This week's interesting finds

The "season for sharing" list 

Even though things are different this year, we’re keeping one of our favourite holiday traditions –
the EdgePoint gift list. 

We believe gift cards and presents from your local restaurant or a business always make a great gift, especially this year. 

Here’s what’s new in the 2020 edition: 

     • Where possible, we added local Canadian retailers in addition to Amazon links 

     • EdgePoint swag – A mask and long-sleeved t-shirt 

     • Recommendations of products made by businesses in our Portfolios 

We hope all of you stay safe during the holiday season. 

Calming investors’ market anxiety 

Morningstar conducted a study to understand how market downturns can affect investors’ decision-making. Specifically, whether particular pieces of advice from a financial advisor could differently affect investors’ engagement with the market during increased volatility. This study turned up three main findings: 

1. There’s power in seeing increased volatility as an opportunity. Most people preferred to either stay put or sell when they faced the story and historical performance conditions. Only when the situation was phrased as an opportunity did the majority of people buy additional stock. 

2. The active stay active. Across all forms of the experiment, participants who self-identified as active investors were approximately 2.4 times more likely to want to buy during a downturn compared with people who didn’t view themselves as investors. 

3. Emotions matter. Participants who reported experiencing positive emotions during the pandemic were more likely to purchase additional assets across all three forms of the experiment. 

These findings suggest that during a downturn it may be more beneficial to help clients reframe their thinking so they feel positive about investing, rather than to simply encourage them to purchase.

Vaccine research and development has improved massively throughout history

Below are the compiled timelines of vaccine development throughout history, from polio to swine flu, to demonstrate how the pace of research has evolved. 

Four valuation metrics using median S&P 500 Index data 

Plunging prices of cheese 

Cheese prices are plunging as Covid’s second wave drives diners from restaurants. The pandemic is forcing U.S. officials to yet again tighten their grip on eating out, and that’s cutting into prices for cheese and other dairy products across the U.S. Some wholesale cheddar prices have fallen more than 40% this month.

This week's interesting finds

This week’s charts

Reversal of equity outflows

The 60/40 portfolio duration risk has risen recently.

 

Global negative-yielding debt climbed to a record $17.1 trillion, as pandemic-spurred economic damage and monetary stimulus continued to grip bond investors even as news of progress on a vaccine lifted equity markets. 

The % of MSCI World stocks beating the index YoY is up to 39%. 

US equities are at their highest levels on record on a price to sales basis. 

Why value investing still works in markets 

Value investing, defined as buying or selling securities at prices different than their true value, is alive and well. You might not know that by reading headlines in the financial press or witnessing the poor returns of stocks with low multiples of price to earnings or book value per share. 

In recent decades, value investing has come to mean buying stocks with low valuation multiples and selling those with high multiples. However, simply buying stocks with low multiples should not be confused with value investing. 

One reason for the change in how people view value investing may come from Eugene Fama and Kenneth French, professors of finance. They published a much-cited paper which showed that adding measures of size and value to beta righted the relationship between risk and reward. Value investing suddenly became synonymous with buying stocks with low multiples and avoiding or shorting those with high multiples. 

Years later, many investors and market observers still unfortunately conflate value investing with the value factor. Value investing is buying something for less than it is worth. The value factor is an ersatz measure of gaps between price and value. Worse, the relevance of the value factor is fading.

Fundamental value investors should focus on gaps between price and value for individual securities. The present value of future cash flows, not misleading multiples, are the source of value. As Charlie Munger, Warren Buffett’s partner at Berkshire Hathaway, has said: “All good investing is value investing.” The value factor may be floundering, but value investing remains as relevant and useful as ever. 

The Big Lessons From History 

Harry Houdini used to invite the strongest man in the audience on stage. Then he’d ask the man to punch him in the stomach as hard as he could. Houdini was an amateur boxer, and told crowds he could withstand any man’s punch with barely a flinch. The stunt matched what people loved about his famous escapes: the idea that his body could conquer physics. After a show in 1926 Houdini invited a group of students backstage to meet him. One, a guy named Gordon Whitehead, walked up and started punching Houdini in the stomach without warning. 

