Major reversals in asset-class performance are obvious only after the fact. As much as we'd all like to think that we "knew" when tech had peaked in 2000, or when financials bottomed early last year, the reality is that it's extremely hard to distinguish the day-to-day noise from the long-term signals until things have had time to shake out.
With that caveat in mind, I nonetheless want to begin this commentary by pointing out the massive divergence in performance between bonds and stocks over the past few months. In August and September, we saw a number of bond issuances at record low yields, while equities struggled under the weight of worries that a double-dip recession might be in the cards. At the time, I noted how it seemed curious that investors would happily scoop up fixed-income streams from Treasuries or investment-grade corporate bonds yielding 3% to 4%, while shunning the generally rising income streams available in the equity markets--at substantially higher (7% to 8%) free cash yields.
A specific event caused this curiosity to pop up on my radar screen. In mid-August, Johnson & Johnson (JNJ) issued some 10-year bonds at a yield of 2.95%, which was notable not only because the yield difference (or "spread") on the bonds relative to Treasuries was quite low, but also because J&J shares were yielding 3.7% at the time. The willingness of investors to lock themselves into a fixed coupon of 3% when they could buy a rising coupon--J&J has raised its dividend for 48 consecutive years and has a balance sheet that literally defines "fortress-like"--at a substantially higher yield seemed very strange to me.
Evidently, I was not alone in finding this situation strange. Over the trailing three months, 10-year Treasuries are down about 4%, 20-year Treasuries have shed about 10%, and investment-grade corporate bonds have lost about 2%. During the same timeframe, equity indexes are up between 10% (large caps) and 20% (small caps.) That's one heck of a spread in relative performance over a pretty short time period.
Is this the start of a longer trend, or just a blip? I don't know, but it sure is interesting that the bellwether of bond funds, PIMCO Total Return , recently had its first monthly outflows in almost two years. It's equally interesting that consensus chatter has turned in just a few short months from fears of a second recession to economists hiking their GDP estimates for 2011.
As Warren Buffett is fond of saying--and I am equally fond of quoting--"You pay a high price for a cheery consensus." The consensus surrounding the desirability of fixed-income investments after a decade of falling yields and very strong performance relative to equities has been cheery indeed over the past year or so. Perhaps that cheer is beginning to dissipate just a bit.
Market Opportunities
As the market has rallied last quarter, we're finding fewer no-brainer opportunities. (That's the problem with being valuation-driven--we get excited when everybody else is freaked out, and when most investors get excited, we become more lukewarm.) The S&P 500 has risen about 9% since the end of the first quarter, while our bottom-up fair value for the index has only risen about 2%, to 1,340. So, while we still think the broad market is modestly undervalued, we're certainly finding fewer truly cheap stocks.
Health care and financials remain the two most undervalued sectors, by our estimation, both trading at a high-teens aggregate discount to what we think is fair value. Medical technology companies like Thermo Fisher (TMO) and Covidien (COV) continue to look attractive to us, as do some device companies, such as Medtronic (MDT) and Zimmer (ZMH). In pharma, we're partial to Johnson & Johnson, Pfizer (PFE), and Abbott (ABT).
In financials, we like well-capitalised banks such as Wells Fargo (WFC) and J.P. Morgan Chase (JPM), as well as a few of the asset managers and trust banks, with Bank of New York Mellon (BK) topping our favourites list. Finally, we think some of the credit card lenders still have room to run. My personal favourite is Discover (DFS), but Capital One (COF) also looks cheap.
Every other sector trades within 5%--in aggregate--of our rolled-up fair value estimate, which is not a large enough margin of safety to make much of a sector-wide call one way or the other. There are still, however, some specific stocks that we think offer some upside.
In tech, I would highlight Cisco (CSCO) and Advanced Micro Devices (AMD). Cisco was whacked 17% on somewhat weak guidance earlier last quarter, and by my back-of-the-envelope estimates, the shares are pricing in only 5% growth or so at their current level, a bar which I think is highly likely to be exceeded. I don't think I ever expected the market to value Cisco at a 10% free cash yield--the company should generate about $9 billion in free cash flow this year off of an $85 billion enterprise value--but it seems silly to look a gift horse in the mouth. And a gift is exactly what Cisco is in the $20 range.
AMD is in many ways the polar opposite of Cisco, as the perennial second banana to Intel (INTC) in microprocessors and lacking an economic moat. However, the company is rolling out a new line of chips in mid-2011 that we think have a good chance of taking some market share from Intel in the server market, and AMD shares are currently priced as if Intel retains its 95% share of this market. Just a 10 percentage point gain in market share would approximately double AMD's bottom line, and with expectations as low as they are, the shares seem like a good bet to me.
In industrials, 3M (MMM) shares still offer some value, and our recent visit to the company's analyst day gave us confidence that its culture of innovation is back to full strength after some misguided cost-cutting under prior management a few years ago. Avon (AVP) and Procter & Gamble (PG) are some of the few reasonably priced stocks in the consumer sector, and in energy, I would highlight Range Resources (RRC) and Cloud Peak (CLD), both of which are interesting special situations.
Two Trends Worth Watching
Before signing off, I think it's worth highlighting a couple of trends that bear watching for equity investors. The first is increased M&A, which I view as a short-term positive (people get excited, which drives shares up), but a long-term negative (most M&A is value-destructive). With credit cheap and organic growth opportunities somewhat scarce, it's no surprise that investment bankers are working overtime pitching deals. That's their job, after all. Remember, however, that the bankers get paid whether the deal generates future value or not, and given the increasingly shortened tenure of American CEOs, the person responsible for pulling the trigger on the deal may very well not be around whenever it eventually unravels. As a minority equity shareholder, I think most M&A activity is best viewed with healthy scepticism.
Caterpillar's (CAT) recent purchase of mining-equipment manufacturer Bucyrus (BUCY) is a case in point. At 14 times EBITDA, it was very richly priced, and the projected synergies are not forecasted to bear fruit before 2014. The conference call announcing the deal was quite interesting. Bucyrus' CEO waxed rhapsodic about the continuing high level of demand for commodities, and painted a rosy picture of future demand for his company's products. I just wonder: If the future is so very bright, sir, why are you selling now?
The second trend that bears watching is a sharp increase in the level of share buybacks, which rose 70% in the third quarter of 2010 relative to the prior quarter. A recent Wall Street Journal piece echoed what I think is the likely sentiment of most CEOs concerning buybacks (emphasis mine): "The fewer shares a company has outstanding, the greater its earnings per share. It's risk-free, and has an immediate effect."
This is pure, unadulterated balderdash. If a company's shares are undervalued, and if the company's opportunities for internal reinvestment offer a lower prospective return than buying the shares, then buybacks can increase shareholder value. Of course, management's estimate of the shares' valuation could be wrong, and management could be missing internal investment opportunities--in which case buybacks are a value-destructive activity. If share repurchases are indeed a risk-free way to increase shareholder value, why does the level of buyback activity invariably fall when shares go down, and rise when shares go up? If someone can enlighten me as to how buying high and selling low is a risk-free way to create value, drop me a line.
