How to Get In Early on the 'Golden Age of Value'
Why we buy expensive stocks... The two indicators of out-of-favor stocks worth buying... One of investing's few constants... The power of shareholder rewards... How to get in early on the 'Golden Age of Value'...
We humans love a good deal...
But there are exceptions... like our strong affinity for buying financial assets, such as common stocks, after their prices have moved dramatically higher.
There's a surprisingly logical explanation for our irrational actions.
Renowned neurologist, financial manager, and author William J. Bernstein (The Four Pillars of Investing) says this "strange quirk of human nature" exists because:
Human beings are profoundly social creatures. Just as people want to own the most popular fashions, so too do they want to own the latest stocks.
Owning a portfolio of value [or out-of-favor] stocks is the equivalent of wearing a Nehru jacket over a pair of bell-bottom trousers.
Seven years ago, it was fashionable to own Apple...
The world was in love with the iPhone, so buying Apple stock felt comfortable.
In 2012, Apple (AAPL) surged 70% in a matter of months...
Earning a comparable return in an S&P 500 fund like the SPDR S&P 500 Fund (SPY) would've taken three years, or four times as long.
But then, as is so often the case with what's fashionable, Apple quickly fell out of style...
In September 2012, Apple shares had hit $681. By April of 2013, they were selling for $390. The stock price had imploded 43%.
In just eight months, Apple went from runway star to the clearance rack... From high-flying, must-have growth stock to bargain-bin value stock.
This fall from grace set the stage for one of Extreme Value's biggest wins...
In June 2013, Dan Ferris and I (Mike Barrett) told Extreme Value readers to buy Apple, saying we'd never seen a "World Dominator" (a top one or two company in its industry) so cheap...
We estimated readers taking our advice could make 50% to 100% over the next two to four years.
Here's what Dan wrote in our June 2013 issue:
There's simply no rational explanation for Apple's current valuation... except that the stock market is manic-depressive.
We don't need to put an exact figure on Apple's intrinsic value. That's not how intrinsic value works. It's like Warren Buffett says, "If a guy walks into the room, I don't know if he's 300 pounds or 350 pounds, but I know he's fat." Apple is fat with enormous value. The stock should be $900 a share, not $450.
And I believe it could get there in the next few years...
He was adamant. Dan described the stock as "filet mignon at Big Mac prices."
He was right. We closed our Apple position in December 2018 – a little over five years after our June 2013 recommendation – for a gain of 190%.
I bring this example up because now is the time to be part of more success stories like this...
As we wrote last month, the starting gun has fired on a new "Golden Age of Value"...
The key turning point came in early September...
I wrote in the September 24 Digest:
Fresh investment capital is finally flowing out of growth stocks – the best performers over the past decade – and into value stocks. As a result, "boring" businesses that investors have long neglected will offer some of the best investment opportunities over the next year.
In less than two months, we've added four positions to our Golden Age of Value portfolio in Extreme Value. We'll add a fifth this Friday, and likely add several more over the next few months while the growth-to-value shift is still emerging.
But we know purchasing out-of-favor stocks can be uncomfortable...
For many investors, buying the stocks others are selling doesn't come naturally. It's not necessarily cocktail-party material (unless you're at the right party).
To help you overcome this discomfort, today let's take a closer look at the Apple story and how it has evolved since 2012.
In the process, I'll identify two important attributes to look for in an out-of-favor stock. When they're present, the odds of success are clearly in your favor.
Growth stocks – like Apple in 2012 and Netflix (NFLX) today – are always about one thing...
Growth!
Investors expect strong revenue growth to translate into fatter profits and higher stock prices. So they pay up for it, mistakenly assuming this growth will continue far into the future.
That was the fatal mistake Apple investors made buying shares during the 2012 surge.
As you can see below, demand for the iPhone, Apple's flagship product and primary revenue driver, was waning just as shares hit a valuation peak...
iPhone growth sharply decelerated during the all-important 2012 holiday season, then continued to decline during 2013.