Whitehead didn’t mean any harm. He thought he was just performing the same trick he saw Houdini pull off on stage. But Houdni wasn’t prepared to be punched like he would be on stage. He wasn’t flexing his solar plexus, steadying his stance, and holding his breath like he normally would before the trick. 

 The next day Houdini woke up doubled over in pain. His appendix was ruptured, almost certainly from Whitehead’s punches. And then Harry Houdini died. The riskiest stuff is always what you don’t see coming. Risk always works like that. In an interview years ago I asked Robert Shiller, who won the Nobel Prize for his work on bubbles, about the inevitability of the Great Depression. He answered: Well, nobody forecasted that. Zero. Nobody. Now there were, of course, some guys who were saying the stock market is overpriced. But if you look at what they said, did that mean a depression is coming? A decade-long depression? No one said that. I have asked economic historians to give me the name of someone who predicted the depression, and it comes up zero. An important lesson from history is that the risks we talk about in the news are rarely the most important risks in hindsight. We saw that over the last decade of economists and investors spending their lives discussing the biggest risk to the economy. This time it was the virus. Out of the blue, causing havoc we couldn’t comprehend.

This week's interesting finds

EdgePoint Videos: Embracing the unknown 

Do you enjoy not knowing what happens next? Other than suspense in movies, people usually prefer feeling like they're in control. But in investing, certainty and comfort are rarely any good. To achieve pleasing long-term returns, investors sometimes need to feel the discomfort of owning businesses that don't offer the short-term peace of mind that most of the market craves. Our latest video explains why successful investors embrace times of uncertainty. 

Latest charts on valuation 

After peaking at +4.5 standard deviations above the mean, the US large-cap valuation spread (the spread in valuations between the cheapest 20% of stocks vs the average stock) has reverted back down to +1.8. Historically speaking this is still a provocative starting point for value. 

The relative trailing P/E of value stocks: 

The relative trailing P/E of the Big Growers: 

After peaking at 5x the P/E of the market, the Big Growers now trade at 3.6x. Historically this group has traded at a relative multiple of around 1.5 – 2.0x. 

Source: Empirical Research Partners Analysis, National Bureau of Economic Research. Big Growers are a group of approximately 75 large-capitalization stocks classified by Empirical Research Partners, LLC to have faster and stronger growth credentials than the rest of the market. Trailing P/E ratios are equal-weighted and relative to the rest of the U.S. large-capitalization universe. 

Unravelling value's decade-long underperformance 

The tendency for value to lag markets for significant periods of time is not historically unusual, and happens whenever a market environment exists where expensive stocks get more expensive; cheap stocks get cheaper; or some combination of both (as we have seen this cycle). Over the past 50 years, it has happened three times in US markets - in the nifty-fifty bubble of the 1960s-early 1970s, in the 1990s dot.com bubble, and over the past decade. In other words, it has happened approximately once every 20 years or so. The only thing unusual about this cycle has been its length and magnitude, which has been somewhat worse than past cycles. 

One of the core reasons that value investing works is that investors systematically overestimate their ability to predict the future. 

A decade ago, investors believed Microsoft was being disrupted by mobile, Apple & iOS, Google Docs and Android. The stock traded for as little as 7x earnings at the time. Suffice to say investors' predictions of Microsoft's imminent demise (a value stock at the time, I might add - something today many people forget) were more than a tad exaggerated. The same can be said of Apple, which was losing money and widely believed to be heading for the bankruptcy courts in circa 2000 - again quite reasonably based on what was knowable at the time - and the stock accordingly traded for less than its net cash. We know how that ended. 

A century of quantitative evidence from market history suggests investors tend to underprice stocks with the most apparently assuredly poor future prospects, and over price those believed to have the most assuredly promising prospects, and there is nothing in the past decade's market experience to suggest that has fundamentally changed. 

What is the smart money saying? 

The impact of successful vaccine rollout on various sectors (“vaccine sensitivity”) 

What's happening with prices? 

While meat inflation (which spiked earlier this year due to supply bottlenecks) is off the highs, prices are still well above last year’s levels. 

And here we have the CPI for cleaning products. 

Fast-food restaurant prices are up sharply. 

Car prices are up. Especially used cars. 

You can buy men’s suits at a much lower price than last year.

