- Sailing a Serious Ocean, North 54
“The Horn lived up to its reputation again. In twelve hours its malign influences had transformed an innocuous summer low coming in out of the Southern Ocean into the most dangerous of storms, what old time square rigger sailors used to call a Cape Horn Snorter.”
- Derek Lundy, The Way of a Ship
For thousands of years, human beings at sea were at the mercies of whatever direction the wind was blowing. If the wind was blowing in the direction you were going (known as “running” - hence the phrase “running with the wind”) that made things pretty easy. The difficulty began when you started the trip for home and you had to sail directly into the wind. With the physics of sails (which I will be mercifully brief about), one couldn’t just sail into the wind. Two basic principles made this impossible. The first is leeward drift or drag. This means the boat will inevitably drift in the course of the wind. Some boats are known as being particularly good at reducing such leeward drift. Others are sometimes referred to as “those horrible old f’ing Dutch buggers” - well…you get the drift (no pun intended). The second principle is lift. No different than airplanes, this is when you put an aerodynamic foil into the wind and have the air pass more quickly on one side and more slowly on the other, thus creating a force perpendicular to the sail. Using lift, a boat can sail somewhat into the wind (known as “reaching”). By utilizing multiple reaches (known as “tacking”) the sailor can make it home even with the wind against them. The most dangerous position for a sailor is to find the leeward drift exceeds their ability to reach. In these situations, if the boat can’t anchor it will be driven to leeward against the sailor’s will (known as the “horrors of a leeward shore”) until hits whatever object it first comes upon.
I bring all this up because over the past decade it seems like value investors have been sailing into relatively strong and steady winds and facing harsh leeward drift. For many, the horrors of a leeward shore are all too real by now. This thinking was captured quite eloquently in a recent Morningstar interview with Charles de Vaulx, Chief Investment Officer and portfolio manager at International Value Advisors. Previously de Vaulx was portfolio manager at First Eagle Global and First Eagle Overseas. The full interview “Charles de Vaulx: Why Value Investing Has Slumped but Will Rebound” can be found here (Morningstar premium membership required). I try not to shamelessly steal from someone else’s intellectual efforts, but I thought the concepts laid out in the interview were powerful enough to “forage liberally” as William T. Sherman so famously said.
Value Advisors International (IVIOX) and de Vaulx have certainly been victims of strong headwinds. The funds positioning in its category (Foreign Large Blend) quartile rank has been hard for managers and investors alike: 98th percentile YTD, 97th percentile 1 year, 99th percentile 3 year, 80th percentile 5 year, and 23rd percentile 10 year. But de Vaulx and his team aren’t tacking repeatedly and altering course on a regular basis. They believe their approach remains consistent with achieving long-term outperformance.
In his interview with Morningstar’s Christine Benz and Jeffrey Ptak, de Vaulx discusses three trends which have provided tremendous headwinds for his funds and fellow value investors. The first is the three-decade long trend of lower interest rates. The steady decline has affected value investing in several ways. This includes DCF model discount rates, corporate free cash flow (as a percent of interest costs), and economic modeling results. The second trend is the pressure put on corporate managements to put low-earning cash to work, particularly in regards to corporate stock buybacks. The last trend is the Federal Reserve’s impact on business cycles making them shallower and longer. This has reduced stock price volatility and thereby investment opportunities for value investors. In combination, these have created such strong headwinds that value investors have seen a reduction in opportunities - and correspondingly results - since the early 1980s.
A 36 Year Headwind: Interest Rates
Starting in 1982 - following Paul Volker’s aggressive efforts to wring inflation out of the US economy – interest rates have fallen from double digits to nearly negative in the US and truly negative around the world. Anybody who uses a discounted free cash model know the double impact of time and discount rates on corporate valuations. In an article from March 2019 (“Looking Back at Nintai’s Discounted Free Cash Flow Model” which can be found here), I discussed the impact of the discount rate on my estimated intrinsic value. The bottom line is that getting that rate wrong can dramatically impact your investment case – sometimes destroying it altogether.
The Federal funds rate dropped from its high of 20.6% in June, 1981 to its low of 0.06% in July 2011 (it has since jumped to 1.6% in November 2019). This represents a remarkable 98.6% drop. If we take a look at current Nintai Investments holding Veeva (VEEV), let’s see the impact of increasing aggressive changes in the discount rate on the company’s valuation.
