One of the core tenets of the Valuentum process not only rests in the all-important price vs. value consideration (see Valuentum’s Brian Nelson talk about that here), but also in “letting winners run.” At first read, these two items appear to be at odds with each other. For example, we preach about getting stocks at a bargain, but yet, we don’t sell holdings when they start to move beyond our estimate of their fair value. What gives?
At the Valuentum core, we prefer an entry point that corresponds to the time when shares have substantial valuation and pricing support (i.e. they have high Valuentum Buying Index ratings), and we prefer an exit point when shares have little valuation and pricing support (i.e. they have low Valuentum Buying Index ratings). This is why we add firms to the portfolios when they register a high rating on the index (we consider a high rating a 9 or 10, equivalent to a “we’d consider buying” rating) and remove them when they register a low rating on the index (we consider a low rating a 1 or 2, equivalent to a “we’d consider selling” rating).
The Valuentum process–in scooping up equities at a steep discount to intrinsic value and removing them only when both a) they become overpriced and b) start to “roll over” (come under selling pressure)–is a strategy that, by definition, creates the largest potential profit for any given idea. The Valuentum strategy doesn’t truncate gains as in the case of a pure value strategy, where holdings are sold at fair value or once they become overpriced, and the Valuentum strategy doesn’t expose investors to outsize losses when “mo-mo” (momentum) favorites start to roll over as traders and speculators head for the exit in a hurry.
Someone once told me that if you can’t explain a concept very simply and in a few words, the concept is probably not worth the time. The Valuentum strategy is very simple: we try to find undervalued stocks with strong momentum characteristics. Said even more simply, we try to find underpriced stocks that are going up. We call these stocks Valu-entum stocks. We think the Valuentum strategy meets the ‘simple’ test.
The concept of “letting winners run” (removing firms only when both criteria a and b are met) has worked extremely well in times of irrational exuberance, or in times like today. This “sell discipline” embedded in the Valuentum process is why you haven’t seen us remove strong-performing, yet somewhat more expensive, positions from the portfolios, despite them running ever-higher than fair value in some cases.
The markets today continue to push winners higher, and investors have come up with a whole host of reasons why the stock market may continue to add to gains. First, consumer confidence hit a seven-year high the other day, and many are counting on higher stock prices to fuel a wealth effect that will drive continued earnings growth across many index constituents—and even higher stock prices. You heard that right: the higher stock prices will cause higher stock prices. Circular thinking? Self-perpetuating? Yes…and a very dangerous line of thinking. According to Bloomberg, “the S&P 500 index…has closed at a new high 30 times this year. By this time last year, it had done so 25 times.” It has been an amazingly consistent run higher, and this has us worried.
At this point, you can probably see the wisdom in our reiterating the view that members should keep a cautious eye on the markets, even as we let the portfolios capture the momentum aspect of the Valuentum process by “letting winners run.” Without a doubt, many “pure” value investors have already moved to the sidelines–and we think it’s prudent for investors to be prepared for some type of pullback—sustained or otherwise is yet to be determined.
In the context of the recent stock-market euphoria, we’d think nothing of a pullback of 20% or more. Now is as good a time as any for investors to work with their advisor to decide whether taking on such risk with respect to a dividend holding is worth doing solely for income purposes over a particular time frame. We call this the dividend dilemma. The answer will be different for everybody, as everybody has different risk-tolerances and investing goals. Preparing during good times is much better than scrambling when the market is in freefall.
If you read my interview from a few months ago (1), we fully acknowledged the possibility of the S&P 500 to reach 2,000, as it has done recently, but our fair value of S&P 500 constituents continues to be far lower than that. The momentum aspect of the Valuentum process enabled the portfolios to participate in such large gains. However, as we reiterated in the price vs. value piece here (which touches on the worst blunder in corporate history), prices can get far removed from fundamentals. We’re less than 6 years from the March 2009 panic-bottom, and we’ve practically gone straight up since then, nearly tripling from those lows. Caution not only is the ‘word on the Street’ (thanks to my baby boy for this Sesame Street reference), but it certainly should be.
Though a concentrated portfolio–such as the Best Ideas portfolio or Dividend Growth portfolio, which houses 15-25 firms–really only needs 2 or 3 stellar outperformers to drive away from the pack, bargains continue to be few and far between. The latest tally from Factset ‘Earnings Insight’ puts the forward price-to-earnings multiple for S&P 500 companies at 15.6, above both the 5-year average (13.5) and 10-year average (14.1). The measure is forward earnings, not trailing earnings, which typically is what is referenced for the omnipresent 15 times number, commonly believed to be a proxy for “fair value.” The market is getting frothy.
In any case, you should be very proud of the annualized outperformance of the Dividend Growth portfolio, but please be sure to take steps with your advisor to preserve gains—there’s nothing worse than seeing large paper gains erode. Trust me.
Someone once told me that it’s easy to sell newsletters if you keep pumping out new ideas regardless of the market environment or with little regard to one’s clientele. But I’m interested in something else: your investing success. I’m willing to accept some member turnover to make sure that you get the very best service out there. Our best dividend growth ideas continue to be in the Dividend Growth portfolio.
Please expect the September edition of the Dividend Growth Newsletter to be released later this evening.
(1) Within the next five years, it’s my view that near-retirees or retirees should expect a retracement in the markets to levels below where they are today. That said, we could hit 2000 on the S&P 500 (SPY) before we fall back. You can pick your own index, but I think you get my view of the potential trajectory investors should expect. We’ve stated previously that 1670-1680 is a more appropriate valuation for S&P 500 stocks (price is different than value).The market is a forward-looking, discounting mechanism, and today, optimism about the future and liquidity is running wild. That means that today we have higher embedded long-term growth rates and lower embedded discount rates in stock prices. Over the next 5 years or so, we’ll likely see these two valuation drivers move against investors, as growth rates will be normalized following the recovery and interest rates likely approach longer-term averages. This isn’t anything to get too panicky about, but preparing for such a price trajectory will be important for near-retirees and those in retirement, especially if these investors have the opportunity to pursue alternative vehicles that may preserve capital while providing necessary income needs. If investors need to sell within the next 5 years or so, some profit taking could be a prudent idea. – Nelson, Five Minutes (source), June 18
Interested in the latest firm to register a 10 on the Valuentum Buying Index? Click here.
Interested in higher-yielding entities than those included in the Dividend Growth portfolio? Inquire about the Dividend100 publication.
This article is tickerized for holdings in the SPDR S&P Dividend ETF (SDY), as of September 2.