This week's interesting finds

This week in charts 

The inverse weight of the Energy sector in the S&P 500 is the best and most consistent explanation of the market's P/E.

Will the election result be a catalyst to change the composition of the S&P 500?

1% out of “Growth and Defense” sectors equates to over 3% increase in Cyclical sectors!

Historically, volatility in the stock market is elevated in the months leading up to an election. This is logical, as the markets hate uncertainty. For investors, it’s important to step back, put personal feelings about politics aside, and objectively assess the situation and what it might mean for your personal finances.

Stock market performance leading up to an election has also been a major indicator of the outcome. The performance of the S&P 500 in the three months before votes are cast has predicted 87% of elections since 1928 and 100% since 1984. When returns were positive, the incumbent party wins. If the index suffered losses in the three-month window, the incumbent loses.

Tonight, we leave the party like it’s 1999

Today, U.S. stock valuations are at ridiculous levels against a backdrop of a global pandemic and global recession. U.S. Treasury bonds – typically a reliable counterweight to risky equities in a market sell-off – are the most expensive they’ve been in U.S. history, and very unlikely to provide the hedge that investors have relied upon.

This is the perfect time to look unconventional, just like in 1999. At today’s valuation spreads, the opportunity set is actually even better. And for those portfolios that are essentially benchmark-agnostic, we believe the opportunity set is the best we’ve seen in our working careers.

In 2020, the economy was destroyed by Covid-19; unemployment went from historic lows to historic highs in a matter of weeks. That should have reasonably dampened the market’s optimistic mood. But it didn’t (after the initial shock of March). The current valuation of the S&P 500 is actually higher than it was pre-Covid-19, which is dangerously odd given the sheer amount of uncertainty that exists (e.g., the shape of the economic recovery, the availability and efficacy of a vaccine, the risk of a second wave, U.S. citizens not adopting safety protocols, just to name a few). 

The real worrisome signs, however, are the increasing silly behaviors of a speculative market. Exhibit 7 is a prime example of the aggressive trading activity of retail investors. 

Though relatively calm for over a decade, this past spring awakened their animal spirits: daily trading activity increased nearly seven-fold over three short months. Bankrupted Hertz rallied 896% in May even though its own management team and the SEC said the company was likely worthless. Nikola, an electric truck maker with no actual earnings, no actual revenue, and…it’s true….no actual manufacturing facility to even make trucks, rallied 692% from April to early June. And then there was Tesla, which was bid up to $400 billion in market cap, making it more valuable than 12 established car companies, combined. The “You just don’t get it, GMO” taunts, the justifications, the mental gymnastics, the outrageous growth assumptions one needs to make to rationalize prices…it is all just too eerily reminiscent of 1999.

Americans have saved an extra $1.3 trillion since the pandemic

If household savings had grown in line with the recent pre-pandemic trend, Americans would have socked away about $2.2 trillion since the start of 2019. Instead, cumulative savings over that time period are worth just over $3.5 trillion. The difference—about $1.3 trillion—could pay for 9% of all the consumer spending that happened in 2019.

This savings boom had two basic causes. First, Americans cut their consumption dramatically. Part of what happened was that the higher-income people who were most likely to keep their jobs while working at home were also the people most likely to slash their spending on virus-sensitive categories such as dinners out and trips to the dentist. They were effectively forced to save because it stopped being safe to go out. Meanwhile, companies borrowed aggressively to offset the decline in sales while the government borrowed to offset the decline in tax receipts and pay for additional unemployment and welfare benefits. The net effect was that consumption spending fell almost 20% in the first wave of the pandemic.

Global energy consumption

Below are the IEA’s projections for electricity’s share of final energy consumption if countries stay on their current course (“Stated Policies Scenario”) and if countries meet the Paris Agreement goals (“Sustainable Development Scenario”). Under both scenarios, electricity’s share grows, but even under the Paris Agreement scenario its share is only 31% of total energy consumption by 2040. Under the Stated Policies Scenario it grows from 20% today to 24% by 2040.

Upstream oil investment needed to meet future demand

This week's interesting finds

Tracking the recovery

The recovery in consumer spending, especially in the low-income category, is now positive YoY, even though employment rates in that category are still down 20% YoY.

