History of Stock Market Morals
Virtually every major athletic and business endeavor has been governed over long periods of time by a set of standards or morals. In basketball it helps to be tall, in baseball it helps to run fast and throw hard and in football it helps to be physically strong. In business it helps to have capital, sales, profits and free cash flow. We believe that the morality of common stock investing gets unhinged after an extended period of easy money and low interest rates.
The history of the stock market lays some reliable markers for long duration investors when it comes to these morals. First, in the long run, a basket of the cheapest of the stocks in the S&P 500 Index has outperformed the expensive ones by 3.6% per year on average over the last 90 years (Source: Ibbotson Associates). Therefore, the moral of the story is that when you have the chance, we believe you should look to bargain prices in relation to earnings if you seek to outperform indexes and other stock picking organizations.
Second, research from Fidelity Investments driven by the legendary investor, Peter Lynch, showed that long term equity performance was attached to earnings growth. He argued that when the noise of stock price movements was backed out after ten years, that price performance followed closely with earnings growth.
Source: Securities Research Co. and Philip Morris. Data for the time period 7/1/1981 – 12/31/1993.
Next, Ben Inker from Grantham, Mayo, Van Otterloo, proved via a 24-year study that companies with stronger balance sheets, companies which maintain high levels of profitability and companies with very consistent earnings produce index-exceeding performance. There is a morality to these factors in common stock selection.
Source: GMO, monthly data for the time period 1/1982-12/2003.
Fourth, history shows that parabolic manias can make people temporarily rich on paper but end up crushing the capital of anyone who isn’t lucky enough to get out before the financial euphoria episode collapses.
Source: DoubleLine Funds, BofA Merrill Lynch Global Investment Strategy, Bloomberg. Data for the time period 1/1/1977 – 12/31/2018.
In his book, A Short History of Financial Euphoria, John Kenneth Galbraith describes the morals of what to do if you are in such a set of pioneering investments:
“We quickly forget financial disasters and the circumstances that brought them about, and as a consequence, when the same or closely similar circumstances arise again, sometimes in just a few years, they are hailed by a new, often youthful, and always extremely self-confident generation as a brilliantly innovative discovery in the financial and larger economic world.” For Galbraith, it becomes a consistent cycle of “illusion to disillusion and back to illusion…. There can be few fields of human endeavor in which history counts for so little as in the world of finance.”
Why have morals underperformed the last five years?
Unfortunately for investors like us who are conscious of these historical truths, the last five years have pulled investors as far away from the long-term fundamental standards as we’ve seen other than in 1999 and 2000. Why has the market given up on proven historical morals?
It begins with the fascination of pioneering use of technology in artificial intelligence (AI) and data analytics. This technology has overtaken investor attitudes just like other euphoric episodes. In the process, this has pretty much divorced stock pricing away from historical morals and standards. Faith in what is viewed as a nearly-riskless secular trend now rivals the faith in the “Nifty Fifty” stocks of 1972, the dot-com stocks of 1999 and those wonderful new 500 million middle class citizens of emerging markets from 2011.
Source: Bloomberg. Data for the time period 6/30/1972 – 6/30/1975.
Source: Bloomberg. Data for the time period 12/31/199 – 3/28/2003.
Source: Bloomberg. Data for the time period 3/31/2011 – 3/29/2019.
The wonderful demographics and the easy money/low rates of the last nine years haven’t yet coalesced into a secular trend that active investors can ride. When we look at housing starts adjusted by population and think about combining 95 million millennials with trillions of dollars of financial-crisis-induced liquidity, we wonder if you need artificial intelligence or any significant level of intelligence to appreciate how much demand for housing we can have.
Source: Fundstrat, “The Long Game,” 2019 Strategy.
Since the Fed can’t see the whites of the millennial boom eyes, they have panicked into a lower-for-longer mode on interest rates, which turns right around and unhinges stock market participants further from the morals and standards which have governed success in long-term time periods. When money is cheap and economic growth is hard to come by, the stock market loves a good revenue growth stock story or investing in the hottest new technology company.
The good news is we have entered the crazy stage. Wall Street stands ready to flood the stock market with initial public offerings (IPOs) of money-losing companies whose business model is built around the AI and data analytics, which matches up with the current financial euphoria episode. First Lyft and Uber, along with a panoply of other money-losing tech unicorns will make their debut. My 39 years on Wall Street helps tell us that exciting companies priced without a connection to the morals and standards of history are not only sexy as hell, but have a high probability to take your investment results to Hades in the next ten years.
How to trust the morals
First, we believe, from the accompanying chart, that you can trust the demographics to lead you to the secular trends which can make you money without selling your investment discipline’s soul to the financial euphoria devil.
Source: Fundstrat, “The Long Game,” 2019 Strategy.
Second, we will stick to our eight criteria for common stock selection which have never changed or wavered. These criteria are anchored in the standards and morals which have proven true over all recorded stock market history. When the demographics and easy money explode together, having your own capital, generating high free cash flow and showing consistent profitability could shine as interest rates rise. When tech goes through one of its many cyclical downturns, we will smile as we watch investors around us wail and gnash their teeth.
Lastly, the CEO of one of our largest holdings, Discovery Inc. (DISCA), said recently that the most popular channel among 25-year-old U.S. women is HGTV. Outside of HGTV, the most popular show among those same 25-year-old women is TLC’s 90-Day Fiancé. Unless we are missing something, this is not very different from what polls said 20 or 40 years ago. The difference today is these 25-year-old women are the most college educated group in U.S. history and will be in charge of future households and businesses. Their interests are tied much closer to the historical standards and morals which have driven long-term equity performance. Thank you for being on the journey of patience with us.
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. The price-earnings ratio (P/E Ratio) 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. 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. Parabolic mania, or a bubble, is an economic cycle characterized by the rapid escalation of asset prices followed by a contraction. 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. Volatility is a statistical measure of the dispersion of returns for a given security or market index.
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 Washington. 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.
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