Apple's price-to-sales (P/S) ratio (its market cap divided by total sales) plunged 47% from September 2012 to June 2013, from 4.04 to 2.16, as the growth story faded.
Investors were suddenly paying a lot less for each dollar of sales...
This setup is the first indicator of an out-of-favor stock worth buying...
"Mean reversion."
Apple's valuation was now well below what had been normal the past few years. This created a significant opportunity for reversion back toward the mean, or average.
There aren't many constants in the investing world, but "mean reversion" is one of them. Think of it as the process of things returning to normal.
As noted value investor Tobias Carlisle writes in The Acquirer's Multiple, mean reversion can turn a great business into an average business... or a bad one into an average one.
This is the crux of it...
Competition eats away at the excess profits of a great business until it becomes average... or causes competitors to leave an industry until the one company that stays earns average profits.
Competition eating away at excess profits is precisely what you see playing out in the chart above. In Apple's case, rivals like Samsung were building smartphones that consumers found to be acceptable substitutes for the iPhone, slowing Apple's market share expansion.
Once the extent of the slowdown became obvious to investors, they sold.
Mean reversion also works on stock prices and valuations. Expensive stocks fall in price and valuation as expectations disappoint. Similarly, undervalued stocks rise as investors' expectations improve. The latter dynamic creates mean reversion opportunities.
When we recommended readers buy Apple in June 2013, shares were trading at a P/S multiple that was 44% lower than its post-Great Recession (2009 to 2012) mean of 3.84.
This meant if Apple's valuation simply returned to its average (i.e., from 2.16 to 3.84) – which we thought was a great possibility – shares could rise 77%.
But the mere existence of a mean reversion opportunity isn't enough.
This brings me to the second indicator of an out-of-favor stock worth buying...
It's the presence of something capable of driving valuation back toward its mean.
In other words, a catalyst...
Keep in mind that businesses usually trade below their mean or average valuations for a good reason, such as dramatically slowing iPhone sales... And many are unlikely to get back to previous valuation levels anytime soon (if ever) because they lack a driver capable of pushing it higher.
Take, for instance, the financial services company Deluxe (DLX), which works with small and mid-sized businesses...
The company's current valuation would have to rise almost 50% to get back to its five-year average valuation...
Revenue growth has diminished due to heavy reliance on its legacy paper checks business. With consumers writing fewer and fewer paper checks each quarter, this part of the business is in terminal decline, causing investors to ignore the stock.
Shares of DLX are down 36% from their all-time high of $77.69 in January 2018.
Desperate for growth, the company is buying its way into adjacent markets, such as managing working capital for financial institutions.
This is a typical strategic move that sounds encouraging. However, there's just one problem... Deluxe will now increasingly compete against strong, entrenched industry leaders like Automatic Data Processing (ADP), Fiserv (FISV), and Paychex (PAYX).
Deluxe's new direction is unlikely to push margins meaningfully higher or generate increasing amounts of free cash flow to support a rising dividend or additional stock buybacks.
And without an obvious improvement in margins, the dividend payout, and/or the number of shares outstanding – all key growth metrics – Deluxe's valuation is unlikely to revert to its mean anytime soon.
Ultimately, improving profit margins and/or growing shareholder rewards drive valuations higher...
Relentless smartphone competition has limited Apple's ability to raise profit margins the past few years.
But the company's enormous cash hoard ($145 billion when we recommended it in June 2013) provided an untapped opportunity to dramatically increase shareholder rewards.
As Dan wrote back in 2013:
Let's say you're like me, a committed lifetime buyer of equities. Your ideal stock is a wonderful business that stays wonderful for decades, gushing cash flow, growing relentlessly in good times and bad... and whose shares remain cheap.
The company's growth and share repurchases will push the share price up over time and still be cheap enough for us to buy...
That opportunity has now been exploited...
Apple bought back $155.9 billion worth of stock from 2013 to 2016 and paid investors $45.5 billion in dividends, compared with only $2.5 billion from 2009 to 2012.
