3Q23 U.S. Value Strategy Newsletter: Honesty is the Policy

Printable Version

If you are a regular reader or have met with us in the last couple of years, you are aware that we have a very dour view of how the US stock market will be impacted by the unwinding of the financial euphoria episode which initially peaked in late 2021. As you can see in the chart below, there has been a triple top in the NASDAQ 100 relative to the S&P 500 Index:


Source: Richard Bernstein Advisors, Bloomberg. Data for the time period 1/1/1985 – 5/25/2023.

In our conversations with investors, we are pointing out the “totality” of this financial euphoria episode. Due to incredibly low interest rates for a long time, we think the history books will look back at this time period as a combination of the 1636 Tulip Mania in Amsterdam and the South Sea Bubble of 1720 combined. Crypto, meme stocks, IPOs and SPACs are representative of the Tulip Mania. The popularity of the Magnificent 7 growth stocks and the addition of the artificial intelligence (AI) mania has added the 1720s growth stock mania to the party. The concentration in the S&P 500 Index among popular tech stocks is breaking all records.


Source: Cypress Capital. Data as of 9/30/2023.

We did a presentation in March of 2009 called “Bull Market Stew.” Our argument was that if you wanted to cook up a good long-term bull market in stocks there were ten ingredients you would throw into the pot.

  1. One or more major Bear Market declines in the prior ten years, preferably with a decline of more than 40% and overall poor multi-year stock market performance.
  2. Historically depressed stock prices, especially among the traditionally most admired companies.
  3. Massive negative psychology among individual and professional investors.
  4. Normally successful and admired money managers are called out on the carpet and in some ways humiliated.
  5. Buy-and-hold investing is viewed as an idea that is no longer useful.
  6. Seemingly unsolvable economic problems as part of a deep recession.
  7. Accommodative Federal Reserve Monetary Policy and fiscally stimulative measures from the US Government.
  8. The public doing 80% of New York Stock Exchange short sales
  9. Cash in money market funds at record levels in relation to stock market capitalization and paying low-interest rates.
  10. Very intelligent and credible economists and analysts are explaining clearly and logically how terrible things are going to be for many years.

Where are we today on those ingredients? To say we are at or nearly at the opposite extreme would be an understatement. Here is one category that is at the opposite extreme.


Source: Bloomberg. Data for the time period 12/31/2022 – 9/30/2023.

We believe this euphoria episode will end badly, but some part of the capital tied up in the episode will work its way into whatever investors gravitate toward in the future. Our job is to find good-performing stocks when it is difficult to make money. We appear to be in the early stages of a commodity super-cycle and believe there is a once-in-a-lifetime opportunity in oil and gas shares:

Second, oil and gas stocks have dramatically underperformed the price of oil this year and have created what we believe is an excellent short-term buying opportunity in the industry. This is exemplified by the announcement on Friday, October 6th that Exxon is in talks to buy Pioneer Natural Resources. We have made the case that with incredible political pressure to not drill for oil, that the major players in the industry that would like to extend the life of their company must drill for oil on the NYSE. We would not be shocked if in 10 years, 40% of the existing companies will have been merged into larger entities.

The two charts below show you how extreme the position that consumers and the US Federal Government have put themselves in when it comes to US crude inventories and days left in the strategic oil reserve.


Source: BofA Global Research. Data for the time period 1/1/1982 – 12/31/2022.


Source: BofA Global Research. Data for the time period 1/1/1982 – 12/31/2022.

Third, if you are skeptical about whether inflation will cease to be a problem because of what the Federal Reserve Board has done with interest rates, look at the chart below. You can see how closely this commodity cycle appears to be tracking with the last two commodity super-cycles:


Source: Bloomberg and Wells Fargo Institute. Data for the time period 10/4/1971 – 3/13/3023.

We also see great opportunities in large-cap stocks in industries that benefit from the upcoming dominance of the Millennial age group (92 million strong). The inverted yield curve and the Fed tightening are scaring people away from economically sensitive businesses that should benefit the most from the fact that there are 40% more Millennials in the 27–42-year-old age group than the Gen Xers who preceded them. Any economic contraction that would bring interest rates down would kick in strong economic activity from this powerhouse population group.


Source: Cypress Capital. Data for the time period 1/1/1995 – 12/31/2020.

For this reason, we like home builders, financial institutions and retail-oriented companies that will feed off the Millennial move to the suburbs like D.R. Horton (DHI), American Express (AMEX) and U-Haul (UHAL). Our portfolio trades at a P/E ratio of 11.47, while the S&P 500 Index trades at 17.40 P/E based on 2024 analyst estimates. This era is providing us the opportunity to own high return-on-equity companies trading at very depressed prices relative to the average stock and at a huge discount to the shares dominating the S&P 500 Index. We thank our investors for their confidence and patience with our long-term discipline.

Fear stock market failure,

_______________________________________________

The recent growth in the stock market has helped to produce short-term returns for some asset classes that are not typical and may not continue in the future. Margin of safety is the difference between the intrinsic value of a stock and its market price. The price-earnings ratio (P/E Ratio or P/E Multiple) measures a company’s current share price relative to its per-share earnings. Alpha is a measure of performance on a risk-adjusted basis. Beta is a measure of the volatility of a security or a portfolio in comparison to the market. FAANG is an acronym for the market’s five most popular and best-performing tech stocks, namely Facebook, Apple, Amazon, Netflix and Alphabet’s Google. Growth investing is focused on the growth of an investor’s capital. Leverage is using borrowed money to increase the potential return of an investment. Momentum is the rate of acceleration of a security’s price or volume. The earnings yield refers to the earnings per share for the most recent 12-month period divided by the current market price per share. Profit margin is calculated by dividing net profits by net sales. Quality is assessed based on soft (e.g. management credibility) and hard criteria (e.g. balance sheet stability). Value is an investment tactic where stocks are selected which appear to trade for less than their intrinsic values. The dividend yield is the ratio of a company’s annual dividend compared to its share price.

The information contained herein represents the opinion of Smead Capital Management and is not intended to be a forecast of future events, a guarantee of future results, nor investment advice.

Smead Capital Management, Inc.(“SCM”) is an SEC registered investment adviser with its principal place of business in the State of Arizona. SCM and its representatives are in compliance with the current registration and notice filing requirements imposed upon registered investment advisers by those states in which SCM maintains clients. SCM may only transact business in those states in which it is notice filed or qualifies for an exemption or exclusion from notice filing requirements. Registered investment adviser does not imply a certain level of skill or training.

This newsletter contains general information that is not suitable for everyone. Any information contained in this newsletter represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. SCM cannot assess, verify or guarantee the suitability of any particular investment to any particular situation and the reader of this newsletter bears complete responsibility for its own investment research and should seek the advice of a qualified investment professional that provides individualized advice prior to making any investment decisions. All opinions expressed and information and data provided therein are subject to change without notice. SCM, its officers, directors, employees and/or affiliates, may have positions in, and may, from time-to-time make purchases or sales of the securities discussed or mentioned in the publications.

This Newsletter and others are available at smeadcap.com

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