“In the short-term, the market is a voting machine. In the long-term, it is a weighing machine.” Benjamin Graham
Warren Buffett’s mentor, Benjamin Graham’s quote is particularly applicable in describing today’s market environment. Euphoric optimism has propelled most asset classes to extreme valuations. As a case in point, the inflation adjusted CAPE Price to Earnings ratio now stands near a staggering 40. According to Cambria’s Meb Faber, no country has generated positive real returns 5 and 10 years after trading at a >40 CAPE.
This doesn’t mean that stock returns won’t be good over the next year necessarily, but the odds of strong returns over the next decade are quite low, as starting valuations are one of the biggest indicators of long-term future performance. A lost decade for stocks has happened before, and should it happen again, it would have a massive impact on both the economy and retirement plans. Remember, the odds of a successful retirement (one that allows you to pay the expenses on your desired retirement goals) go down dramatically if one takes big losses five years directly before or after retirement. Sequence risk is a critical factor, but many that are 60-100% invested in stocks might not be prepared to protect themselves from this risk.
At TTCM, we take a business approach to investing. Valuations matter to us, as opposed to the valuation agnostic index approach. By definition, this means that we don’t chase bubbles, or try to keep up with them, because we don’t want to be blown up when the bubble pops. We want sustainable investment growth, not short-term sugar highs. In an overvalued market, this means finding pockets of value, and using tactics to generate income, reduce risk, and to maximize risk-adjusted returns.
Currently, there are extremely attractive investment opportunities in real assets, such as real estate investment trusts, and commodity-based companies. High interest rates and the economic slowdown in China have made the near-term outlook for these industries foggy, leading to major discounts in valuation. This has allowed us to buy some of the highest quality companies at extremely attractive prices, offering very high dividends, and upside potential of 50% or greater. These stocks also offer a much larger margin of safety if we do indeed see a major bear market, because many of these stocks trade at discounts to their net asset values. A lot of these stocks pay dividends between 4-8%, and I think on average they have the potential to appreciate by 15% per annum from current levels over the next 5 years or so.
Another area of opportunity that we have been taking advantage of is in the stocks of business development companies. These are companies that invest in diversified loan portfolios where they have been able to benefit from the higher interest rate environment. We have been investing in these stocks offering dividends yields of between 9.5-14%. Often, we buy them at discounts to their liquidation values, or tangible book values. By buying them at discounts to their liquidation value, we create a larger margin of safety to deal with any higher-than-expected credit costs, while also providing greater upside potential if that discount to net asset value closes. These are great sources of income, and those cash flows can either be reinvested, or they can fund retirement expenses. Our research-based fundamental analysis gets into the weeds on credit quality and the risk management of these respective companies, as they are not all equal of course.
Beyond identifying undervalued investments, we utilize tools such as covered calls and cash-secured puts to generate income and reduce risk. These are strategies that pay the biggest dividends to us as investors in flat to negative market environments. They trade a higher probability of success, more income, better protection, for less potential upside in the most optimistic scenarios.
In closing, I think we are very well situated for the current market environment. I believe we still have the potential to generate very attractive investment returns even if the stock market is far less favorable over the next decade, which is my base case scenario. I believe in a severe bear market; our losses would be dramatically less than the S&P 500 or Nasdaq. I also believe that with the way that our strategy is structured, we would be able to switch from defense to offense upon the market turning down, where we would be able to really take advantage of stocks trading at large discounts to intrinsic value.