I was going to say there is good news and bad news, but like the wise turtle from Kung Fu Panda says, “there is just news, there is no good or bad”. This post has my thoughts on how I see current market conditions and the opportunities it’s creating (which is the good news part).
With the S&P 500 trading north of 25 P/E and many of the world’s great companies trading at 40 P/E or higher (Costco is now at 55 P/E!), I think we could be at valuation levels that might lead to disappointing results for these stocks over the next 5-10 years, even if the businesses continue to do well (which I expect many of them to do).
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A cut from 40 P/E to a more normal 20 P/E is difficult to overcome over even a long period — a stock that grows earnings at 12% annually for a decade would lead to just a 4% annualized return in the stock if the multiple fell by half over that time. Most of the world’s best businesses today will not grow at 12% annually over the next decade (though a very select few might). It’s far more rare than people realize, especially for companies that grew this fast or faster over the previous decade.
I wrote a post recently about how the largest tech companies are looking very different than they were just five years ago. If the AI spending boom slows down or if demand for AI proves to be somewhat less than expected (or takes longer to materialize, which is what happened in the late 90’s telecom/internet boom), then some of these companies will have excess capacity and lower returns on capital. They became great stocks in large part because their ROIC’s were sky high coupled with a starting valuation of 10-15 P/E in many cases (AAPL, META, MSFT and GOOG all traded around this level or cheaper at times last decade). Now we’re faced with the opposite: much more capital intensive businesses with much higher starting valuations closer to 30-40 P/E.
These are truly great companies and many of them will have continued strong fundamentals. I’ve owned stock in a few of these over the years and I’ve never been opposed to mega-caps, but as a group, I think these stocks have become much riskier. Durability in an investment comes from paying a price that is far less than the stock is worth (a margin of safety). Fragility comes from doing the opposite. Stocks of the world’s best companies can fall into either of those two groups depending on price.
So what’s an investor to do?
The good news is there are lots of opportunities to find great value outside of the mega-caps currently (see a few examples in my recent archives). I think there is an interesting valuation gap emerging between the largest 25-50 stocks and everything else. This has happened numerous times in the past where the large high-quality stocks became expensive while bargains existed elsewhere, most famously in the early 1970’s and the late 1990’s. Both of these periods were followed by a multi-year correction where the expensive stocks fell and the cheapest stocks soared.
In 90’s internet boom, money was flowing into the largest high fliers and out of the “old economy” boring stocks like Berkshire Hathaway, M&T Bank, Fastenal, NVR and Autozone. These stocks and many others lagged during the boom but all soared during the bust and were big winners in the early 2000’s even as the market declined. AZO actually tripled between 2000-2002 as the S&P plummeted 50%. NVR soared 6x during this same stretch, during a recession and a stock market crash.
Stocks like AZO and NVR are household names today, but they weren’t viewed this way in 2000. They were viewed as cyclical, old economy companies with inefficient or outdated business models and their valuations reflected this sentiment. But they were durable (even if not fast growing) companies that produced cash flow and had rational management teams, and eventually, their cheap valuations became a catalyst for future returns for their shareholders.
There are many differences, but I’m noticing some rhymes with the late 90’s and early 2000’s (which corresponds with the time I began investing). I was not investing (or doing anything else) during the late 60’s and early 70’s, but if you study that time you’ll notice some common themes. Two great books on those two boom decades are Bull (the 1990’s) and The Go-Go Years (1960’s).
Walter Schloss is one investor who capitalized on the values that arose after the bust that followed the boom of that latter period.
Take a look at the results he earned in the years after the 1972 Nifty Fifty period:
Source: www.walterschloss.com
In the 10 years following 1972, Schloss’s fund returned 22% annually vs. around 7% for the S&P. After the market downturn of 1973-1974, he had a five year stretch where his fund returned over 30% annually.
I recently went back and reread some of the articles about his approach just out of curiosity to see what types of stocks he was looking at (see full list of his stocks here — my friend Dirt Cheap Stocks did a case study on one of them which compounded at 15% per year for decades and is still around today).
