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  • Eric Cinnamond

This is Not 1999

<February 25, 2020>


The year 1999 was a very difficult period in my life and career. I was 28 years old and had recently left the Evergreen Funds to join a small investment management firm. Leaving an established asset manager was a risky move. However, based on my experience since beginning my career in 1993, I was confident I’d prove myself with the new firm and strategy.


I began managing the new strategy in October 1998. The portfolio consisted of many of the small cap equities I recommended at the Evergreen Funds. For the most part, they were traditional small cap value stocks with strong balance sheets and attractive price to free cash flow multiples. It was the type of portfolio that worked well for me in the past and I saw little reason why it wouldn’t work again. Little did I know, a technology bubble of epic proportions was about to inflate, challenging almost everything I knew about investing.


The Nasdaq Composite was trading at 1,612 on October 1, 1998. Over the next year and a half, the Nasdaq soared to 5,132 by March 10, 2000. It was breathtaking to watch. I say “watch” as I did not participate, nor did the clients invested in the portfolio I was managing. My relative and absolute performance paid a heavy price for refusing to purchase technology stocks. In fact, I was one of the few portfolio managers in the country that somehow found a way to lose money in 1999, even as the Nasdaq rose 86%!


I was devastated professionally and began questioning my investment philosophy and discipline. Things were so bad, I even enrolled in graduate school! I concluded the investment world had changed and I might need to find a new occupation. And if things weren’t bad enough, I lost a large patch of hair on the back of my head from an immunity disorder caused from the associated stress. So, there I was, preparing to go back to school and missing a big chunk of hair on the back of my head—a constant reminder of how bad of an investor I’d become. Good times!


Although it was a difficult period to remain disciplined and committed to value investing, there was a bright side. As capital flooded into technology stocks, a broad section of the equity market was being neglected and was selling at very attractive valuations. Small cap value stocks—my area of expertise—were particularly cheap. Looking back, it was a fascinating time to be a value investor. Performance may have been awful, but the opportunities were wonderful.


That was the beauty of the technology bubble and 1999. If you could handle the underperformance, it was possible to not only protect capital by owning stocks with large “margins of safety”, but you could even make money when the bubble popped! And that’s exactly what happened. Investors who avoided growth and bought value in 1999 were ultimately rewarded with attractive absolute and relative returns. In fact, the collapse in technology stocks in 2000-2001 and the capital flow into value stocks in 2001-2002 saved my career. And, as a bonus, my hair grew back!


Fast forward to the current market cycle, and value stocks are again significantly underperforming growth stocks. The performance dispersion between small cap value and small cap growth has been particularly noticeable. From the beginning of the current market cycle through February 18, 2020, small cap growth has increased 494% versus a 300% increase in small cap value.



The significant underperformance of value relative to growth has caused some investors to ask if value stocks currently represent an opportunity similar to 1999. Before we attempt to answer this question, we thought it would be useful to review what many of the value stocks in our opportunity set looked like during the tech bubble. To illustrate, we went through our current possible buy list and found all of the stocks that were members of the Russell 2000 Value Index in 1999. We then compared their enterprise value to operating income (EV/EBIT) valuation in 1999 to their most recent valuation.



As illustrated above, the valuation of these formerly labeled “value” stocks has increased meaningfully since 1999. Specifically, the average valuation of the group has increased from 9.8x EV/EBIT in 1999 to 22.7x EV/EBIT (19x EV/EBIT median). Although we agreed with their “value” labels in 1999, value is no longer how we’d describe this subsection of our possible buy list. In fact, considering most of these businesses are mature and slow-growing, we’d label their valuation as expensive or overvalued.


In our opinion, during the current market cycle, the transition from value to overvalued has not been limited to our possible buy list. As can be seen in the chart below, small cap value stocks in aggregate (represented by the Russell 2000 Value ex-financials) have also seen significant multiple expansion.



Based on our review of valuations within our possible buy list and small cap value stocks in general, we do not believe opportunities in most value stocks are attractive like they were in 1999. In effect, the relative underperformance of small cap value stocks has not translated into meaningful value in absolute terms, in our opinion. Furthermore, based on our equity screening and bottom-up valuation work, we’ve found many stocks currently labeled as “value” have different quality attributes. Unlike 1999, when many high-quality businesses were classified as value stocks, the values we are finding today often carry above average operating risk, such as energy stocks (see Opportunities in Energy), or above average financial risk (see Friends in Leveraged Places). And while we believe there may be value in these areas of the market, the risks, in our opinion, are considerably higher than the numerous high-quality value stocks we were considering in 1999.


The current market cycle has been very long and frustrating for disciplined value investors. In fact, it’s been the most expensive and broadly overvalued opportunity set we’ve ever encountered. While we sympathize with value investors attempting to remain invested in such an environment, we do not share the belief that the current opportunity set in value stocks is as attractive as 1999. Our view is based on objective valuation measurements and our subjective assessment of quality. Throughout much of the tech bubble, there was a plethora of opportunities in high-quality businesses categorized as value stocks. As much as we’d like to conclude the same today, this is not 1999.

eric@palmvalleycapital.com




The Palm Valley Capital Fund can be purchased directly from U.S. Bank or through these fund platforms.


Index performance is not indicative of a fund’s performance. Past performance does not guarantee future results. Current performance of the Fund can be obtained by calling 904-747-2345.


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.


References to other funds or products should not be interpreted as an offer of those securities.


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.


Definitions:

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.

Price to Free Cash Flow: A valuation metric that uses the market value of an equity and divides it by free cash flow, or cash from operating activities minus capital expenditures.

Margin of safety: the difference between the estimated intrinsic value of an investment and its price.

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. One cannot invest directly in an index.

Russell 2000 Value: The Russell 2000 Value Index is an American small-cap stock market index that includes Russell 2000 companies with lower price to book ratios and lower historical and forecasted growth rates.

Russell 2000 Value ex financials: The Russell 2000 Value Index ex financials is the Russell 2000 Value index (definition above) excluding financial companies. Russell 2000 Growth: The Russell 2000 Growth Index is an American small-cap stock market index that includes Russell 2000 companies with higher price to book ratios and higher historical and forecasted growth rates.

Nasdaq Composite: The Nasdaq Composite is the market capitalization-weighted index of over 3,300 equities listed on the Nasdaq stock exchange.