Know what you own, and know why you own it.
In his prime, few would bet against Peter Lynch or his insights. During his 23 years running Fidelity’s Magellan Fund, he averaged double digit annual returns and assets grew more than 80-fold. Yet, for all his success, we wonder what investors would make of his words today—based on comments heard lately, probably not much.
At a “best ideas” conference we recently participated in, portfolio managers from top firms around the country pitched what they saw as surefire investments. Talks focused on fascinating businesses and great growth projections. The one thing missing? Valuations of the companies.
Case in point, when a portfolio manager was asked what would make her sell the stock she was touting, she answered by giving a market cap target—no price-to-earnings, or cash flows, or any other valuation metric. If sales are projected to jump, buy it! Forget the price.
This was just one event, but it echoes the drumbeat we’ve been hearing for many months: “Valuations don’t matter.” The indifference toward valuation is troubling given the level of angst in the market.
A look at the most recent AAII survey shows that 38% of investors have no sense whether the markets are heading higher or about to drop. Throw in the 33% who are bearish and you are left with just 29% who think equities will rise in the near term.
Following the Brexit vote last month, we saw how quickly anxiety can turn into selling. The surprising results heightened concerns already out there and raised fears of challenges still unknown.
So what are the question marks investors are focusing on? Here are a few culprits:
Sluggish gross domestic product (GDP) growth
An earnings recession
Muddled messages from the Federal Reserve
Global economic and political uncertainty
This backdrop appears to be pushing investors toward what makes them feel safe—bonds and Index funds. The chart shows the flood of money going to passive products. By spreading bets across hundreds of stocks, they hope to insulate themselves from risk. But a look at recent winners in the popular benchmarks raises more concerns than it answers. The top 20 performing names in the S&P 500 Index are trading at 40x 2016 earnings. On a price-to-book, they’re at 6x. Debt levels also leave little room for error.
Net Flows Into Domestic Equity Index Funds
*Annual data updated in May for prior year, includes Exchange Traded Funds.
Source: Investment Company Institute and © Copyright 2016 Ned Davis Research, Inc., 1/1/1993 to 12/31/2015
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Given the slow-growth economy, these valuations seem unsustainable. Instead of buying 500 companies in an index and hoping the good will offset the bad, we believe the best approach is to follow Lynch’s words and know what we own and why. That means bottom up analysis, scouring balance sheets, and grilling management.
A good example of this discipline is holding MDU Resources Group, Inc. (MDU), a $4 billion Utility with construction, pipeline, and energy services businesses. It reported solid earnings thanks to recently approved rate increases. We think overlooked potential lies in its construction services and materials units. Backlogs for both groups grew considerably and the aggregates business could see improved margins in the quarters ahead.
Based on our work, it is trading at a 20% discount to the sum-of-its-parts, offers a healthy dividend, and MDU’s diversified business should provide multiple avenues to continue to grow. We took a position in the company when it was trading at 1.4x book value—significantly below the average of the S&P 500.
As active managers we agree with Lynch on the importance of knowledge, and knowing our portfolios show compelling values gives us peace of mind when uncertainty runs rampant.
We thank you for your continued trust and confidence.