Active Investing in the Age of Disruption. Evan L. Jones
were paid for with newly issued debt. The sector now trades at a net debt to cash flow ratio of 6.7 times. This is the highest level of net debt in history, completely supported by low rates and a chase for yield by investors. Utilities are a very stable industry historically, but any disruption caused by renewables and consumers' ability to generate electricity independently to move off the grid will cause a severe down trend given the sector's debt levels.
FIGURE 2.4 S&P 500 utilities sector trailing 12-month P/E ratio (2009 to November 2019)
FIGURE 2.5 S&P 500 utilities sector dividends paid per share and free cash flow per share (2009 to November 2019)
Another rate-sensitive sector driven by margin stability and large established brand-focused business model is the consumer staples sector. Again, technological disruption has not had a huge influence on the sector (yet) and the sector has been primarily influenced by low rates driven by the Fed (and in Europe by the ECB). Investors have bought into the sector as a bond proxy. When bond rates drop to levels that will not provide the necessary return to an institutional investor, there is a move out the risk curve in a search for yield. Investors have decided that the consumer staples sector is an equity safe haven. Figure 2.6 illustrates the significant multiple expansion that has occurred in the sector, as investors pay up to own consumer staples. In a low-rate environment, investors who may generally hold 30% or 40% of their capital in Treasuries or investment-grade corporate bonds must either accept lower returns than they have achieved historically or take on more risk.
If an institutional investment mandate is to achieve 5%–6% real (after inflation) returns and the ten-year Treasury trades at 2.5% with inflation at 2.0% (yielding a 0.5% real return), what are your options?
The first would be to maintain traditional capital-allocation exposures and convince constituents that they should accept lower returns (not usually a readily accepted path). The second would be to sell bonds and buy riskier assets, usually equities. Because allocators know they have taken on more risk in selling safer bonds, they will search for lower risk equity solutions, like utilities, consumer staples, and minimum volatility–factor ETFs, all of which have very extended multiples. These rate-driven investor decisions and valuation increases have nothing to do with fundamental investing and pressure the success of any active manager. Macro concerns and Fed decisions overwhelm business analysis.
FIGURE 2.6 S&P 500 consumer staples sector trailing 12-month P/E ratio (2009 to November 2019)
Some may point to the overall S&P 500 P/E multiple as being in line with historic levels, but that does not tell the entire story. Price is only half of the P/E equation. Revenues and earnings (operating margins) have also been pushed to historic highs by low rates. Net income margins have been heavily influenced by lower interest expense, lower commodity costs, and lower wage inflation. Of course, the Trump administration's 2017 corporate tax reform lowered tax rates and drove net margin growth even further. Looking at the 30-year S&P 500 net income margin in Figure 2.7, you can see that net margins are at or near their 30-year highs. This coincides with the longest expansion in history, now ten years long. Most long-term successful investment managers create a great deal of their outperformance in down markets when security selection driven by strong balance sheets, barriers to entry, and a deep understanding of their businesses can make a major difference. These fundamental issues that become apparent in a down market have not been an important driver of returns for a decade.
The fact is almost anyone can achieve positive absolute returns in a trending up market. Watch TV and listen to market pundits, buy the hot stocks of the day, and ignore valuation. Growth and momentum have been the lessons learned by new portfolio managers in the 2010s.
Only when the tide goes out, do you discover who has been swimming naked.
—Warren Buffett
When the tide goes out, good investors create outperformance. Global central banks have made sure the tide has not gone out for a decade. US equity market drawdowns of more than 10% have occurred only four times in the last decade and each drawdown has lasted less than 60 days.
FIGURE 2.7 S&P 500 net income margin (1990 to November 2019)
FIGURE 2.8 S&P 500 price-to-sales ratio (1990 to November 2019)
Price-to-sales ratio is a good valuation metric to review when thinking about markets from a top-down holistic perspective. High operating margins are evidenced in the multiple more so than other valuation methodologies. You can see in Figure 2.8 that we have surpassed the dot-com era valuation levels using this valuation metric. This combination of net income margin and valuation multiple expansion has created an environment in which even a historically mild recession will cause a large equity market drawdown.
Low rates have also allowed weaker companies to prosper due to the cheap and easily available credit environment. This scenario of high valuations and weak companies prospering creates the worst environment for fundamental investors to create excess returns.
Low rates and the US consumer
If inflating assets was the primary success of central bank intervention, creating a low rate environment to support US consumer spending was the second success. Federal Reserve support has kept the US consumer happy with low rates and flush with credit. Consumer purchases are made with either current income or credit. Current income has not grown and can be driven only by a thriving economy and even then income only grows marginally each year. Credit can be greatly influenced by low rates and new financing strategies. Credit growth has been the primary driver behind the US consumer economy for more than 30 years, but low rates have had a material influence since the 2008 financial crisis. Consumer spending now drives the entire US economy, because US manufacturing strength has waned since the 1990s. Consumer-related companies, regardless of their quality, competitive positioning, or good management, are strengthened by cheap, easy consumer credit. When consumers spend at the levels they have over the last decade, it covers up a lot of operating or capital allocation mistakes made by subpar consumer companies. The success of subpar companies hurts the security selection differentiation