This is Part III of a three-part series. Read Part I here and Part II here.

In the early 1970s, a group of high quality growth stocks such as Coca-Cola, Procter & Gamble, Johnson & Johnson, Walt Disney, American Express, and Pfizer generated gangbuster returns. At the time, these stocks were referred to as the Nifty Fifty. At their peak in late 1972, these stocks traded at a PE ratio of 42x while the overall S&P 500 was trading at a PE of 19x. But in 1973 and 1974, inflation rose rapidly, a recession hit, the overall market declined, and Nifty Fifty stocks underperformed sharply.

Most investors think of the collapse of the Nifty Fifty stocks as a bubble that burst. But in fact, if you had bought these stocks at their all time highs and hung on for the long term, you would have earned a 12%+ annual rate of return, or the same as the overall market.

If these stocks proved they were not in a bubble by generating strong returns even from peak valuations that were more than double the overall market valuation, why did they perform so poorly during the 1970s and then perform so extraordinarily well in subsequent decades? And what does this history tell us about today’s market, where high quality growth stocks have traded down by so much this year after trading at relatively high valuations at the end of 2021?

First, let’s step back and review where stock returns come from and how we can prove in retrospect whether a stock was overvalued and by how much.

A stock’s return can be broken down into three drivers:

  • The growth of earnings over time.
  • The starting and ending PE ratio investors pay for those earnings.
  • The dividends the stock pays out.

So, if earnings grow at 10% a year for a decade, a stock starts with a PE ratio of 25x and ends the decade with a PE ratio of 20x, and dividend payments add 1.4% per year to returns, the stock will generate a return of 9% or the long-term average rate of return for stocks.

Year 1 Year 10
EPS $1.00 $2.59
PE 25x 20x
Stock Price $25.00 $51.80

10-year annualized stock price return: 7.6% + Dividend Yield of 1.4% = 9%

If 9% a year is the fairly valued rate of return for the stock in question, then we know in retrospect that the stock was fairly priced 10 years ago when it was trading at a PE of 25x. If it had been trading at a PE of 16x, it would have returned 14.7% a year – a very attractive rate of return – and thus, we would know that it had been trading at too cheap a price. If it had been trading at a PE of 35x, it would have returned 5% a year – a very weak rate of return – and thus, we would know that it had been trading at too expensive of a price.

In January of 2021, we wrote about this approach to retroactively demonstrating fair value. Our analysis in that post showed that while Costco traded at a median PE ratio of 15x between 2002 and 2015, it was actually worth a PE of closer to 40x. The fact it traded so cheaply is why the stock generated returns of 15%-20% over that time period. If you had paid as much as 40x, or twice the highest market valuation the stock obtained over that time period, you still would have earned a 9% rate of return.

Professor Jeremy Siegel of the University of Pennsylvania ran this type of analysis on the Nifty Fifty to generate the following chart.

What the chart shows is that while the Nifty Fifty stocks underperformed during the 1970s after their 1972 peak, they subsequently generated outstanding returns that fully reversed all the prior underperformance. Thus, in retrospect we know that the Nifty Fifty stocks as a group were not overvalued in a material way.

In this next chart, Siegel shows the members of the Nifty Fifty along with their annualized rate of return from the 1972 peak, their peak PE ratio and the PE ratio investors could have paid and still earned the same return as the S&P 500. His methodology for determining in retrospect what the actual fair value PE was is identical to the approach we explained in our post on this topic using Costco as an example.

The data shows that while Coca-Cola’s PE ratio at the end of 1972 was 46x, a huge premium to the S&P 500 PE ratio of 19x, Coke still went on to generate a 16.2% annual rate of return, beating the S&P 500’s 12.7% rate of return and demonstrating that Coke was actually cheap at 46x earnings. In fact, investors could have paid as much as 82x earnings, an eye popping PE ratio, and still have generated returns in line with the overall market.

