Valuentum Exclusive Analysis for the Discerning Investor

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Read President of Investment Research Brian Nelson's prepared remarks for the yearly roundup conference call, held for Nelson Exclusive members.

If you would like to subscribe to the Nelson Exclusive publication, please learn more about the publication here. The Nelson Exclusive publication does not reflect real performance. Performance is hypothetical and does not represent actual trading.

Ladies and Gentlemen,

Thank you very much for joining us on the first conference call for members of the Nelson Exclusive publication. The first year of the publication has surely been an exciting one for all involved.

When I first wrote the introductory letter of the Nelson Exclusive on July 1, 2016, we were well-aware the market had laid down the gauntlet for this publication. The launch week coincided with news that Britain had voted to leave the European Union, their banks tumbling violently. Broader market valuations were at frothy levels, and interest rates at all-time lows. I noted at the time that the investment-decision landscape was far more complicated than ever before for all types of investors, from those seeking long-term capital appreciation to those seeking targeted income goals. I noted at the time that cyclicals were trading at peak multiples, possibly on near-peak earnings, and even consumer staples equities had reached valuation levels that may be more appropriate for aggressive growth stocks, not mature dividend-paying operators.

I noted in that introductory letter July 1 of last year that the next few years in the markets may be among the most difficult witnessed since the Great Recession. Even a broader market pullback of 20% from the highs set when the publication launched wouldn’t have been abnormal given that the collective market price of S&P 500 companies had effectively tripled from the March 2009 panic bottom. I noted that the launch of the Nelson Exclusive in such conditions could be considered perilous as broader market performance inevitably could act as ballast to the ideas surfaced, should reversion-to-the-mean dynamics take hold. In that spirit, I reminded readers in the introductory letter that not all ideas in this publication will be successful, and some that are eventually successful may encounter tough sledding over extended periods of time.

Let me remind you of what the Nelson Exclusive is and what it is not. What we’re seeking to deliver in this publication is ideas that fall outside the reach of Valuentum’s existing stock coverage universe. We’re breaking down the traditional barriers of equity coverage to identify under-followed ideas across the investing spectrum, delivering in each monthly edition one idea for income investors, one idea for readers seeking long-term capital appreciation, and an idea for those looking for a “short” idea consideration. Not all ideas will be right for you, and you should always check with your personal financial advisor.

We noted that underfollowed ideas doesn’t mean obscure ideas, however, and the ideas that we continue to highlight in the Nelson Exclusive publication will be investable ones, meaning that we’ll avoid thinly-traded instruments and penny stock “traps,” as they might be called. Though we may close an idea for measurement purposes (to reflect what we may do), we highlight a reasonable time horizon for each consideration in the publication, on the very first page that each idea is highlighted. Where applicable, we continue to update our theses on previously-highlighted ideas in subsequent editions. We’ve also said we’ll keep score, tracking the “performance” of ideas over time. Such performance will always be hypothetical.

Let’s now talk about what the Exclusive isn’t. The Exclusive does not constitute individual investment advice, and the ideas within it are not personal recommendations. Each of you reading should always work with your personal financial advisor who knows your individual goals and risk tolerances. I do not. Only you and your personal financial advisor know what’s best for your life circumstances. The personal financial advising markets and what we do at Valuentum via financial publishing are two different verticals in the same industry, but they are different nonetheless. As I noted in the introductory letter, I want to be very clear about this because I can never tell you to buy or sell or hold anything at any time, even if this may be what you want. It’s not that I don’t have conviction in my work – it’s the rules of the business.

Let’s remind everyone the goals that we set forth for this publication in the inaugural letter. AND I QUOTE:

Within the twelve editions of the Nelson Exclusive each year, we’ll be highlighting in total 36 ideas for consideration with varying investment parameters. That’s a lot. Depending on the time horizon set forth with each idea, fantastic performance might mean a success rate of 60%, great performance might be 55%, average performance might be 50%, while anything below that mark may constituent a poor showing. Obviously, I’m aiming for a 100% success rate, but I also have to be realistic. The great Joe DiMaggio may have hit safely for 56 consecutive games in the last baseball season before the United States was thrust into World War II, but he “only” hit .357 that year. That season of ‘41, the great Ted Williams would be the last player to hit .400, meaning that one of the best hitters in baseball…ever…was still called out ~60% of the time.