Schloss had a different investment style than my own approach, but he is one of my favorite investors to read about, mostly because of his personality and attitude. His simplicity, common sense, humility and his gracious attitude toward his clients and colleagues are all traits worth emulating.
He compounded his capital at 21% for 50 years, resulting in mid-teen returns net to clients after his share of the profits (he charged no management fee). There are investors who have compounded at higher rates, but I don’t know of anyone who picked stocks for as long as he did that surpassed these results.
Schloss Guest Lecture
I recently re-listened to this guest lecture he gave in 2008. Sometimes it's helpful to go back to basics. Schloss was focused on downside protection, which he prioritized through investing in stocks that traded below an easily identifiable net asset value (he often used tangible book value) and that also had great balance sheets. He used the numbers and ran an insurance type approach that utilized the law of large numbers approach where any one stock might not work out, but “if you have 15 to 20 of them”…
It's amazing how simple Schloss's strategy was and how well it worked. He must have mentioned 10 times "I don't like to lose money" and probably another 10 times warning about debt.
In a nutshell, he was a classic Ben Graham style investor that looked for stocks trading below net asset value. He wanted good companies, but was willing to own average ones if he felt the asset value was there. He didn't talk to management. Wasn't concerned too much with thinking about the company's long term prospects or competitive position, didn't think about the economy or stock market. He just bought value, sold it when the value gap closed, and repeated the process over and over again.
One of the things I like about him was his detached view of the stock market and even his own portfolio companies. He came in at 9am, left by 4:30, and didn't seem to be bothered by bad events (that were inevitable, especially with so many stocks). He once said "Let the Tisch's worry about that" when his son was asking him about his view on some problems going on at Loews, one of his investments.
Schloss’s Longevity - Stay in the Game
One under appreciated aspect of Schloss's approach: it was simple enough for him to manage virtually by himself (with his son) for 5 decades. Compounding works best when you have a long runway. Some track records are incredible but only last a relatively short period of time because it's hard to keep up the required pace and effort needed for peak performance. Schloss found a way to achieve peak performance that also allowed for longevity, and that is absolutely critical to compounding capital.
Other than Buffett, most other managers tend to burn out after a period of time that often isn't much more than a decade: Peter Lynch had perhaps the best mutual fund record of anyone over the period of time he ran Magellan, but he had to retire because "he kept calling his kids Fannie and Freddie" (one of his big positions at the time).
This business can be all consuming. Joel Greenblatt earned 50% annually for a decade before returning outside capital; saying that it was hard to see your net worth drop by such a large amount in one day due to the extreme concentration levels he had. Even Charlie Munger and Warren Buffett ran partnerships that both closed down, coincidentally, after 13 years of operations (of course they found a different path through longevity by owning a controlling stake in an operating business that better suited their personality and goals).
Schloss is one of the rare investors who lasted more than 20 years, and he lasted nearly 50. John Neff is another one who ran money effectively for 30 years, and also coincidentally ran a value strategy that was largely numbers based.
Schloss reminds me somewhat of the tortoise and the hare, although that metaphor doesn't really work because his rate of compounding (21% over 50 years) was anything but tortoise-like. But the fact that he just kept at it, day after day, week after week, year after year is something I really admire and strive to achieve for my own business.
I have another post with a few more thoughts on Schloss along with a recap of some current investment ideas that might resemble some of the valuations that he might have liked back in his day.
Some will think his ideas are outdated, and it’s true that certain aspects of his approach would require new tactics, but I think it’s worth studying successful investors who achieved their success in a manner that’s different from the current conventional wisdom (buy and hold great compounders forever). It’s not that this conventional wisdom is wrong, but when it’s practiced at the extreme, it could lead to results that disappoint the practitioner. Many of Schloss’s ideas are no longer en vogue or perhaps viewed as outdated. Markets go through long cycles and opportunity sets vary within those cycles. I have no idea when or even if we’ll see a market correction, but my hunch is that the opportunities of the next decade might look different from those of the last one. I’m excited about these opportunities and to watch it all unfold.
John Huber is the founder of Saber Capital Management, LLC. Saber manages separate accounts for clients and also is the general partner and manager of an investment fund modeled after the original Buffett partnerships.
John can be reached at john@sabercapitalmgt.com.
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