March 21, 2019
As we begin managing an absolute return strategy again, Jayme are I are putting considerable thought into portfolio positioning. Given our belief most small cap stocks are significantly overvalued, liquidity and capital preservation are on the top of our minds. Since our goal is to generate attractive absolute returns over a full market cycle, we are attempting to position the portfolio to defend against and take advantage of the end of the current cycle.
As full-cycle investors, we place significant emphasis on late-cycle positioning and performance. We view it similarly to a gymnast’s routine. A gymnast can get everything right throughout most of the routine, but until the gymnast dismounts and sticks the landing, the routine is incomplete. If the gymnast falls after dismount and fails to stick the landing, suddenly the gymnast’s past performance becomes a fading memory. During 2000-2002 and 2008-2009, getting the end of the cycle wrong, or failing to stick the landing, ruined many full-cycle routines.
So how do investors get the end-of-the-cycle landing right? Some would argue what’s in a portfolio matters most. Obviously, what an investor owns is important, but we believe what isn’t owned can be equally, if not more important. In our opinion, the securities investors avoid can be the difference between an end-of-the-cycle soft and hard landing.
What investments are we avoiding? Our list starts with the most obvious and important—equities trading over our calculated valuations. While there are many ways to lose money in small cap stocks, the easiest to avoid, in our opinion, is overpaying. Given the heights small cap valuations have reached this cycle (see below), we believe the risk of overpaying is very high.
In addition to stocks trading over our calculated valuations, we’re avoiding businesses that exceed our financial risk guidelines. Specifically, we’re excluding companies with debt-to-free cash flow ratios above 5x. Our financial risk thresholds are meant to screen out companies that are overly reliant on the generosity of the credit markets and bankers. In effect, we prefer to own businesses that we believe can repay their debt with internally generated cash flows.
With the sharp rise in U.S. corporate debt this cycle (see chart below), a growing number of companies on our possible buy list are failing to meet our financial strength requirements. Higher leverage ratios can also be seen in aggregate leverage measurements. One of our favorites is the median net debt/EBITDA ratio of the Russell 2000 (excluding financials), which has risen from 0.9x in July 2007 to 3.2x in March 2019!
We are also analyzing other liabilities, such as pension plans. Unlike corporate debt, which is typically fixed, a pension’s net liability can fluctuate considerably with changes in pension assets, liabilities, and plan assumptions. At this stage of the market cycle, we are particularly focused on the risks associated with a pension’s assets. For instance, as of July 1, 2018, Briggs and Stratton’s (ticker: BGG) pension had a $959 million projected benefit obligation. With pension assets of $766 million, the plan was underfunded by $193 million. While its net pension liability of $193 million is noteworthy, we believe the potential risk of its pension’s assets is equally important.
At the end of fiscal 2018, Briggs & Stratton’s pension had an equity allocation of 40%, which is similar to the average pension plan. Based on a 40% allocation to equities, what happens to a pension’s assets and net liabilities after a bear market? Using the average decline of the S&P 500 during the last two market cycles as our guide, let’s assume equity prices fall 53% during the next bear market and other asset prices are flat. In Briggs and Stratton’s case, such a decline would result in a $162 million increase in its net pension liability, representing 30% of BGG’s current market capitalization! In essence, by owning companies with large pension obligations, investors may be doubling down on equity market risk—the stock itself and the pension assets.
In addition to financial risk, we are increasingly focused on the mispricing of operating risk. We define operating risk as the expected volatility of a business’s cash flows. During a prolonged period of economic expansion, identifying and measuring operating risk can become more challenging. Also, during economic expansions, we believe it’s important to avoid confusing cyclical growth with sustainable growth. As such, we are currently avoiding cyclical companies that we believe are pricing in unrealistic operating stability and growth rates.
