Dear Clients and Friends,
As the world grapples with the most serious pandemic in 100 years, as central banks undertake unprecedented steps to stabilize financial markets, and as citizens demonstrate around the world for equality and social justice, it is tempting to believe Sir John Templeton’s words no longer apply and that this time really is different.
When it comes to investing, there are popular narratives that come and go, and there are principles that are enduring. In our opinion, a key enduring principle is the idea coined by Benjamin Graham when he wrote that “In the short run, the market is a voting machine—reflecting a voter-registration test that requires only money, not intelligence or emotional stability—but in the long run, the market is a weighing machine.”1
Throughout history there have been unexpected, dramatic events that caused markets to behave more like a voting machine. At these times, market participants tended to extrapolate current events while disregarding classic fundamental measures such as earnings power, balance sheet strength, etc. Such events can produce stock prices that become untethered from company fundamentals. While it can take a long time, the weighing machine is likely to eventually sort through the noise and penalize stock prices that are not supported by fundamentals while rewarding those that are. Indeed, the chart below shows that since 1987, valuation has been a critical element of subsequent long-term stock returns.
Valuation Is Almost All that Matters for Long-Term Stock Returns
Price to Normalized Earnings Predictive Power on Subsequent Holding Period Returns (Since 1987)
CORRELATION OF VALUATION WITH FUTURE RETURNS, 12/31/1987 to 12/31/2019. Source: BofA Global Research, US Equity Strategy in Pictures, 6/8/20. Past performance is not a guarantee of future results. It is not possible to invest directly in an index.
The relationship between fundamentals and price, and the opportunity to purchase companies at discounted prices has been—and will always be—a key tenet of value investing. We believe it is a mistake to suggest this time is different. While the COVID-19 environment has undoubtedly favored some businesses and hurt others, in our experience the voting machine tends to over-inflate prices for favored businesses and over-penalize prices for un-favored business. This has happened over and over and is why we do not believe this time is different.
Consider for a moment how the voting machine works. There is now widespread consensus that interest rates will remain low and that a low interest-rate environment is a headwind for value investors. That interest rates will remain low is a reasonable assumption and we don’t necessarily disagree. However, remember the adage “what’s good for the goose is good for the gander.” As one of our senior analysts, Brian Matthews, noted recently: “I see some disconnects with the thesis that lower interest rates justify higher multiples. First, if that were the case, then one might expect Europe and Japan, both of which have negative interest rates, to trade at a P/E (price/earnings) premium to the U.S., and they do not. Second, during the last two major interest rate downcycles in the U.S. (the popping of the tech bubble and the global financial crisis), the P/E multiple on the US market contracted. Third, the argument that lower rates justify higher P/E multiples seems to be selectively applied to growth stocks but not to value stocks. For example, market commentators are quick to use lower rates to justify the ever increasing multiples of the FAANG stocks, but since the Federal Funds Rate affects the entire economy, then shouldn’t the multiples on, say, steady, growing, cash generative pharmaceutical companies go up too? Instead we have seen multiple expansion primarily for growth stocks while value stocks have not enjoyed much, if any, rerating. This leads me to the conclusion that either growth multiples could decline or that value multiples are due for a big catch-up.”
With a clear focus on company fundamentals and a long-term investment mindset, we at Brandes have built a repeatable process to estimate the true value of a business. Building portfolios with this bottom-up process will, we are convinced, do well if or when the market shifts back to being an impartial weighing machine.
As we consistently encourage our clients and friends, review your asset allocation and make sure that you are appropriately diversified and have carefully considered your exposure to the value style and to international markets—two areas that we view as being extremely compelling from both an absolute and relative return perspective. We welcome an opportunity to speak with you about the opportunities we see around the world with “unpopular” companies that, in our opinion, have attractive fundamentals, excellent margins of safety, and exceptional long-term appreciation potential.
Brandes Investment Partners
1 Warren Buffett, Berkshire Hathaway, Inc., letter to shareholders, March 1, 1994
Price/earnings: Price per share divided by earnings per share.
Normalized price/earnings: Price per share divided by earnings adjusted (or normalized) for one-off items such as restructuring costs, gains or divestments, etc.
Multiple expansion: A change in share price without a corresponding change in valuation multiples.
Correlation: A measure of the extent to which two variables move in relation to each other.
R-squared (R2): In general, the percentage of a security or portfolio’s results that was likely caused by the movements of a benchmark index.
Federal Funds Rate: The interest rate at which a depository institution lends reserve funds maintained at the Federal Reserve to another depository institution overnight.
The S&P 500 Index measures equity performance of 500 of the top companies in leading industries of the U.S. economy.
The margin of safety for any security is the discount of its market price to what the firm believes is the estimated intrinsic value of that security,
This material is intended for informational purposes only. The information provided should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any security transactions, holdings or sectors discussed were or will be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance discussed herein. Strategies discussed herein are subject to change at any time by the investment manager in its discretion due to market conditions or opportunities. The Brandes investment approach tends to result in portfolios that are materially different than their benchmarks with regard to characteristics such as risk, volatility, diversification, and concentration. Market conditions may impact performance. International and emerging markets investing is subject to certain risks such as currency fluctuation and social and political changes, differences in financial reporting standards and less stringent regulation of securities markets which may result in greater share price volatility.
The foregoing reflects the thoughts and opinions of Brandes Investment Partners® exclusively and is subject to change without notice. Brandes Investment Partners® is a registered trademark of Brandes Investment Partners, L.P. in the United States and Canada.