Of course, not all the members of the Nifty Fifty did so well. Xerox also traded at 46x earnings, but it went on to generate annual returns of just 6.5%, far less than the S&P 500. The chart shows that investors would have had to pay no more than 19x earnings to generate the same returns as the S&P 500.

Why did Coke do so well, while Xerox did not, despite both trading at the same, optically high, PE ratio? The answer is in the far-right column of the chart where you can see that Coke grew earnings at 13.5% a year over the time period measured while Xerox grew earnings at just 5% a year.

In retrospect, we know that the Nifty Fifty stocks as a group performed just fine even from peak earnings multiples of more than twice the valuation of the S&P 500. Many members of the Nifty Fifty went out to produce gangbuster, multidecade returns even if you bought them at peak valuations before they temporarily collapsed.

So, if they were not overvalued, why did they underperform so badly during the 1970s, and why did their performance turn around in 1980 to begin a period of massive outperformance that recovered all of their prior underperformance?

The reason was the stagflation that began in 1973 was not fully brought under control for a decade. The chart below shows the rate of inflation (the white line), the level of the S&P 500 (blue line), and the three recessions that occurred over the 10-year period (red shading).

What the chart shows is that the overall market fell very dramatically from 1972 through 1974,[…]

This is Part II of a three-part series. Read Part I here and Part III here.

“Conceptually, if you think of what you’re doing when you’re buying an equity is you’re buying two cashflows: the cashflow given out as a dividend and the cashflow that is retained by management to invest on your behalf and that’s the wildcard.” -Donald Yacktman

Before he retired, former Morningstar Mutual Fund Manager of the Decade nominee, Donald Yacktman, used to give a presentation on stock picking that he called Viewing Stocks as Bonds. Many investors think of bonds as safe, low returning investments that produce cash while stocks are dots on your computer screen that bounce around and your job is to guess where they will bounce next. But Yacktman understood that, in fact, both stocks and bonds are securities that provide potential cash in the future in exchange for providing cash today.

Bonds are easy to think about this way. Today, if you give the US government $100,000 in cash, they will give you a newly issued 10-year treasury bond that will pay you 3% cash interest payments each year for 10 years and then return the $100,000 to you. This bond is considered an extremely safe investment because the US government is absolutely certain to make the interest payments on time and return your $100,000 to you in 10 years.

However, while this bond is considered safe, it could fall in value by 10% to 20% rather quickly. While there is near zero chance that the US government will not fulfill their side of the contract, other investors may decide that 3% is not a high enough return to interest them in buying your bond should you want to sell it. If other investors decide that they need to earn 5% to buy a 10-year treasury, they will only be willing to pay you $85,000 for the bond that you paid $100,000 for.

How could this be? Since the US government has not changed the terms of the bond in any way, what makes it worth 15% less? While nothing has change for you as the buyer of the bond or the US government as the seller of the bond, other investors have decided they want to earn a higher rate of return for choosing to own the bond in question. Since your $100,000 bond only pays $3,000 (3%) a year in interest, to earn a 5% rate of return other investors need to pay you $85,000 for your bond. By doing so, they will earn the same $3,000 in annual interest that you would get, and they will get $100,000 ten years from now for the bond they only paid $85,000 for. If you run the math, you will find that will yield the other investor a 5% annual return.

So, while the contractual cash flows of a 10-year treasury bond are as guaranteed as it gets in global financial markets, the actual value of a treasury bond is set by other investors who at any moment might radically change how much they want to get paid to own the bond.

Here’s a long-term chart of the yield to maturity of 10-year treasury bonds.

Over the last 60 years, investors have required a rate of return of anywhere between a 0.7% (in 2020) and 15.8% (in 1981) to own a 10-year treasury. This is despite the fact that at no point during that time period was there any doubt that the US government would indeed make good on contractual bond payments.

Let’s say you bought a 10-year treasury with a 0.7% yield, but when you turn around to sell it other investors wanted to earn a 15.8% rate of return. In this case, the bond you paid $100,000 for would be worth only $26,000. A 74% decline in value. If instead you bought a 10-year treasury with a 15.8% rate of return, and then sold it to an investor who only needed to earn 0.7%, the other investor would be willing to pay you $245,000 a 145% gain.