As of November 2019, the stock trades at roughly $156 per share. In our discounted free cash flow model, we currently use a discount rate of roughly 7.5%. Utilizing a 10-year time frame, we estimated the intrinsic fair value at around $173/share or an 11% discount to the current price. If we raise the discount rate by 3% to 10.5% the estimated intrinsic value drops to $89 per share or a decrease by nearly one-half. A 40% increase in the discount rate cuts the estimated intrinsic value in half! If we invert this, then it’s easy to see the three decade trend of falling rates puts a near perpetual increase in the discounted free cash flow-generated intrinsic value. If we look at a company like IBM, nearly 85% of the increase in stock price since 1982 can be explained by the falling discount rate. That doesn’t leave much room for finding a bargain price during that time.
A Fake Floor: Stock Buy Backs
If the falling discount rate helped create an inflated stock price over the past 35+ years, then the growing trend of stock buybacks has helped solidify the concept of a fake price floor. Companies have spent hundreds of billions of dollars over the past
decade in repurchasing their stock. In some cases this has reduced overall outstanding shares by 40, 50, or even 60%. Some of these have been examples of outstanding capital allocation. In other cases companies have spent billions of dollars simply repurchasing the vast amount of options handed out to management. In these cases the number of outstanding shares have not gone down – and in some particularly egregious examples – outstanding shares have actually increased. No matter how these transactions add up, they frequently create a fake floor whereby potential investors see an illusionary minimum share price.
Using IBM as an example again, since 2004 the company has spent $148B repurchasing stock. That comes out to be roughly $1B each year. During that time total outstanding shares went from 1.7B to 893M – or a 47% in outstanding shares. In that same period earnings per share went from $4.38 per share in 2004 to $8.61 per share in 2019. Of note, earnings per share were $8.89 per share in 2008, peaked at $14.94 per share in 2013 before descending each year hitting $8.61 per share in 2019. You might think at some point such disappointing performance would create some fairly opportune buying moments, but sadly not. The company’s P/E ratio never dropped below 10 between 2004 – 2019. Rather it averaged nearly 15 during that time period. For a company that showed zero growth for 11 years (2008 – 2019) and a nearly 45% drop in earnings over the past 6 years (2013 – 2019), it seems the PE ratio was inflated beyond reason. I suspect the repurchase of shares played a role in convincing shareholders to pay a rather high premium for IBM shares. It would be interesting to hear Warren Buffett’s thoughts on this after his experience as an IBM shareholder.
A Case of the Dog Not Barking: The Lack of Business Cycles
Perhaps the most interesting concept raised by de Vaulx was the dramatically different length and scope of business cycles in the US over the past two centuries. Utilizing data from Sanford Bernstein’s “An Economic History of Now” (which I highly recommend), de Vaulx points out the fact that the average time of economic expansion has increased dramatically (25 months in the 19th century, 44 months in the 20th century, and 101 months in the 21st century) while the average economic contraction decreased equally in magnitude (the average depth of GDP decline was 3.7% in the 19th century, 4.3% in the 20th century, and only 2.1% in the 21st century).
So what’s happening here? In de Vaulx’s view – and I completely agree – the
decreased volatility in terms of time and magnitude has reduced the opportunities to employ value strategies. With smaller time frames and vastly decreased magnitude of contractions (investors in the 21st century have seen GDP declines be less than half those of the 20th century), the ability to capture inefficiencies in the market have dropped correspondingly.
For any sailor who has spent an entire day beating into the wind, tack after tack, seeing their destination seemingly getting no closer, the limits of patience may be reached. They will employ every trick in the book to lay half a point closer to the wind. It’s no different for many value investors. The last ten years have been like that for many value investors. They’ve tried every trick in the book but unfortunately – as de Vaulx has so eloquently pointed out – the headwinds faced by these investors have been insurmountable. That said, I actually don’t think all is lost. Over the last 12 months we’ve seen volatility increase both in scope and length. The rapid drop – and size of it – at the end of 2018 brought many investors up short. Certainly anyone watching the VIX index and the drops in the major indexes thought the return of old fashioned value was upon us.
At Nintai Investments we’ve done everything possible to create a weather proof boat design (think of this as your portfolio strategy and holdings), that can reduce the risk of rising seas while maintaining as much headway as possible (think of Nintai’s “Quality Portfolio/Value Pricing” from our last article), and has the strength to survive extraordinarily long voyages (think of Nintai’s companies that are decade long in their holding time). Whether you see it as a vessel to help you travel the globe or an investment vehicle to meet your retirement goals, there ARE ways to help defeat de Vaulx’s three great headwinds. I highly recommend readers review the Morningstar interview, take notes, and identify the issues as they exist in your portfolio. You might just find you have an all new confidence as you put to sea in your latest investing journey.
 The discount rate is made up of the current 10-year treasury rate (1.74% as of November 2019) plus factors for the company size, financial leverage, cyclicality, corporate governance, economic moat, and complexity.