The greatest investors face a similar paradigm. Stock selection is a process where there will be homeruns and strikeouts…The Exclusive is not a “get-rich-quick” product, and you should keep a close eye on your wallet if you encounter anyone promising anything of the sort. In (each year) of the Nelson Exclusive, I’m going to take 36 swings – they are going to be hard and through the zone, and I’m not going to pull my shoulder out or take my eye off the ball. Market conditions are expected to be stormy in coming years as “reversion-to-the-mean” dynamics rain down, and a crafty left-hander with great “stuff” may be on the mound, but we’re stepping up to the plate and digging in.

We stepped to the plate. How did we do?

First, I have to remind you that performance is hypothetical and only provided for informational purposes. To retain our independence, neither I nor Valuentum will take any position in any idea highlighted, and because the Nelson Exclusive, itself, is not an investable portfolio but a publication, its performance can never be matched precisely by any reader. In any case, we think it is fair for members to know how well or poor some of the ideas have performed from their highlight price to ‘close’ price or current price. We make everything available in the table in each edition of the Nelson Exclusive publication, so you can always review previous ideas there in complete transparency. Through June 3, 2017, prior to the release of the June edition of the Nelson Exclusive:

8 out of 11 income ideas highlighted in the Nelson Exclusive have been successful, or 73%, as measured from highlight price to 'close' or current price.

7 out of 11 capital appreciation ideas highlighted in the Nelson Exclusive have been successful. Excluding the speculative biotech ideas, the tally comes to 7 out of 9, or 77%, as measured from highlight price to 'close' or current price.

An incredible 10 out of 11 short idea considerations highlighted in the Nelson Exclusive have been successful, or 91%, as measured from highlight price to 'close' or current price.

The total success rate, or total win rate, of all Nelson Exclusive ideas--income, capital appreciation, and short ideas--thus far has been ~76% from highlight price to 'close' or current price.

We set the bar high in the introductory letter to members, and we said that the 60% threshold would be fantastic. As you can imagine, I am simply blown away by the ~76% mark on all ideas through June 3. Frankly, I find it surprising, amazing, in a good way, and I could not be more pleased with the idea generation. But I must remind you--past performance is not a guarantee of future results, and it may more unlikely than likely that we put up as good of figure in the coming year. Simply stated, we won’t get everything right, and we have the share of ideas that have not worked out as planned as a stark reminder.

What about the market today? Well, the market is even more challenging than it was last year when I penned the introductory letter to the Nelson Exclusive. The drivers behind this multi-year bull market have been many--ultra-low interest rates and their magnifying impact on equity valuations, strong earnings growth from the doldrums of the Financial Crisis, and the proliferation of passive and dividend-growth strategies de-emphasizing the price-versus-value equation. “Money,” it seems, is chasing stocks at any price, and most of the trading on exchanges has become “speculation.”

According to a recent study by JP Morgan, AND I QUOTE: “‘fundamental discretionary traders’ account for only about 10% of trading volume in stocks today. The majority of equity investors today don’t buy or sell stocks based on stock specific fundamentals. Passive and quantitative investing accounts for about 60%, more than double the share a decade ago.” I ask: Are investors that are counting on income for retirement supposed to be excited about these stats? Are those saving for their children’s college fund supposed to be comfortable parking their assets in a stock market where only ~10% of participants are “paying attention” to fundamentals. Surely this is not something to be proud of. I’m not viewing this statistic positively at all. Is the stock market truly on a firm foundation? It doesn’t appear so.

The financial industry doesn’t seem to care either. After all, times are great--perhaps like the roaring 20s all over again. The stock market continues to set new highs after new highs, unemployment continues to set new lows, and all appears well on Main Street. Those bringing forward concerns about equity valuations today are being mocked. How can this possibly be?

