Valuentum Exclusive Analysis for the Discerning Investor

Symbol Keyword

Changes to the Newsletter portfolios

Best Ideas Newsletter portfolio

BRK.B: 8-13% à 3.5%-5%

AAPL: 4.2%-6% à 6.5%-8%

MSFT: 4.2%-6% à 6.5%-8%

Dividend Growth Newsletter portfolio

BKLN: 4.25%-6.5% à 0%

KMI: 3.25%-4.25% à 0%

LMT: 3.25%-4.5% à 6.25%-8.5%

ORCL: 4.25%-6.5% à 6.25%-8.5%

AAPL: 2.75%-4% à 3.25%-4.5%

MSFT: 2.75%-4% à 6.25%-8.5%

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Hi everyone:

Trust you are doing great. I wanted to let you know of a few newsletter portfolio changes we’re making today. In the Best Ideas Newsletter portfolio, we are reducing the position in Berkshire Hathaway (BRK.B) to the weighting range of 3.5%-5% from 8%-13%. Though we think Warren Buffett is getting back on track now that he has dumped the airlines and many of the banks, we no longer think Berkshire warrants a top-weighted position. The position has largely been a drag on otherwise stellar portfolio performance this year.

We’re using the “proceeds” to increase the positions in Apple (AAPL) and Microsoft (MSFT) to the weighting ranges of 6.5%-8% from 4.2%-6%. We continue to be “fully invested” in the Best Ideas Newsletter portfolio, as we remain bullish on the long haul (our fair value on the S&P 500 is 3,600). Our latest write-ups on Apple and Microsoft can be found here and here, respectively. We continue to love net-cash-rich and free-cash-flow generating powerhouses with secular growth opportunities. Why We Like Apple and Microsoft in the Newsletter Portfolios >>

In the Dividend Growth Newsletter portfolio, we’re getting rid of the Invesco Senior Loan ETF (BKLN). The ETF has bolstered the Dividend Growth Newsletter portfolio’s dividend yield, but we’re going to exit the leveraged loan space, as our outlook on some of the weakest credits and the fixed-income markets, in general, has soured somewhat since before the COVID-19 outbreak. We’re also removing Kinder Morgan (KMI). The energy giant does offer a nice dividend yield, but the company will likely continue to be held back by its very large net debt load and large upstream division (pumping CO2 into the ground to extract oil from old fields in the US), which are two things that we just don’t like as COVID-19 continues to spread.

This frees up roughly 7.5%-11%, and the expiring put option increases the re-allocation efforts to 8.5%-12% in the Dividend Growth Newsletter portfolio to retain “fully invested” status. With the “proceeds,” we’re upping Lockheed Martin (LMT) to the weighting range of 6.25%-8.5% from 3.25%-4.5%. Our latest work on Lockheed can be accessed here and here. We’re going to take Oracle (ORCL) to the weighting range of 6.25%-8.5% from 4.25%-6.5%. Our latest take on Oracle can be accessed here. We’re also increasing Apple to the weighting range of 3.25%-4.5%, up from 2.75%-4%, and Microsoft to the weighting range of 6.25%-8.5%, up from 2.75%-4%.

The Valuentum methodology is not one lacking oversight as in traditional systematic quantitative processes. Our methodology with respect to portfolio construction focuses intensely on the discounted cash flow model, or enterprise valuation, and the key cash-based components of enterprise valuation (net cash on the balance sheet and future expected free cash flows). We want the portfolios to be full of names with these qualities. The second component, which has become less significant given temporary near-term pressures on earnings, is relative/comparable valuation--a forward P/E ratio or forward PEG, for example. The final component is strong share-price momentum, which we view as an indication of the market backing the company at existing prices.

Our systematic process translates into a VBI output, but unlike most other quant processes, the VBI output is just one consideration of many to be evaluated qualitatively (think of the VBI as another data point in your tool kit). We have to be able to recognize, for example, when today’s near-term valuation multiples lack informative substance (and how they may impact the VBI), and then adapt to the changed environment without overhauling the infrastructure. We have to be able to make qualitative judgements on discount rates to assess whether we’re now okay with certain equities that have cash-based sources of intrinsic value (e.g. net cash, strong future free cash flows) that are trading near the high end of the fair value range, or even above the range, provided the equity still has strong momentum.

During the past few years alone, the valuation environment has experienced structural changes with respect to 1) corporate tax rates, 2) the 10-year Treasury discount rate, as well as 3) expectations for long run inflation due to accommodative Fed/Treasury policy. Our process requires oversight and a skilled portfolio manager that can make these types of adjustments, where necessary, and weigh them within ever-changing market conditions. In the second edition of Value Trap, included in the new Prologue, I’ve added a 15-point checklist that goes into greater detail of the firm-specific components we look for within the three main components of the Valuentum process: DCF undervalued, attractive relative valuation, and strong technical/momentum indicators.

