Fundamental Value returned 8.3% for the fourth quarter, slightly trailing the market’s return of 9.0%. For the year, FV was up 29.7% vs the S&P 500’s 31.2% return. Since inception in 2016, FV has beaten the market by 4.4% annualized after fees, returning 19.2% annualized.1
FV’s outperformance has come in spite of two material drags. First, FV tilts toward value stocks, which have had weak relative returns (as we have discussed in depth). FV has outperformed the S&P 500 Value Index by 6.7% annualized. Second, FV has carried net cash, averaging a net long position of only 89% and a monthly beta of only 0.83. Despite a much more concentrated portfolio, FV has had 20% lower downside volatility than the S&P 500.
The fourth quarter of 2019 and the beginning of 2020 was one of the calmest periods in S&P 500 history. However, that honeymoon came to an abrupt end as increasing coronavirus fears brought about a week-long crash of over -12%.
We do not want to minimize the severity of coronavirus risks to global trade and global health; undoubtedly, it is a very serious threat to both. Further, we have no special insight into the likely future path of the pandemic. However, we view the coronavirus at this point as more proximate catalyst than underlying cause for the market’s tumble.
When markets are cheap, some things can go wrong with little impact; investments have a margin of safety, and there is room for error should events not turn out exactly as planned. However, when markets are expensive -- as we have argued that they are today -- the market can decline for no reason whatsoever, and any bad news can have enormous effect. As we said back in 1Q17, “sudden and precipitous falls erasing months or years of market gains are common when periods of high valuation are accompanied by deteriorating market action.”
In our 4Q17 letter, we listed many potential catalysts for a repricing of risk in the marketplace. Obviously, coronavirus was not listed. But we knew at the time that the eventual proximate cause of a decline might come from an unnamed source. From 1Q19:
It is important to recognize that our valuation concerns are independent of any of the risks du jour. Our projections for low returns are not predicated on a trade war, or hawkish monetary policy, or slowing earnings growth, or political instability. Lower returns are embedded because of rich valuations; should any of these idiosyncratic risks materialize, that will merely worsen our expectations.
Investors should have expected sudden declines regardless of the idiosyncratic risks presented by coronavirus. The coronavirus pandemic clearly catalyzed and exacerbated the market’s decline, but the likelihood of a quick and severe market slide at the first piece of bad news was baked in.
It is unfortunate to have lost so much ground in so few days. However, given the torrid advance in the S&P over the past six months, this week's decline has only resulted in the erasure of a few months of gains. The S&P has merely been set back to the then-record highs of the third quarter of 2019. Thus, we do not think this is a meaningful correction of still-stretched valuations. The signs of speculative excess and deteriorating market fundamentals are legion.
- Increasing concentration. The market’s advance has become increasingly thin and concentrated in just a few names. The five largest companies are now a higher percentage of the S&P 500's market cap than at any point in the last 40 years. Excluding these five companies, S&P year-over-year earnings growth is zero (and the Russell 2000 is at -7%!). The percentage of publicly-listed companies who are losing money is nearly 40%.
- Frothy sentiment. Sentiment is frothy, leaving us concerned there are few investors with dry powder remaining to support valuations. Professional fund managers are fully invested. Among mutual funds, ICI reported that cash dropped to 2.5%, an all-time low. A BofA Global Research survey found cash levels among other managers at a six-year low. RBC Capital Markets found that among institutional investors bulls outnumbered bears by the highest margin on record. Individual investors are also increasingly involved. This week’s cover story in Bloomberg Businessweek details a trading frenzy among retail investors reminiscent of the excesses of the tech bubble. Retail investors have driven extreme surges in speculative companies like Plug Power, Virgin Galactic, and Tesla.
- Bond market warnings. The yield curve continues to flirt with inversion, suggesting a recession may be near. Corporate debt is at all-time highs, fueled by record-low borrowing costs. Covenant-lite loans -- which offer investors less protection in times of stress and are a sign of investor complacency -- are abundant, amounting to some 80% of all loans issued, up from <10% in 2006. A mountain of debt exists at the lowest investment-grade rating -- twice as much as prior to the financial crisis. Any downgrades could spark a flight from these bonds by the many ratings-sensitive investors who are obligated to hold investment-grade bonds.
Bireme has positioned clients for an increase in market volatility in several ways. In Fundamental Value, we have been adding short positions. We have taken short exposure from 0% in the middle of 2019 to 9% at the end of January, resulting in a conservative net long position of only 78%. We also believe our strong tilt towards value stocks will benefit us when the decade-long bear market in value eventually ends, as we wrote about in detail in 2Q19
. Finally, our primary means of risk control, as always, will be security selection: finding underappreciated companies priced lower than their economic value.
