Extreme optimism took hold of the market as investors responded to approval of a $1.9 trillion deluge of new stimulus spending by the federal government and the rapid rollout of COVID-19 vaccinations. The euphoria led to a widespread runup for equities and drove the so-called Buffett indicator to its highest level in of the past 35 years. The ratio, shown below, compares the market cap of virtually all publicly traded U.S. companies to the GDP of the U.S. As illustrated, investors are paying nearly $1.85 for every dollar of GDP produced—or about 40% more than the historical average. When updated GDP numbers are released in the coming weeks, we expect that ratio to move even higher.
Total Market Cap to GDP
Source: FactSet Research Systems Inc., Quarterly data 3/29/1985 to 12/31/2020. Total Market Cap is represented by the Wilshire 5000 Total Market Index. All indices are unmanaged. It is not possible to invest directly in an index.
Past performance does not guarantee future results.
The buoyant mood reflected by the Buffett indicator led investors to flock to more volatile names and leveraged companies. The willingness to embrace debt-laden businesses continues a trend evident during the past few quarters—but now, investors have finally shown a willingness to look beyond a small pool of large-cap names. The result was outperformance by shares of smaller companies.
The portfolio was up sharply and kept pace with its benchmark, the Russell 2000® Value Index, for the period. Stock selection in Information Technology was strong as were holdings in the Utilities sector. The portfolio’s holdings in Consumer Discretionary were up sharply but lagged the benchmark average for the group.
Healthy growth. The portfolio’s Health Care names were up on a relative and absolute basis and built on strength they enjoyed in late 2020. Phibro Animal Health Corp. (PAHC), was up double-digits for the second consecutive period.
Phibro, an animal health and mineral nutrition company that produces vaccines, microbial products, and medicated feed additives, saw its shares rise after reporting better than expected earnings in February. We anticipate the company should continue to see healthy gains in free cash flow generation in 2021, as it begins to reap the benefits of investments made in 2020.
Additionally, Phibro has seen growing demand for its products as animal production has rebounded following a slowdown in the meat packing industry due to COVID-19. As food inflation has accelerated, we expect Phibro’s products will see increasing demand as the company’s customers look to capitalize on rising protein prices. Despite the favorable outlook for the company, shares trade at 10x estimates of 2022 enterprise value/earnings before interest, depreciation and amortization (EV/EBITDA).
In control. The portfolio’s IT holdings boosted results and we continue to find opportunities in a variety of industries in the space. Methode Electronics, Inc. (MEI) is a manufacturer of electronic controls and components primarily for the automobile and industrial end markets and is an example of the type of business we favor.
Shares of Methode advanced nearly 10% during the period following management reporting solid quarterly results and a robust sales forecast for 2022 along with improving margins.
The company offers an attractive mix of steady revenue from an established core business and rapid growth from its electric/hybrid vehicle, which may see sales double within the next year. Additionally, Methode’s management team has been aggressive in paying down debt and has optimized costs following recent acquisitions.
With Methode shares trading at 7.5x estimates of 2022 EV/EBITDA, we believe the company is an attractive opportunity to capture growing cash flows at a price that could mitigate downside risk.
As bottom-up stock pickers, we continue to focus on individual companies and their ability to succeed in a variety of economic scenarios. However, we also recognize that any unforeseen economic headwinds, higher interest rates or inflationary pressures could be particularly damaging to highly levered companies.
In response, our work continues to center on balance sheet strength and prudent use of capital, and we seek to avoid companies that undertake large-scale transformative acquisitions. Instead, we prefer businesses that are involved in selling off noncore, underperforming business lines or those that have the financial wherewithal to opportunistically make small-scale, bolt-on purchases that further enhance core competencies.
Outlook and Positioning
While we welcome investors’ increased attention to smaller companies, we also think the current “extreme optimism” is overdone. The flood of liquidity injected into the market along with still low interest rates has set the stage, we believe, for future growth to pale in comparison to the artificially juiced numbers many companies are currently forecasting.
The willingness to extrapolate the effects of government stimulus into the foreseeable future is misguided, in our view. While the economic outlook has improved given the development of COVID-19 vaccines, the sustainability of economic growth when government checks dry up is still unknown. The latest government stimulus is likely to offer a temporary boost to production and demand, but we expect the long-term expansion to be tepid due to excessive corporate and government debt depressing the economy.
As such, we are taking a longer view by seeking businesses we believe could be well positioned to weather long-term uncertainty. We believe this tactic will produce a portfolio of companies that should endure when interest rates rise and government stimulus dries up.
Thank you for your continued trust and confidence.