After eliminating a large number of companies with operating and financial risk, we view many of the remaining candidates on our possible buy list as high-quality companies. This should be good news, as we prefer owning high-quality companies near the later stages of a market cycle. However, based on the valuations of many high-quality stocks, it appears other investors have a similar late-cycle strategy. Although such positioning is logical, given current valuations of most high-quality businesses, we believe investors may not be reducing a portfolio’s risk by rotating into quality. Instead, we view the rotation as simply swapping one form of risk for another—valuation risk in lieu of operating/financial risk. Based on what we believe to be elevated levels of valuation risk, we are currently avoiding most high-quality small cap equities.
We’re also seeking to avoid the risks associated with crowds. During most of the current market cycle, we believe ETF and passive fund inflows have affected small cap valuations and liquidity. As the current cycle matures and eventually ends, we want to avoid the risks associated with possible passive fund outflows and forced liquidations. Based on our experience in previous bear markets, we believe the avoidance of crowds and liquidity risk is especially important for small cap stocks.
In summary, as we position the portfolio for the later stages of the current market cycle, we are seeking to avoid: 1) small cap stocks trading above our calculated valuations; 2) excessive financial risk; 3) mispriced operating risk; 4) most high-quality stocks; and 5) concentrated ETF and passive fund ownership.
Given the length of our list, is there anything we’re willing to purchase at this stage of the market cycle? Fortunately, we believe there are things worth owning. First, we are excited about T-bills at this stage of the cycle. In addition to protecting capital, T-bills are very liquid, provide a competitive yield relative to equities, and allow investors to act decisively when future opportunities return.
Second, as it relates to potential equity purchases, we are very attracted to businesses with strong balance sheets. At this stage of the market and credit cycle, we want liquidity in the portfolio and liquidity in the balance sheets of the businesses we own. Many of the companies we are considering for purchase have little, if any, net debt.
And finally, due to our belief that large flows into ETFs and passive funds have impacted valuations and liquidity, we are seeking small cap stocks with below-average passive ownership. This has led us towards companies with smaller market capitalizations, which in some cases are closely held. While they are lesser-known businesses, we believe they are high-quality companies, nonetheless.
While this market cycle feels like a gymnast’s routine that will never end, we are confident it will and are positioning the portfolio accordingly. Until the longest and one of the most expensive bull markets in history concludes, we expect to remain liquid and positioned differently than most small cap managers. While our liquid and different positioning may not be the most popular, it’s exactly where we want to be as we attempt to stick our end-of-the-cycle landing.
eric@palmvalleycapital.com
Past performance does not guarantee future results.
There is no guarantee that a particular investment strategy will be successful. Opinions expressed are subject to change at any time, are not guaranteed, and should not be considered investment advice.
Fund holdings are subject to change and are not recommendations to buy or sell any security. Current and future portfolio holdings are subject to risk. Briggs and Stratton is not expected to held in the Fund.
Definitions:
Russell 2000: The Russell 2000 Index is an American small-cap stock market index based on the market capitalizations of the bottom 2,000 companies in the Russell 3000 Index.
It is not possible to invest directly in an index.
Median EV/EBIT: EV/EBIT represents the Enterprise Value of a company (Market Capitalization – Cash + Debt) divided by its trailing twelve-month Earnings Before Interest and Taxes (i.e. operating income). The Median EV/EBIT of the Russell 2000 represents the middle EV/EBIT value when the ratios of all companies are ranked from smallest to largest.
Debt/Free Cash Flow: The Debt of a company divided by its trailing twelve-month Free Cash Flow, where Free Cash Flow equals Cash from Operating Activities minus Capital Expenditures.
Median Net Debt/EBITDA: Net Debt/EBITDA represents the Net Debt of a company (Debt – Cash) divided by its trailing twelve-month Earnings Before Interest Taxes Depreciation and Amortization. The Median Net Debt/EBITDA of the Russell 2000 represents the middle Net Debt/EBITDA when the ratios of all companies are ranked from smallest to largest.