What this illustrates is that the value of a bond, even one guaranteed by the full faith and credit of the US government, is highly influenced by the opinions of other investors. These other investors may demand a higher or lower rate of return at any point in time for reasons that make sense or may not.

At the beginning of the year for instance, other investors only demanded a 1.5% return to own a 10-year treasury while today that has doubled to 3.0%. This change has knocked down the value of a newly issued 10-year treasury by 12%. Since a buyer of a 10-year treasury at the beginning of the year agreed to be paid just 1.5% a year, the 12% decline in value is equivalent to having lost 8 years of interest payments!

But here’s the thing. When you buy a 10-year treasury, you will end up earning whatever the initial rate of return was that you agreed to, so long as you hold it until the bond matures. Other investors’ opinions about the value of the bond and the rate for return they demand are irrelevant unless you decide you want to sell the bond prior to its maturity. But these other investors’ opinions can dramatically impact the current market value of the bond between when you purchase it and when it matures.

What Donald Yacktman was trying to communicate was that stocks behave the exact same way as bonds. The only difference is that bond interest payments and maturity values are guaranteed by contract (although of course, sometimes bond issuers default on the contract), while stocks, which offer a pro-rata claim on corporate cash flows, have uncertain future cash payments (dividends) and uncertain “maturity value” (i.e., the future value of the company when its growth phase is over, and the business model is fully mature).

In our very first blog post, we explored the concept of “intrinsic investing” and how we think about investing in much the same way as Donald Yacktman.

“If you forget about the stock market for a moment and just focus on businesses (after all, stocks are just a fractional share of a business), you’ll see that businesses have value to their owners that is independent of how valuable anyone else thinks they are. Businesses generate a stream of cash profits that have various degrees of volatility and risk. Clearly this cash is valuable to potential owners. But each potential owner will value that cash slightly differently.

In this way, the intrinsic value of a company is the price an investor would pay such that the cash return on their investment is satisfactory to them. That is, the cash return generated by the business, not the potential return generated by selling the business at some point[…]

This is Part I of a three-part series. Read Part II here and Part III here.

“Our willingness to wait reveals the value we place on the object we’re waiting for.” – Charles Stanley

There are three general scenarios in which stocks decline. Let’s look at them through the lens of the price-to-earnings (P/E) ratio.

  • P-driven: The price investors are willing to pay for each dollar of corporate earnings. An example would be when a valuation bubble pops and investors come to their senses, or an external shock creates temporary panic.
  • E-driven: Expectations for corporate earnings. To illustrate, a recession or cyclical downturn leads to temporarily lower earnings.

Stock prices fall in both scenarios, but the “fair value” of most businesses doesn’t change. Assuming no changes in a single company’s fundamental outlook, either scenario can present opportunities for long-term minded investors looking to capitalize on the market’s short-term myopia.

The third scenario, on the other hand, can have a far different result and remedy.

  • P-and-E-driven: A stagflationary environment that reduces both earnings and the price investors are willing to pay for each dollar of those earnings.

Here, the fair value of most companies drops alongside the share price, as the terminal P/E – or the multiple investors expect to pay when the company reaches maturity – is also diminished due to persistently higher expected discount rates. Compared with the other two scenarios, these selloffs are more rational. What a prudent investor should do in this case is far less certain.

As we’ll see in Part III of this series on the Nifty Fifty stocks of the 1970s, it’s not until the market stops worrying about stagflation that P/E multiples and earnings can return to a more balanced state and great businesses once again get their due.

We believe we are in the third scenario today. To formulate a prudent response to a stagflation-worried market, we must first understand the role equity duration plays. Over the next three posts, we will explain ways in which investors can approach today’s market through the lens of equity duration.

