When you compare the last 18 years as Bernstein did, the average includes 1998-2000, dramatically understating how crowded owning tech is today. It means there were three years out of 18 in which tech was the most expensive any S&P 500 sector has been in 70 years. These facts make the 59 percentile ranking ex-Amazon look heavily understated. Compared to the last 15 years, tech is at the very high end of popularity. With Amazon and Netflix included, it would put tech well above the 90th percentile, based on our analysis. This time growth buyers were joined by income-chasing dividend stock investors who have “piled in” on generous dividends coming from staple, utility, telecom and tech companies. We advise the buyers of historically expensive common stocks to beware! Today, these sectors are being piled into by passive index investors (automatically by capitalization) and Exchange-Traded-Funds (ETFs), which are emphasizing the currently hot and over-crowded dot. Can you hear the rhyme?
For other reasons, we must be extremely careful with energy investments. In the majority of the last 18 years, energy companies had one of their best runs in history. Therefore, its percentile ranking is a bit deceptive because they were one of the darlings during the China Boom of 2004 to 2014. This isn’t very difficult for us to deal with due to their weakened balance sheets and negative free cash flow numbers. None of the integrated oil companies or the exploration and production companies even vaguely fit our qualitative criteria for stock selection.
Lastly, among the anomalies, the last 18 years included deeply out-of-favor periods for financials from 1998-2000, 2007-2012 and the last year. As you know, we believe they have effectively become a political and investing cuss word. This means financials are in the 25th percentile as compared to a really terrible 18 years of existence!
Besides examining the anomalies, we need to examine our existing holdings to see if we own anything manically priced in the more popular sectors which investors have “piled” into. We own Johnson and Johnson (JNJ) and Walgreen’s (WBA), which have historically traded with the consumer staple sector of the index. Both trade at a sizable discount to the consumer staples category on a price-to-earnings (P/E) ratio basis and trade more in sympathy with the healthcare sector (where JNJ resides) and with the consumer discretionary sector in the case of WBA. We will watch them vigilantly.
We must double our efforts to find and hold companies which fit our eight criteria for common stock ownership and are in great disfavor from a long-duration standpoint. Among financials, American Express (AXP) has some problems in the aftermath of divorcing Costco (COST), but it has one of the premier balance sheets, credit card businesses and free cash flow in the S&P 500 Index. It trades at a big discount to the index, its peers and to where it has traded in much higher interest rate environments over the last 18 years.
The article and chart continues to make us drool over the shares of Berkshire Hathaway (BRKB). Buffett has it loaded with financials like Bank of America (BAC), Wells Fargo (WFC), Amex and GEICO. Buffett also owns industrial companies like Burlington Northern Santa Fe, Precision Castparts and Marmon Group. It looks like a marvelous way to bargain hunt in the most out-of-favor sectors. Berkshire is under-owned and very contrary at 1.3 times book value.
In conclusion, this chart and our analysis makes us feel very good about the future performance of our portfolio relative to the S&P 500 Index or other passive large-cap vehicles. A massive part of the total capitalization of the S&P sits in the spendy consumer staples and glamour technology stocks, making it rhyme with 1999. Other active managers are very committed to them as compared to the last 18 years. On the other hand, we are heavily over-weighted financials (30%) and consumer discretionary shares (32.5%), which are under-owned by active managers when AMZN and NFLX are excluded. We believe as the rhyme plays out, there is very little chance of investors piling out of under-owned holdings which meet our eight criteria for stock selection.
William Smead is CEO and chief investment officer at Smead Capital Management.