By most measures, domestic equities are fully valued, and in some cases multiples are above their 10-year averages. As value investors we see the stretched metrics as cause for concern. The levels could lead to stock prices remaining flat for several months as the market waits for companies to grow into elevated valuations. A more troubling possibility is that inflated levels set the stage for a deeper sell-off should the economy falter.
Money for Nothing
While we are not making a call on the direction of stocks or the strength of the underlying economy, we think investing in a portfolio of financially sound companies trading at attractive valuations is always a prudent approach. This concept is the cornerstone of our investment philosophy. That’s why we’re puzzled by the unabated flow of assets into passively managed index portfolios that hold stocks regardless of value or strength. As the chart shows, during the past 10 years flows into passive funds has totaled more than $1 trillion while $1.1 trillion has poured out of actively managed portfolios.
Annual Net Flows - U.S. Equity Mutual Funds
Source: FUSE Research Network, 1/1/1993 to 12/31/2016
Data reflects long-term open-end mutual fund flows excluding fund of funds.
The torrent of assets into passive products, we believe, could be contributing to pricing distortions in the major indexes. Market-cap weighted portfolios take nothing into account but market capitalization. As a result, large companies receive a greater portion of each new dollar invested than smaller ones—even if the larger companies have poor valuation metrics. In a sense, each new dollar invested is therefore blindly following other dollars already invested. This herd-following has the potential to be dangerous.
Valuations not for Free
A look at data for the Russell 3000® Value Index through the end of 2016, as pictured below, illustrates how even value-oriented names have seen their multiples balloon. On a price-to-earnings basis, companies in the Index are trading at an 18% premium to their 10-year average. Adding debt into the equation by looking at enterprise value to earnings before interest, taxes, depreciation and amortization (EV/EBITDA) makes a similar case. Based on consensus estimates for 2016, the Index is trading at 13.8x EV/EBITDA, or a premium of more than 25% to its long-term average. The expanded multiples come despite projections that earnings-per-share growth will slow over the next three to five years.
Russell 3000® Value Index Valuations
Source: FactSet Research Systems, Inc., 12/29/2006 to 12/30/2016
Price/Earnings and Price/Sales ratios reflect weighted median calculations; EV/EBITDA ratios reflect weighted average calculations. Past performance does not guarantee future results.
Investors who believe holding a large number of names will mitigate risk may be overlooking the fact that an index approach requires holding some of the riskiest individual names in the market. In contrast, bottom-up analysis allows investors to dig deep into a company and side step those determined to have weak balance sheets, poor management, or diminished prospects for revenue or margin growth.
Out of Sight, Out of Mind
Passive investors have been willing to overlook bloated valuations and business risks for the past several years because the index approach has produced solid returns. However, consider that low interest rates and accommodative Fed policy have resulted in a macro-driven economy and performance that is more tightly correlated among individual names. Both factors have been a significant tailwind for a passive approach.
With rates on the rise, capital allocation decisions should play a greater role in the relative success of businesses. Volatility is also likely to move up in response to policy changes initiated by a new Trump administration. As market gyrations increase, so too will dispersions of returns—a necessary element of outperformance for active investors. Signs of a breakdown in correlations started to appear in November 2016 and we expect the trend to continue.
Prescription for Trouble?
Examples of hard-to-justify valuations and shaky balance sheets can be found throughout the major indexes, and Specialty Pharma provides some clear examples. The group’s leverage stands at 6.4x debt-to-EBITDA—more than double where the group was just three years ago. With rates on the rise, borrowing levels could eat into margins and debt levels will become a greater concern. Instead of taking an index approach of blindly buying shares of every company in the group proportionate to market-cap weights, we have taken a more common-sense approach and turned to fundamental analysis.
By digging deeper into names in the industry, we’ve uncovered AmerisourceBergen Corporation (ABC). Its debt to EBITDA is just 2.2x. The Pennsylvania-based business, along with two competitors, controls 90% of the drug distribution market. Its partnership with Walgreens has helped the company gain economies of scale, which has allowed it to be more aggressive in pursuing additional clients. Despite its attractive balance sheet, shares trade at approximately 7.5x EV/EBITDA.
Specialty Pharma is a single example but not an isolated case. As bottom-up investors we continue to find compelling opportunities in a broad range of sectors and industries. At the same time, our active process allows us to weed out businesses where our research points to an unfavorable balance of risk and reward.
We believe the value of this approach is often overlooked in the debate between active and passive management.