Our qualitative overlay to the Valuentum process is why you might see us adding to more of our favorite name Apple, even though it is trading at a relatively elevated share price. Apple is still a Valuentum stock (its technicals have yet to roll over meaningfully). The data points we provide for members from the VBI to the fair value estimate range should always be viewed as the starting points in the analysis, not the conclusion. Sure, the P/FV ratio and the VBI are vital considerations, but we still want to know, for example, what the cash-based sources of intrinsic value are for each company. We’d never, for example, consider airlines no matter how cheap shares may look because of the sensitivity of their future free cash flow streams to energy resource pricing and fare transparency. We may “pay up,” however, for an Apple or Microsoft, given their tremendous cash-based sources of intrinsic value (e.g. net cash and free cash flow generation) that coupled with considerable secular growth prospects.

What the COVID-19 crisis has exposed is that systematic quant processes with no qualitative overlay can fail miserably. Active management with a stock picker is simply vital. These days, however, many investors sadly are being taught to invest as if they are gambling at the horse track (picking numbers or the colors of jockey silks and sticking with the systematic process for the long run). They may say: “Keep betting on 3 or keep betting on the blue silks. It will come back. Things will mean revert.” Haven’t you heard things like this with factor investing, or about the quant small value factor, in particular? The quant small value factor, for example, fell over 40% during the first quarter of 2020, and many quants did little but watch things get worse for years before then.

They simply missed that most of small value are firms that may never bounce back--from banks to overleveraged energy to mall-based retail and beyond. Their processes failed because they relied too much on just a few data points that experienced structural change as the economy rapidly shifted away from capital-intensive firms to asset-light operators. They kept betting on 3 or blue silks at the track, pointing to history as if it had any relevance in this case. Instead of thinking through the entire process and evaluating whether the items they are focusing on are causal considerations, they just continued to gamble away investors’ money. Just because something has a low P/E ratio or low P/B ratio doesn’t necessarily mean the stock cheap. Very simply, it could be a value trap!!!

The same is also true with the 60%/40% stock/bond portfolio today. Many advisors are only looking backward and are trying to brush under the rug that asset correlations increased rapidly during the March swoon, which pointed to growing cracks in the foundation of modern portfolio theory (if there weren’t already gaping holes). Worse still, fixed income investors may have a hard time finding meaningful yield in coming years, as some junk-rated issues are getting rates at all-in prices under 3% these days. If inflation ratchets up like we think it will, the 60%/40% stock/bond portfolio might continue to fail investors. During the past 10 years, it has underperformed a broad market index fund by 110 percentage points, and during the past 30 years, it underperformed by 1.5 percentage points per year, on average. No “goals-based” investor wants this type of underperformance, no matter what they say.

That said, we can build an awesome enterprise valuation infrastructure for you and couple it with a sound methodology with extensive checks-and-balances (relative valuation, technical/momentum indicators), but you still have to think about your investments, not only whether they make sense for you but also how they fit within the construct of an overall portfolio. Systematic quant processes have failed because they have left the thinking out of it, and I don’t want you to fall into the same traps, picking one or two data points. Most quant processes, for example, are so far off the map that they are not even using the right data in their asset pricing models: future expected data.

Investing is simple, but it is not easy. Let me explain. It’s simple in that you can learn what the important cash-based sources of intrinsic value are and how that impacts enterprise valuation, but it is not easy in the way of choosing an Apple or a Microsoft over an airline or a bank given the same P/E ratio, VBI rating, and P/FV discount (i.e. why some cash-based sources of intrinsic value are more dependable than others). It’s simple to understand why net debt is bad, but it’s not easy to grasp how the probability of a bankruptcy scenario increases for capital-market dependent companies under adverse conditions, and how this impacts equity pricing. Investing is simple, but not easy.

Experience and a qualitative portfolio management overlay will always matter to any process. The rules-based passive strategies out there today just aren’t helping investors, however. Just like rebalancing a 60/40 stock bond portfolio periodically in the coming decades may offer a false sense of security given the shortcomings of modern portfolio theory and what looks to be a coming bear market in bonds, investors are also leaving the thinking out of it when it comes to stock selection, too. The COVID-19 crisis has all but shown the importance of the duration of equity value composition in stock values as in the enterprise valuation process, and how near-term multiples are largely arbitrary short cuts with little information value, especially under abnormal market conditions such as these.

As I’ve written before, we continue to be focused on what matters to long-run valuations--normalized economic conditions and the prospect for pricing power and inflationary expansion in the out years of any modeling infrastructure due to accommodating Fed and Treasury policy. Stock values today, in many instances, are worth more than before the COVID-19 outbreak. For example, a cash flow of $100 million in 2030 would now be worth 60% more if the discount were to fall to 5% from 10% in a discounted cash flow model. Yes, earnings for 2020 and 2021 can fall (and economic conditions can be terrible), and values can still rise.

With that said, I wanted to finish by letting you know that I am working hard to be able to manage portfolios for you. I hope to have an announcement available as soon as possible on this initiative, so please stay tuned. Trust is everything, and I sincerely hope I have earned yours over these many years. Many thanks for your continued interest, and please let me know if you have any questions. Always my very best.

Kind regards,

Brian Nelson, CFA

President, Investment Research

Valuentum Securities, Inc.

brian@valuentum.com 

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Brian Nelson owns shares in SPY and SCHG. Some of the other securities written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.