sheet). Our weighted average is 13X. A metric that I prefer is Enterprise Value to EBITDA, and, on a trailing basis (over the past four quarters), our weighted average is just 6.2X. The final metric, and one that's useful for assessing downside, is the Price to Tangible Book Value. Our weighted average is 1.5X, and not a single company has negative tangible equity. 4 of our stocks are trading below their accounting book value (including the natural gas company).
I am disappointed that we have lagged the market somewhat this year. We performed very poorly last summer as well, but we came out of it very strongly. I believe that longer-term investors benefit from the inclusion of smaller companies that are less followed by Wall Street, but holding them in downturns can be very painful (although well-known big companies can be even more painful). Our industry exposures have hurt us too - more defensive sectors like Utilities and Consumer Staples have performed much better than the overall market. At this time, I am comfortable with our exposures, but I acknowledge that we have some risk to earnings if the economy actually contracts. I am looking to replace our small biotech holding and potentially one or two other names. I have several potential buys lined up, but the extreme volatility has left me a little reticient to pull the trigger.
Conservative Balanced/Growth lagged its benchmark just slightly and remains ahead of it in 2011. I have had the model poorly positioned compared to our benchmark. We have held close to the maximum of 75% stocks (compared to the 60% target), while we have held close to the minimum of 10% in bonds (40% target). Fortunately, our stocks have performed better than average. In August, only 2 of the 14 stocks have declined more than the S&P 500.
The metrics for this model reflect the conservative nature of its investment philosophy. Here, we have fewer small companies. The overall forward PE is just 10X. The EV/EBITDA metric I discussed above is just 5.5X. Our P/TB is slightly higher than Top 20 at 2.3X, with a range of 1.3X to 6.3X. 3 companies have more debt than cash, but the maximum is just 26% Net Debt to Capital. Our weighted-average dividend yield is 2.9%, with 4 companies paying a dividend that exceeds a 4% yield.
Sector Selector ETFgave up some more ground this week. After ending July at essentially flat to the S&P 500 since the launch at the end of April, it has underperformed by a little over 1% this month. The model has been poorly positioned for the downturn, with too much exposure to Financials as well as Emerging Markets. Our exposures to Large-Cap Technology as well as the Mega-Cap part of the market have only slightly offset the poor performance from other parts of the portfolio. When there are signs of stability in the market, I intend to increase our Small-Cap exposure further. If the market continues to slide, I will likely need to reduce some of our other exposures.
Market Outlook
I shared my adjusted framework last week that assesses the odds of three scenarios over the next few months. The most likely scenario, in my view, is that the next few months could be challenging, but this proves to be a correction. A more optimistic scenario is that we rocket right out of here shortly. The least likely scenario is that we are entering a new bear market.
Despite the crappy action this week, my views are unchanged. The major reversal from the lows earlier this month after the FOMC announced new Fed policy (low rates for two years) took the S&P 500 from its intra-day lows 10% higher as of the peak on Wednesday. The massive retreat Thursday didn't violate the lows and looks to be normal to me thus far. If weakness persists early next week, I believe the technical situation may become worse.
This second correction of the bull market still leaves prices substantially higher than a year ago. As I assess the current environment, I sense that fear of "another 2008" abounds. Unfortunately, the playbook for how markets act after a major economic collapse like 2008 isn't very thick. We can look back to the Great Depression, but the data and how the world works are very different these days. So, we can't really look to history for a guide, though we do hear people trying to extrapolate from the 30s.
Fiscal policy is not as bad as folks make it seem. It could be better, especially on the regulatory front. Obama-care has created a barrier to hiring as well as the likely rolling off of reduced payroll tax contributions by employers. Monetary policy is downright helpful. So, what's the problem? I have said all along that it takes a lot of time to work through a credit crunch, but we have made much progress. There is concern, of course, about federal spending levels, but this has been going on for 30 years now. We have an economy built on consumption, and consumer spending will be the long-term key to economic growth. It is economic growth that will get us out of the government debt morass. Unfortunately, consumer spending isn't helped by crashing stock markets, high gasoline prices or watching the morons in D.C. play chicken like they did earlier this month.
So, all of this is fine, but it doesn't explain what's really going on: Fear of European bank contagion. I have to admit that this is a very tough issue - no one knows. The U.S. government was slow to act, but it did a very good job, like it or not politically, of averting the type of disaster that could have happened. Europe doesn't have the political will or perhaps even the mechanisms to back-stop their banking system, and this is really the big risk right now.
Stocks climb a wall of worry, almost always. Looking back, those who sold out of fear in 2008 or early 2009 ultimately proved foolish (unless they were the three people who were able to buy back in at lower prices). Gold and Treasuries have entered BUBBLES. I haven't used that term, and I don't use it lightly. Stocks are now oversold and cheap. Fear is rampant. On the other hand, company insiders are buying hand over fist like rarely before. Companies are flush with cash, and, those that aren't have certainly, for the most part, put their own houses in better order by extending their borrowings. We aren't likely to have a massive margin call like we did in 2008.
So, I have no crystal ball. Clearly, I missed this one, and badly. By my forecast, we would be up 12% or so by now and not down almost 10% in late August in the S&P 500. I know, though, that stocks don't march in a straight line. I warned that we were ahead of pace in late April - the pendulum swings too far both ways. At this point, I am not seeing what makes others so clearly fearful. While I doubt we hit my +20% target for 2011, it's not out of the question (it would require a 33% rally). At this point, I think we improve from here, though I have to admit tremendous uncertainty limits my conviction.
You can count on me not to act like a lemming and follow the crowd. You can count on me to understand what's going on with the companies in our model and to make my best effort to find the most attractive stocks that are consistent with the goals of the model. You can count on me to keep my cool. Top 20 and CG/B lost a lot in late 2008 - it's impossible to make money when almost all stocks are declining. We held in better than the markets, though, in both cases. This includes a disastrous mistake in Top 20 (Fannie Mae), which won't happen again. I don't know when the markets will turn, but you can count on me to be positioned as best as I possibly can for that day.
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Regards,
Alan Brochstein, CFA
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