How LBW See’s It
The first quarter of 2016 did not disappoint. The S&P 500 hit a quarter low on February 11, 2016 equating to an approximate decline of -10%, falling to what pundits call a correction. How did the S&P 500 finish the quarter? Up approximately 1%. In short, we experienced more than a 10% swing during LBW’s first full quarter - what a ride. The swing was caused by the usual suspects: the continuing commodity rout, the strengthening U. S. dollar, the unpredictable Federal Reserve’s (“Fed”) interest rate moves, and continuing fears of a global slowdown. Was this volatility valid, or in other words, was the market overvalued on a valuation basis?
In order to answer this question, we need to select a metric that gives us an approximation of the overall valuation of the markets. A metric widely used is the Shiller P/E (Price to Earnings) ratio, invented by Yale Professor Robert Shiller. This ratio differs from the normal P/E ratio as it smooths out the net income of the underlying companies over a 10-year period, thereby increasing the accuracy of the metric. As a reminder, LBW does not take a macro point-of-view when investing; however, we do pay attention to how macro factors could potentially impact our individual holdings.
The Shiller P/E, as mentioned, can be applied to the overall markets as well as certain sectors. To determine if the markets are over or undervalued, we need to establish a baseline. For this example, we will use the Shiller P/E for the S&P 500 Index (“S&P”). The Shiller P/E’s historical mean is an adequate candidate and is currently 16.7. As of April 8th, 2016, the Shiller P/E ratio was 25.8, meaning the S&P was overvalued relative to its historical mean. Even during the quarter’s low, the S&P 500 was overvalued, but what about individual sectors? Let’s examine two sectors the media discusses more often than not: Healthcare and Energy. As of January 4, 2016 (first trading day of the year) the Healthcare sector’s Shiller P/E read 30.3 and on February 11, 2016 (the low of the quarter) the ratio stood at 31, an increase of ~2%. On the other hand, the Energy sector, during the same time frame, declined approximately -9%, from 11.5 to 10.5. Healthcare, relative to the Shiller P/E’s historical mean, was overvalued, and Energy, undervalued.
To answer the question posed above, “Was this volatility valid or in other words, was the market overvalued on a valuation basis?”, yes the overall market was, but not every sector. As seen in our sector break down, Healthcare’s Shiller P/E increased while Energy’s decreased. While valuation of the markets on a macro level need to be taken into consideration, it is not the end all. Although the markets are overvalued, this does not indicate that all individual companies are as well. This is important to note because it sheds light on LBW’s and its third party managers’ investment philosophy. LBW and funds such as the Kinetics Paradigm Fund attempt to find value, despite macro factors indicating possible overvaluation, throughout the market’s lifecycle. This leads us into Nathaniel’s Beautiful Mind as he will discuss the Kinetics Paradigm Fund’s investment philosophy in more detail. Welcome to…
Nathaniel’s Beautiful Mind
As you all are aware, we invest our clients’ money with other like-minded value investors, typically via mutual funds. One of these mutual funds is the Kinetics Paradigm Fund (“Kinetics”). Kinetics’ portfolio managers, Peter Doyle and Murray Stahl, have been investing for quite some time. While they are keenly aware that according to the Shiller P/E ratio, the S&P 500 is historically overvalued, they do not let such macro indicators dictate how or when they invest in individual companies. Instead, as Tim mentions above, they seek companies with strong competitive advantages, are run by shareholder-friendly management teams, and are undervalued on an absolute return basis regardless of whether the company’s sector is over or undervalued based on its respective Shiller P/E ratio.
Before we move forward, we need to understand how a ratio such as the Shiller P/E ratio, and others similar to it, are derived and their role in security valuation. For example, a P/E ratio is simply taking the market capitalization of a stock and dividing it by its trailing twelve months’ earnings. Wall Street uses this as shorthand for valuation of a security. But what does this particular ratio actually represent? It provides a glimpse into the security’s valuation based upon its future cash flow earnings discounted back to the present. There are a number of inputs that go into this calculation including discount rate, estimated future ten years’ cash flow growth rate, and long-term growth rate. Suffice it to say, it is a highly subjective process. Generally, the lower a ratio is, the cheaper the security. We value investors then input a Margin of Safety thereby lowering the ratio we’re willing to buy at even further.
Kinetics’ managers will not necessarily shy away from an overvalued sector, like Healthcare, simply because its Shiller P/E ratio might be too high; as mentioned earlier, it is not the end all. This is where the fund’s managers shine. Let’s take one of Kinetics’ top holdings, Texas Pacific Land Trust (“TPL”), as an example. TPL falls under the Real Estate sector classification. As of April 8th, 2016, the S&P 500’s Shiller P/E was 25.8, Real Estate’s Shiller P/E was 57.5, and TPL’s Shiller P/E was ~63.36. Just looking at the high 63 ratio causes your average investor to move onto the next idea. Instead, Kinetics’ managers have done the opposite. TPL is a land trust in Texas with over 900,000 acres. They lease out their land for grazing, mineral royalties, and other such endeavors. Due to fracking technology innovations, their acreage became more valuable as known oil and gas deposits could then be profitably drilled. Kinetics performed their due diligence and determined that the market is too heavily discounting TPL’s acreage value due to the downturn in energy prices impacting TPL’s oil and gas royalty revenues. In the medium-term, Kinetics believes the market will realize TPL’s current price is severely below TPL’s intrinsic value, and will reset accordingly. As energy prices increase (as we and Kinetics believe they will in the medium-term), TPL’s earnings will increase, and that high 63 Shiller P/E ratio will likely decrease as its denominator (earnings) increases.
If Kinetics had moved onto the next idea simply because TPL’s Shiller P/E ratio was 63, they would have missed out, by their estimates and in their opinion, on a severely undervalued security. This is exactly why we invest with Kinetics’ and funds like them - they are willing to dig beneath the surface to find the hidden gems like Texas Pacific Land Trust.