The slower recovery in consumer spending by the high income group has had a disproportionate impact on the low income workers living in higher income zip codes because the reduction in consumer spending hit businesses in those neighbourhoods hardest. As these businesses lost revenue, they laid off their employees, particularly low-income workers. Nearly 70% of low-wage workers working in the highest-rent ZIP codes lost their jobs, compared with 30% in the lowest-rent ZIP codes.

Consumer spending by income:

The policy efforts to date haven’t led to a rebound in spending at the businesses that lost the most revenue, and as a result, have had a limited impact on the employment rates of low income workers.

Consumer spending by industry:

Percent change in employment by income:

Percent change in employment by industry:

More on the recovery. 

The Q3 US GDP report noted that the downturn as a result of COVID-19 was led by services consumption which is usually the most stable component of GDP and is also seen as lagging in the recovery. Goods consumption is what’s driving the recovery. This shows how incredibly atypical it is and represents a sharp dichotomy in the economy.

From a policy perspective, if you stop imports, the goods recovery will flow through to employment from fixed business investment. But that’s not the case today.

The importance of entry price

Drawdowns over the past three decades.

Source: S&P Global Market Intelligence

Inflation

Inflation was +1.3% year-over-year in August, and +1.4% year-over-year in September. But here is the breakdown. 

A game of musical chairs

Active managers are under severe competitive pressure.  If they don’t perform they will be removed and the money will go to a passive option, or at least an outperforming peer. Therefore their desire to take significant risk away from the benchmark is low.  Active management has become like a game of musical chairs where it makes sense to hover close to the chairs at all times, rather than risk being at the other side of the room when one is pulled away. 

Allied to this defensive behaviour is the closely related problem of increased short-term thinking.  The threat that most active managers face of being fired tomorrow has profound implications for decision making, both for individual managers and their employers.  Is there any purpose in making a long-term investment decision if there is little chance you will be around to witness it come to fruition?  Indeed, making such farsighted decisions may well hasten your departure. 
 
Success in this game is based on the measurement of performance over increasingly contracted time horizons.  Investors in active funds and managers of them consistently talk about results in terms of days, weeks and months.  This is nonsense.  Financial markets are hugely unpredictable and chaotic, and discerning skill is incredibly difficult.  Over short-time horizons it is impossible. 

This week's interesting finds

Business Applications – Timely Gauge of Real GDP

When Covid struck, new business applications collapsed. But then they soared to a record high by a wide margin. New business applications correlate with U.S. real GDP. This is another economic indicator suggesting significant upside, contrary to the pervasive Wall of Worry.

High-Propensity Business Applications are a subset of total business applications, which includes only applications that have a high likelihood of turning into businesses with payrolls. This avoids applications by laid-off gig workers/independent contractors, and is likely the best representation of “true” new business formations.

The surge in new business applications shows spirits remain optimistic, suggesting strengthening business and consumer sentiment.

There is a 73% correlation between high-propensity business applications, and real GDP growth. Why? New business formations are a function of confidence, both business and consumer. From 2007-2019, business applications led real GDP by 3 quarters.

No price too high

Jim Chanos, the founder of hedge fund Kynikos Associates Ltd., is critical of companies that, he says, are increasingly defining themselves not by revenue or earnings, but by the total addressable market they can win. The idea is “how big is what you’re chasing, forgetting for a second that everybody else is chasing those same markets”. An example is Netflix Inc., which has said their total market “is all the people on the planet”. Chanos said he would “go long any of the space companies that have gone public because we know that space is infinite. There’s no price too high to pay.” His remarks sent shares of Virgin Galactic Holdings Inc. up 7% before paring gains after Chanos said he was just joking.

Domestic China back to Normal?

China Hotel RevPAR grew 24% year-over-year last week. While this is exaggerated by the Golden Week, Morgan Stanley estimates that after adjusting for this holiday, year-over-year RevPAR was flat to pre-pandemic levels.

Note: RevPAR is a metric used in the hospitality industry to measure hotel performance. The measurement is calculated by multiplying a hotel's average daily room rate by its occupancy rate.