Well, Warren Buffett has been known to quip a time or two that we only know who has been swimming naked when the tide goes out. The stock market is not and never will be a magic generator of wealth, no matter what historical studies going back centuries suggest. The stock market is a market, and it will always be a market (and market participants can become irrational, and they often do). According to FactSet, the forward 12-month P/E ratio for the S&P 500 is nearly 18 times, above the 5-year average of about ~15 times and above the 10-year average of ~14. The forward P/E ratio for consumer staples stocks is nearly 21 times, above its 10-year average of ~16 times.

Even consumer discretionary stocks, trading at nearly 20 times forward earnings may be getting such multiples on near-cyclical peak earnings numbers. What kind of growth is supporting such multiples? Well, excluding the energy sector, earnings growth for the second quarter is expected to be less than 4% for S&P 500 companies. And what happens if President Trump’s initiatives with respect to corporate tax reform fail? 2018 consensus numbers are probably at risk, in my opinion. Forget about the political uncertainty that might be caused under Trump impeachment proceedings, the probability of which may be immaterial. There’s tremendous tail risk regardless.

The forward P/E ratio on S&P 500 stocks isn’t the only measure raising red flags. The Shiller P/E, also known as the CAPE (cyclically-adjusted price-earnings) ratio, is at nearly 30 at last check, about where it stood during the stock market euphoria of 1929 and only lower than the dot-com bubble levels. The historical mean of the CAPE ratio is a whopping 16.8 times. Today’s level implies a near-80% premium. Netflix is trading at ~80 times 2018 earnings. Tesla, expected to lose money in 2018, sports a market capitalization of over $60 billion at the time of this writing.

According to Advisor Perspectives, what Warren Buffett called “probably the best single measure of where valuations stand at any given moment,” the market-cap-to-GDP ratio, stands at ~133%, the highest it has been, save for the dot-com bubble when it topped at over 150%. “Cryptocurrency” is now a part of the market’s vocabulary, with Bitcoin speculators driving its value up 3-fold during 2017—incredible performance for a digital currency. Castles in the air? I think so.

So as I did in the introductory letter in July 2016, I must remind you that the market has again laid down the gauntlet for us, and the coming year may be one of the most difficult ones yet. But the Nelson Exclusive will continue to surface ideas. And again, not all of them will be successful and not all of them will be right for you. Please be sure to contact your personal financial advisor that knows your individual goals and risk tolerances.

Before I open it up to questions from members (and I encourage you to type your questions into the system now), I wanted to talk about two important concepts: 1) the time horizon and 2) income as composition of capital appreciation. First, regarding the time horizon. I am asked the following question frequently: Is the Nelson Exclusive publication for traders, short-term investors, long-term investors or somewhere in between? Well, the answer to this question isn't quite as simple as you might think. Let me explain. 

In a stock market like today's where, for example, the average consumer staples stock is trading north of 20 times forward earnings on meager revenue growth (if any at all), it's very difficult to be a long‐term investor as reversion‐to‐the‐mean dynamics could end up becoming extremely painful to one's portfolio. A reversion to 15 times forward earnings on these stocks, for example, could wipe out 25% of investor capital and that's if earnings forecasts hold true, which in the event of a stock market decline, it's more likely that consensus numbers are falling, not holding steady. That's the risk long‐term investors are facing in today's market.

Now that said, in the times of legendary investor and arguably the father of value investing, Benjamin Graham, it was much easier to be a long‐term investor because stocks at that time were trading below their very own net current asset value, meaning that most could be liquidated and still have greater value than what they were trading at. There was tremendous 'option' value in these equities, and downside in such cases was actually upside because liquidation meant getting more for shares than you bought them for. One could sit on the stakes of these equities for as long as it took for the market to become rational again. Long‐term investing in the times of Benjamin Graham was easy pickings.