Shares outstanding dropped from 6.6 billion at the end of fiscal year 2012 to 5.3 billion at the end of 2016.
The ongoing reduction in Apple's share count, plus a large and growing dividend (of 10% average growth from 2014 to 2018), attracted more and more investors to the stock during our holding period.
As investors paid higher and higher prices, Apple's P/S multiple eventually reverted to, then surpassed, its 2013 mean of 3.84 by the time we told subscribers to sell in December 2018.
The key lesson is that valuation matters... a lot.
- Buying Apple when it was most hated put smart investors on the right side of mean reversion.
- There was also a clear catalyst to drive the valuation higher in the form of $145 billion in cash on hand, which Apple leveraged into massive shareholder rewards – growing dividends and a much lower share count.
Our four recent 'Golden Age of Value' picks (and the fifth one we're adding this Friday) look a lot like Apple did in 2013...
Valuations of each of these companies are low... The potential for mean reversion is high... And key drivers of those higher valuations are growing shareholder rewards.
Combined, the initial four stocks have $7 billion in share repurchase programs in place and have been actively buying shares this year. The one we're adding on Friday expects to repurchase $16 billion of its stock (about 7% of shares) through next June.
Another has also committed to paying out 65% of net income, primarily in the form of dividends... and its current yield is 5.4%, almost three times higher than the S&P 500's paltry 1.9% yield.
Our first four recommendations are also using cash flow to repay debt, with one reporting it'll pay another $600 million later this year. Reducing debt lowers the claims on cash flow and boosts a company's equity.
There are interesting opportunities for revenue growth and margin expansion as well...
One of our recommendations is planning divestments of lower margin, lower growth businesses. During the company's latest conference call with analysts, its executive chairman noted they're in "7-day a week work mode right now," evaluating different transformational moves.
Another of our recommendations is launching new products that are expected to generate $2 billion of new revenue over the next five years – all of them designed to boost the global production of food.
And a third is in the midst of a new asset-light strategy that's dramatically reducing the cost of its most important asset. We think the combination of improving margins, declining debt, and stock buybacks can push its shares 50% higher in as little as a year.
To get in early on these opportunities when they're at they're cheapest and to get our newest "Golden Age of Value" pick on Friday, click here to learn more about a subscription to Extreme Value.
New 52-week highs (as of 11/1/19): Blackstone (BX), Celgene (CELG), iShares Select Dividend Fund (DVY), SPDR Euro STOXX 50 Fund (FEZ), Hannon Armstrong Sustainable Infrastructure Capital (HASI), Ingersoll Rand (IR), JPMorgan Chase (JPM), Nuveen Preferred Securities Income Fund (JPS), Masco (MAS), Invesco S&P 500 BuyWrite Fund (PBP), Flutter Entertainment (PDYPY), Polymetal International (LSE: POLY), ProShares Ultra Technology Fund (ROM), ProShares Ultra S&P 500 Fund (SSO), Sysco (SYY), AT&T (T), ProShares Ultra Financials Fund (UYG), and Vanguard S&P 500 Fund (VOO).
In today's mailbag, a longtime subscriber shares why he decided to become an Alliance member. What's your story? As always, you can email us at feedback@stansberryresearch.com.
"Porter, I have watched the video and read what you wrote this weekend. I must tell you again... probably many times in the past several years, had I not watched End of America 2000, I wouldn't be writing this. This year I became an Alliance member. Sure, to me it was a lot of money. But I had reached the point where the material that I was getting wasn't enough. I knew there was so much more.
"Now that I have it, I know it was a wise decision. At the end of last year the markets were pretty crappy. My options trading was making and losing money. But I was having fun. I told my wife that I needed to move on from [the returns] I was getting and that we should buy a hard asset instead of relying on the markets... We bought another house and an Alliance membership.
"My Alliance membership has given me access to newsletters that I have wanted for a couple of years. Plus so much more. Thanks Porter." – Paid-up Alliance subscriber Jeff S.
Regards,
Mike Barrett
Orlando, Florida
November 4, 2019