Sooner or later, whether after minor or severe economic damage, coronavirus-specific fears will start to taper. The market may shrug off the effects and quickly make new highs. Or, the market might view coronavirus as a wake-up call and more permanently reassess the price of risk.
Regardless, we will continue to pursue a disciplined, historically-informed and conservative approach for our clients, with an emphasis on risk management. We will not get overly greedy when the market advances or overly cautious when the market declines. At this point, we are content to patiently wait in a defensive position until more attractive opportunities arise.
During the quarter, our biggest winner was Kite Realty Group (KRG), which finished up more than 50% on the year including reinvested dividends.
KRG is a neglected, open-air shopping center REIT that traded at a mere 8x cash flow (aka Funds From Operations or “FFO”) prior to the move upward this year. 8x FFO is quite low for a REIT with high-quality anchor tenants like TJ Maxx, Publix, Lowe’s, and Walmart.
We believed KRG’s valuation was depressed due to representativeness bias. Because of the Amazon-induced “death of retail” narrative, investors had hammered the stock prices of both retailers and their landlords (mostly shopping malls). We feel that KRG was unfairly lumped in with this group as KRG’s open-air shopping centers ought to be more resilient than malls. For one, open-air centers are not dependent on struggling department stores. Instead, they are anchored by grocers, which have been relatively unimpacted by ecommerce to date. Second, a much lower percentage of KRG’s tenants are apparel stores, which have struggled. Where KRG has apparel tenants, they are predominantly off-price retailers like TJ Maxx and Ross, whose success has come at the expense of the traditional mall retailers. Finally, many open-air tenants are service businesses that are untouchable by ecommerce, such as nail salons.
So far, KRG’s portfolio has continued to perform well despite stress among select retailers. 95% of KRG’s square footage was leased at the end of Q3 2019, and the company’s average rent per square foot has grown from $13 in 2014 to $17.70 today.
In addition, the company has recently completed a disposition program of non-core locations. These asset sales have lowered debt levels from 6.7x EBITDA to 5.9x. Management claims that these sales occurred at a cap rate — the ratio of rental operating income to sales price — of about 8%. This suggests the remaining portfolio may be underpriced by the stock market, given that KRG trades at an implied cap rate of roughly 8% and that the assets sold were of lower than average quality. We remain long the stock, which trades at a dividend yield of >7%.
We initiated one new short position in the quarter, Dunkin’ Brands (DNKN), which we find substantially overvalued at 25x earnings and 30x FCF. For our full writeup please see here
DNKN is a franchisor of coffee (Dunkin’) and ice cream shops (Baskin-Robbins). Over the past few decades it has blanketed the US with Dunkin’ locations, ending 2019 with 9,600 US locations. Today, it says it plans to open (i.e., have franchisees open) 200 to 250 net US stores per year. Given meager same store sales growth of 1-2%, limited international success, and the decline of Baskin-Robbins, we think the company is likely to produce limited earnings growth over the next five years.
Competition has been increasing significantly in the retail coffee space. Starbucks will continue to open >500 stores per year while McDonald’s, Panera, and Wendy’s are all refocusing on breakfast/coffee. In addition DNKN ought to fear Caffe Nero and Costa Coffee, two successful European coffee chains which are likely to pursue aggressive US expansions, as well as the continued proliferation of higher-end coffee shops.
One theory to explain the lofty valuation of DNKN is investor enthusiasm for consumer-oriented, lower-volatility stocks -- especially through passive vehicles. Unsurprisingly, the ETF with the largest percentage of its assets in DNKN is a low-volatility ETF (ticker XMLV). The trend in assets in this ETF demonstrates the market’s fondness for this sort of strategy: the AUM of XMLV has risen from <$100m in Feb 2015 to $3.8b today.
When used properly and judiciously by informed investors, ETFs can make the market more efficient. But ETFs can also be a conduit for hot money to rapidly flow in or out of particular themes, distorting stock prices without regard to underlying company fundamentals.
Heuristic-based, valuation-agnostic buying and selling creates opportunities for discerning investors. Exploiting the analytical flaws of other investors is the crux of our investment strategy
on both the long and short side. We believe our DNKN short capitalizes on just such an opportunity.
Ryan and his wife Kelly are thrilled to announce that their first child, Quinn Catherine Ballentine, was born in January. Quinn and her mom are both happy and healthy.
We are grateful for your business and your trust, and a special thank you to those who have referred friends and family. There is no greater compliment.
- Bireme Capital
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1 Net calculations assume a 1.75% management fee. Fee structures and returns vary between clients. FV inception was 6/6/2016.