Today, on the other hand, the stock market has more than tripled from the March 2009 panic bottom, and the long‐term picture might be one painted with a very tumultuous environment if stocks do revert to more normalized, long‐term tendencies. So how does this factor into what we do in the Nelson Exclusive? Well, if we feel strongly that the market is unfairly beating down an equity and we think shares are undervalued, we might keep that idea open for a long period of time, as in the spirit of Benjamin Graham's value‐oriented framework. However, if an idea has rapidly converged to our estimate of its intrinsic worth or if the idea has generated a tremendous annualized return that is unreasonable not to lock in, then we might consider closing the idea. We want to be as prudent as possible, and the stock itself, to a degree, determines whether it becomes a short‐term or long‐term idea.

As you can see, the market is often going to tell us when "profit taking" might be prudent. For example, if a stock is purchased at $10 and doubles to fair value in a matter of weeks, an investor may be interested in unloading it for a profit at that time...in a matter of a few weeks...as upside from that point may be rather limited. On the other hand, if a stock is purchased at $10 and it takes 10 years for it to double to intrinsic value, the holding period for an investor might be 10 years, if he or she would like to sell at an estimate of intrinsic worth. The price‐to‐fair value equation matters much more than the passing of time, per se. For example, one wouldn't hold a significantly overpriced stock just for the sake of holding it because they made money too quickly, would they? I think it makes the most sense to think in terms of price versus fair value, not in increments of time.

In explaining the other concept, that is income as a component of capital appreciation, I’d like to quote from my working document, The 16 Steps:

You cannot control the returns you receive from the market, but only seek to achieve your investment goals from the market. Unfortunately, I think there may exist a group of investors that believe they can control the stock market.

Let’s say an income investor bought a stock today and it doubled in price tomorrow, meaning that it generated 100% in income-equivalent in just one day--or let’s say at a hefty 10% annual required yield-equivalent, 10 years’ worth of income (in just one day). The investor can sell the stock and lock in 10 years’ worth of income, or he or she can let it ride. Some long-term investors may choose to let it ride, but what if that same stock’s price is cut in half tomorrow and those 10 years’ worth of income are completely wiped out? Would there be regrets, even if the income idea is still a strong dividend payer? I think so--10 years’ worth of income-equivalent would have been completely wiped out.

Each investor has different goals and risk tolerances, but it’s important investors understand that a dollar is a dollar. Forcing one’s returns to be generated strictly via income over the long haul is trying to tell the market what to do, which could end badly. Not even Warren Buffett can control the market and the distribution of returns. If the market hands you lemons, make lemonade. Said in another example, if an income idea jumps 30% in a few months, handing you the equivalent of 5-10 years’ worth of income in the form of capital appreciation (again, a dollar is a dollar), why not consider taking it, even if you may have been planning to hold the stock for longer than 5 years? Surely, one can’t be disappointed by taking profits?

But some investors might be. How you may ask? Because achieving the goal didn’t take years, and the return didn’t come in the form of a dividend payment. It seems these investors want to tell the market what to do. The last 8 years in the stock market through the middle of 2017 have been phenomenal, but I think such success has done nothing more but to provide a false sense of security. What the market gives, the market can take away--markets don’t always go up! If you’re disappointed because income ideas are providing you with significant income through alternative means such as in the form of capital appreciation, strive to be flexible and open your mind to ways you might be able to convert that capital appreciation to income to achieve goals.

If the market hands you a winning ticket in a short time, it may be okay at times to cash it in (converting capital appreciation to income), instead of letting it ride, only to potentially set yourself up for disappointment later. Every situation is different, of course, but markets will be markets. It’s important to use common sense. Capital appreciation can be converted to income quite easily. You can’t control what the market does and in what forms returns are provided, or how long it may take for goals to be achieved.

With that said, I appreciate your attendance, and I will now open the call to questions.

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If you would like to subscribe to the Nelson Exclusive publication, please learn more about the publication here. The Nelson Exclusive publication does not reflect real performance. Performance is hypothetical and does not represent actual trading.