Q1 2021: Is A Rotation Underway?
We interrupt the regularly scheduled growth stock bull market to alert you that value stocks have been on a tear. For comparison, since September 1, 2020, large US growth stocks are up 6.3% while small US value stocks are up 44.2%. This has added a long-awaited reward to diversified portfolios. We’re hoping the return difference persists.
The market forecasts the economy
A change in presidential administration, rapid deployment of vaccines, and a new $1.9 trillion stimulus package have all contributed to exceptionally strong economic recovery expectations. Having been trapped in quarantine for over a year, we have pent up demand. Add to that a fresh round of stimulus checks, and there seems to be a palpable eagerness to spend money, dine out, and get back to normal. The industry consensus is that there will be tremendous economic growth in the second half of 2021, and value stocks have responded!
Theoretically, when the economy recovers from a recession, value stocks do the best. To some degree, they are leveraged by upside in the economy; when the market goes up, they go up a lot more. Think institutional banking, real estate, industrials, and manufacturing. These businesses have high fixed costs, and once those costs are met, the next dollar in sales turns mostly into profit. The market is expecting a strong recovery and has bid up value stocks dramatically over the last 3-6 months. High demand during a recovery causes capital-intensive businesses to ramp up production and grow earnings, for which the market rewards them with high returns.
A common holding in most portfolios, as well S&P 500 index funds, is Berkshire Hathaway. It’s a conglomerate that helps fuel American commerce across a wide array of businesses. Berkshire and its CEO, Warren Buffett, have been beacons for value investors for decades, and Berkshire the business is positioned to do well as profitability recovers and growth picks back up.
Warren Buffett has piloted Berkshire Hathaway since 1965; his co-pilot is Charlie Munger. Together, they’ve trounced the averages since inception, generating a 2,810,526% cumulative return compared to 23,454% for the S&P 500. Due to this astounding investment track record, they are followed by investors of all types the world over. Yet, despite their world beating performance, there is constant chatter about Berkshire’s demise. All investments underperform, and sometimes for long periods. Berkshire has been no different.
The past ten years have been one of those decades of underperformance. Berkshire the stock has generated total returns of 207.8% versus 266.5% for the S&P 500. Berkshire the business has grown its equity value by 184% and its earnings by 236% over the same period. Not too bad considering it has traded at a discount to the market for most of the last ten years. And right now, it has a price multiple of 14x versus the S&P 500’s 28x.
For everyone, and every business, 2020 was a doozy. Berkshire didn’t make any huge purchases, but did buy back about 5% of its shares. In other words, it invested in itself. As of this writing, Berkshire Hathaway the company is valued at $580 billion. They own a stock portfolio worth $281 billion, of which Apple makes up $120 billion. As noted by Buffett, this adds an element of capriciousness to their earnings. They have to adjust earnings based on short-term fluctuations in stock price. But they’re not in their investments for a year, they’re in for a lifetime.
What’s less capricious are Berkshire’s long-term purchases of complete businesses. When Berkshire buys a business, their earnings get merged. You pay a price today and hope to develop a growing earnings stream over time, making it a good investment. A major buy was Precision Castparts in 2016 for $37 billion. So far, it has turned out to be a high price. Berkshire took a $11 billion write down in 2020. It’s kind of like being underwater on your mortgage, except this mistake has a few more zeroes behind it.
Berkshire Hathaway continues to strike us as a sensible long-term investment, though. Its four main pillars: energy, insurance, railroads, and investments continue to grow and remain strongly positioned. In fact, as noted in their annual report, at $154 billion, Berkshire owns more American-based property than any other US company. Berkshire, is in part, a bet on the continued prosperity of America, and is a critical operator of its infrastructure. At a below market valuation and at least average prospects, investors should be rewarded over time.
Estimating future returns
While growth stocks have done exceptionally well the last ten years, it may now be value’s time to shine. Then again, as noted by Buffett, the best companies require the least amount of money to operate, so we’re not about to give up on capital-light technology stocks either. Growth and value will remain important components in diversified portfolios.
To ease the burden of estimation, think of investment returns as having three components. First, you have current earnings yield. Second, you have expected earnings growth. Third, and this is almost impossible to know, you have the price you think someone will pay in the future. Add the three together and you have your expected return. Take Berkshire Hathaway for instance. Its current earnings yield is 7% (earnings divided by price), then assume earnings continue to grow at the average long-term rate of US corporate earnings, 5%. In no way shape or form is this a guarantee or promise, but based on these assumptions, you can estimate that Berkshire will deliver a 12% return over the long-term if it continues to trade at a price-to-earnings ratio of 14x.
A powerful force in the markets is mean reversion. Mean reversion teaches us that a period of exceptional returns should be followed by a period of lean returns, and vice versa. As stock prices change, so do their price-to-earnings ratios. The direction in which it reverts will impact investor returns correspondingly. Empirically, the lower the starting price-to-earnings ratio, the better the future returns. One way Berkshire Hathaway’s returns could grow higher is if investors bid up the price and pay more than a 14x price-to-earnings ratio.
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