“Know what you own, and know why you own it.” — Peter Lynch
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.
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, and 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.
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
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.
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.
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.
Your Heartland Team