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By Brian Nelson, CFA
Market volatility has picked up quite a bit of late, and frankly you shouldn’t be the bit surprised. I’ve been quite active explaining the impact that the proliferation of index investing and quantitative investing has had and will have on the marketplace. The more people index or invest on backward-looking empirical criteria, as in most quant models, regardless of future expectations, the more people that buy everything at any price and hold no matter what, the more people that aren’t making decisions on the basis of underlying valuations, then the more people that can contribute to severe price-to-fair value dislocations.
In many ways, when nobody is paying attention to what is going on, it sets the table for a painful stock pricing bubble…when everyone is buying regardless of price, and when people aren’t paying attention, bad things tend to happen. The attraction of low-cost index investing is a great one, and past returns artificially bolstered by ultra-low interest rates and accommodative policies following the Great Recession have only emboldened those looking for an easy way to riches. Let me assure you: there is no easy way to riches, and those promising you this are more interested in receiving fees from you than anything else.
Since the launch of the simulated Best Ideas Newsletter portfolio, the ideas have generated significant capital appreciation, without a doubt. The same is true with the simulated Dividend Growth Newsletter portfolio. The ideas in the Exclusive publication have been solid and backed by strong theses, and despite a very challenging environment, ideas in the High Yield Dividend Newsletter have held up, even in the face of a rising 10-year Treasury yield. Let us know what you think. Believe it or not, some of the best value investors are down over 26% this year!
All in, however, I know how well we’re doing as a research provider, and we can’t be anything but pleased with our publication suite, and given how effective our fair value estimates, how solid the Dividend Cushion ratio has performed, and the innovative metrics we’ve created with respect to new dividend-adjusted leverage and the Economic Castle rating, we know that we’re providing our members with tremendous value. The lure of index investing and backward-looking quantitative investing will be great though, but you know better.
I’ve been spending these past few months writing intensively on a new book (which I hope to share soon!), where I will explain the major pitfalls of backward-looking quantitative analysis, what the word “empirical” truly means in finance, as well as the concerns that may arise with respect to an increased level of indexing across the marketplace. From what I understand, those that have been members of Valuentum have benefited greatly from this economic boom and cyclical upswing in equities, but it is when things really start to hit the fan where the value of a membership comes in.
Importantly, however, think of index investing as that adjustable-rate mortgage that sucks you into thinking that everything is just going to be fine, that stock prices (like housing prices) always go up in the long run, that one doesn’t have to pay attention to stock selection. Indexing sounds so easy, right? And now indexing is free! C’mon — You know better than to fall for such things. Pay attention to what you buy and what you own. Seriously. You know if everybody is doing something, it’s not going to end well.
Now is the time to be careful, not greedy. I know things are great more than 9 years into a bull market, but investing is not so much about making money, it is about keeping it! There is nothing worse than a fortune lost, and I fear that many of the thousands of newly-minted 401k millionaires will find it rather frustrating when what has worked during the previous decade falls incredibly short in the coming decade. With the vast majority of trading on the markets today comprised of index funds and quants, nobody truly knows how volatile the markets will become.
That is why intrinsic value analysis is so important. Enterprise valuation is not about being precise. It’s about making sure that the ideas that you are interested in also have a solid foundation. It’s about evaluating the size of the fair value estimate range to get a feel for the riskiness of a company’s fundamentals, and how wide a range of probable fair value outcomes might be, as that range in many ways may imply just how volatile the stock price may be.
Frankly, you shouldn’t care if your neighbor made money on cryptocurrency, or if your best friend is chasing cannabis stocks, or if your uncle is crazy about Tesla (TSLA) and Netflix (NFLX). Look – times are good right now, and a lot of people have made a lot of money during this upswing, but now is the time to be smart. Now is not the time to think that all you have to do is buy an index fund and things will just work out! Don’t confuse a bull market with brains!
I have to admit I am so worried about the coming generation. Okay – I’m scared. I think some believe that stocks are merely pieces of paper or some potion that can be distilled into separate qualities to extract some possible excess return. You know that investing involves real companies, and if others want to take the chance on not knowing anything about their investments, let them. Frankly, you’ve worked too hard for your money not to pay attention!
I get the sense that we’re building into something climactic soon. The 800-point drop in the Dow Jones Industrial Average October 10 was just eerie. Frankly, it came out of nowhere, and nobody really could give a good fundamental explanation, other than the 10-year Treasury yield was on the march higher. It’s hard to believe that consultants are actually allowing index investing and quantitative investing for their clients, in such large scale. I just wonder who will be to blame when things really start heading south. Will the client say, “You mean — you really didn’t know anything about the underlying stocks that you’ve invested in?” For some reason, I think that conversation is not going to go well for consultants.
I know Valuentum is doing a great job. I know of perhaps one other research firm that publishes fair value estimates on over 1,000 stocks. I mean – we’re talking fully populated intrinsic-value models! We update the fair value estimates roughly four times a year, too! That’s in addition to all that we do with respect to the newsletter publications. The marketplace, to me, is just crazy right now, and while prudence hasn’t been rewarded as much as moral hazard since the Financial Crisis, the tide will eventually turn. It always does.
Valuentum is going to be here for a long time. We know what we’re doing, and we know what others are doing. We know the core component of investing is free cash flow, and we know it better than just about anybody else. It’s easy to get sucked into the blogosphere on a hot tip, but don’t. It’s easy to buy index funds and forget it, but you know it’s not that easy. Remember when buying a home was a no-brainer, too? Look – you’ve already experienced cycles like this.
I know it’s hard work to study your companies inside and out, but now is the time to do it. Now is the time to prepare for the worst because now the times are good. The very worst thing you can do is to sit back and think that ultra-low interest rates and accommodative policy, two drivers of this prolonged bull market, will last forever. Stick with fundamental, free-cash-flow based analysis, and embrace the idea that the market contains valuable information in its prices.
We’re here for you. You know how much you pay us. We’re not charging you 2% and 20% like hedge funds, and we’re not charging you 1% of your assets. We work really, really hard for you as a publisher, and we understand that it is vitally important that you keep more of your money. I don’t know how investors can give away 20% of their upside or give away 1% of their assets every year in index funds held by advisors. Maybe I’m old school. I don’t know, but I am glad that we have an advisor client base that is so focused on their clients’ needs that they have a membership to Valuentum.
It makes me proud to be a part of this company.
That’s it for now. We’re in the middle of earnings season, so we’re publishing quite frequently on the website, so please do visit. If you ever have a question, please be sure to ask it, too. We’ll do our best to get that information available to all. Finally, I am so excited about the book that I am writing, and I sincerely hope that you will read it. I talk about so much in it, including my experiences at Morningstar and Driehaus. I’m counting on your book review, too!
Related: SPY, QQQ, DIA, SDY
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Brian Nelson does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.