Rally powered by assets you can’t see or touch

Take all the physical assets owned by all the companies in the S&P 500, all the cars and office buildings and factories and merchandise, then sell them all at cost in one giant sale, and they would generate a net sum that doesn’t even come out to 20% of the index’s $28 trillion value. Much of what’s left comes from things you can’t see or count: algorithms and brands and lists.

Back in 1985, before Silicon Valley came to dominate the ranks of America’s biggest companies, tangible assets tended to be closer to half the market’s value.

The shift picked up after the financial crisis of 2008 and is taking off anew during the Covid-19 lockdown, with the value of intangible-heavy companies like Google and Facebook soaring while smokestack stocks languish. All of which is a source of deep concern for those who worry about things like employment and inequality.

As a result of those gains, S&P 500 members held more than $21 trillion in intangibles at the end of 2018, more than double 2005. That’s 84% of the S&P 500’s market value, the most ever.

Back in the 19th century, capitalism required large physical investments, such as canals, dams and railroads, which in turn created jobs. That’s true to a much smaller extent now.

Economic recoveries that focus more on intangible investments have increasingly been met with slower labor market bounce-backs. 

Difference between market cap weighted and equal weighted performance

Because the S&P 500 is weighted by a company’s market value, the biggest internet firms have overshadowed declines in several sectors this year. This year, the S&P is outpacing a version of the index that gives every stock an equal weighting by nearly 10%, a gap that would be the highest since the late 1990s.

ESG funds under scrutiny

Investors propelled ESG funds to new heights in 2020 and federal agencies are watching. Inflows into ESG funds peaked in 2020. Many of these funds have recently outperformed the markets, but regulators say they may not be all they claim to be. The tension around ESGs has to do with the way that they’re built. This video goes over various strategies for constructing ESG funds and highlights the lack of standardization and common concerns that investors should be aware of. 

This week's interesting finds

 Coming into Focus

In his latest memo, Howard Marks discusses the unusual characteristics of this year’s economy and the impact of COVID-19 related monetary and fiscal policy actions on today’s markets. Below is one excerpt where he discusses the changes in the composition of the stock market and how that compares to the Nifty Fifty.

Today’s leaders are often compared to the Nifty Fifty, but they’re much better companies: larger; faster growing with greater potential for prolonging that growth; capable of higher gross margins (since in many cases there’s no physical cost of production); more dominant in their respective markets (because of scale, greater technological superiority and “lock in,” or impediments to switching solutions); more able to grow without incremental investment (since they don’t require much in the way of factories or working capital to make their products); and possibly valued lower as a multiple of future profits. This argues for a bigger valuation gap and is perhaps the most provocative element in the pro-tech argument. 

Of course, many of the Nifty Fifty didn’t prove to be as powerful as had been thought. Xerox and IBM lost the lead in their markets and experienced financial difficulty; the markets for the products of Kodak and Polaroid disappeared, and they went bankrupt; AIG required a government bailout to avoid bankruptcy; and who’s heard from Simplicity Pattern lately? Today’s tech leaders appear much more powerful and unassailable.

But fifty years ago, the Nifty Fifty appeared impregnable too; people were simply wrong. If you invested in them in 1968, when I first arrived at First National City Bank for a summer job in the investment research department, and held them for five years, you lost almost all your money. The market fell in half in the early 1970s, and the Nifty Fifty declined much more. Why? Because investors hadn’t been sufficiently price-conscious. In fact, in the opinion of the banks (which did much of the institutional investing in those days) they were such good companies that there was “no price too high.” Those last four words are, in my opinion, the essential component in – and the hallmark of – all bubbles. To some extent, we might be seeing them in action today. Certainly no one’s valuing FAAMG on current income or intrinsic value, and perhaps not on an estimate of e.p.s. in any future year, but rather on their potential for growth and increased profitability in the far-off future.

How long does it take to double your money?
 

Source: @jsblokland  

Do Treasuries still offer diversification benefits?

The rise of retail trading.

China's Share in Global Exports

China’s exports rose 9.9% YoY. Leading the global economic recovery,

Photo contest: Winner!

For this quarter's EdgePoint photo contest, we wanted everyone to stay safe with our "socially distanced" theme. Our contributors put their zoom lenses to work by capturing some really far out shots, but we'd like to congratulate Craig Advice for his photo of canoeing on Lake Louise.