In that piece, we showed that the 100 most expensive stocks are the most overpriced relative to the index and to the 100 cheapest stocks since the tech bubble broke in 2000. Based on our research, if Amazon and Netflix were added to the information technology sector, which we think more properly represents what they do, it would represent 23% percent of the S&P 500 Index vs. the 21% we see today. This would be its highest weighting since 2001. These levels may suggest a storm could be on the horizon, even as the narrowness of the current stock market suggests a furious pace of those seeking to reach the summit!
Higher interest rates may be another storm coming to those making the common stock climb, particularly in the broad index. The industries that would benefit from higher interest rates are in many cases among the most attractive on a relative valuation basis in the market today. These would include banks, insurance companies, homebuilders and other economically sensitive shares. As history has shown, higher interest rates reduce the price-to-earnings (P/E) multiples paid for common stocks. We would argue that this is particularly true of the broad S&P 500 Index. The share prices of companies that benefit from higher rates will be less impacted, because their earnings and profitability tend to grow in an above-average way, while valuations may be challenged across the broader stock market.
Going into the Death Zone
The problem with the narrowness of the broad indexes is that investors have been willing to pay nose-bleed multiples on certain stocks today. This risk in equities reaches a certain level that we feel is comparable to the risk of climbing Everest above the 8,000-meter altitude. This height is referred to as the “Death Zone.” The “Death Zone” creates its own risks, separate from the weather, due to the lack of oxygen. CNN, talking of this risk about Everest stated, “The lack of oxygen to the brain, called hypoxia, can cause people to make poor, rash and sometimes deadly decisions in the confusing landscape.” They go on to say, “The best and quickest treatment is for climbers to descend to a lower altitude, although many can’t do this on their own and must be helped or carried.” Paying 50 to 200-times earnings for exciting revenue growth or paying 25-times earnings for high-dividend, consumer staple shares, looks to us like a potential “Death Zone.” We have provided a chart that shows the percentage of oxygen relative to sea level.
At the peak of Everest, a climber only gets 32% of the oxygen compared to sea level. We see a lack of oxygen for a group of companies today which appear to provide very little profit and free cash flow to the owners. There are two reasons for this. On one hand, investors are paying high prices for stocks with high revenue growth. It is presumed that the revenue growth will someday cause much higher profits in the future. On the other hand, investors are paying high prices for consumer staple companies with little earnings growth. This is based on the expectation that low volatility stock trading and income from dividends will be factors which succeed in a permanently low interest rate environment. These slow growth businesses should not have leverage in an expanding economy and should not benefit from higher rates, in our opinion. What if the “groupthink” of today is wrong? Many investors could be carried to lower heights as they heal from hypoxia-related decision making.
Breathing Easy
At Smead Capital Management, we have made the decision to stay back and not go forward with the stock market participants to higher altitudes and multiples. As long duration investors, we know that storms do come and “groupthink” can be fatal. Attractive valuations in our portfolio provide us plenty of oxygen at these lower altitudes and lower P/E multiples. We don’t know what the future brings, but we can’t overlook risks that could cause a significant loss of capital similar to the loss of human capital that happened in 1996 on Mount Everest.
Cole Smead, CFA, is managing director and portfolio manager at Smead Capital Management.