Bird in hand

Imagine two bonds, both with a 5% coupon. Every other characteristic is the same, except one matures in five years and the other in 30 years.

Even though both bonds are paying $50 per year in interest, the 30-year bond is much more sensitive to changes in benchmark interest rates. This is because you won’t receive the bulk of the bond’s cash flows for over a decade.

“Long-duration” stocks are similarly expected to generate the bulk of their cash flow in the distant future. These are generally “growth” companies that are in the process of widening their economic moats.

By comparison, “short-duration” stocks are usually well-established companies that produce high levels of current cash flow.

Goldman Sachs tracks baskets of 50 stocks in the Russell 1000 Index with the longest and shortest implied equity durations. As this chart shows, it’s been a rough year for long-duration stocks.

Source: Goldman Sachs, as of 8/16/22

When the market panics, investors want cash now, not cash tomorrow. Makes sense. But how should investors consider equity duration when evaluating an investment?

Duration is an important term to understand when investing in bonds because it tells you how sensitive a bond’s price is to changes in benchmark interest rates. With bonds, you know exactly what the bond will pay in interest each period until maturity, so you can mathematically determine each bond’s sensitivity to interest rates. (Sean will talk more about “stocks as bonds” in Part II of this series.)

With equities, it’s more complicated. For one, we don’t know how much distributable cash flow a company will generate over the next five years and beyond. And unlike bonds, there is no maturity date on businesses.

Still, the comparison is apt because long-duration bonds and equities are more sensitive to interest rates and inflation. Long-duration equities can endure higher interest rates when it is accompanied by robust economic growth. The economic tailwind increases the chances that the business achieves its long-term objectives.

This year, however, stagflation worries are working against long-duration equities in two ways – higher interest rates and inflation paired with slower economic growth. This double whammy has called into question both long-duration companies’ abilities to meet distant objectives and what investors are willing to pay while they wait for those companies’ (increasingly uncertain) objectives to play out.

Future in focus

Let’s illustrate by looking at the annual free cash flow forecasts for two fictional companies – one long-duration and the other short-duration.

The long-duration company is not expected to generate free cash flow until year five and doesn’t match the cash flows of the short-duration company until year nine. By comparison, the short-duration company plods along, steadily growing its free cash flow.

Yet, assuming an 8.5% discount rate and a 5% terminal growth rate for both, the fair values are equivalent. *

Judging by the cadence of the cash flows, you can see why the long-duration company might sell off harder during a market panic. Based on the above assumptions, 94% of the long-duration company’s fair value depends on it reaching those 10-year targets. A whiff of worry about the company’s long-term cash flows and investors will sell first and ask questions later.

That said, even though the short-duration company is currently pumping out free cash and its future appears a lot more dependable, 72% of its fair value still depends on the company achieving the 10-year forecast.

But that’s just the recession risk part of the equation. As this chart shows, keeping the cash flow forecasts the same, the long-duration company’s fair value is more sensitive to changes in the discount rate.

Source: Ensemble Capital calculations

But not by as much as you might think. The move from an 8% to 11% discount rate drops the long-duration stock’s fair value by 60% and the short-duration stock’s by 50%.

The reason both types of equities sell-off in stagflationary environments is that they are punished by all three of the scenarios we discussed earlier. The “P” in the P/E declines due to fear, the “E” declines due to the recession, and the terminal P/E declines due to expectations that higher interest rates and inflation persist well into the future. Long-duration stocks are more sensitive to these effects, but all equities are exposed to stagflation risks.

Either way, you’re always betting on long-term outcomes with equities. This is the risk of investing in equities versus bonds, where cash flows are pre-determined. We can be compensated for taking on that[…]

My wife is an avid seashell hunter. Her family tells me this has been a lifelong obsession. She’s intent on only keeping the good ones.

Within five minutes of setting up our umbrella, I’ll look up and she’ll be halfway down the beach looking through the sand, increasingly with our kids in tow, unknowingly learning from a master.

Oil on canvas by Anna Bryant

She’ll go hunting no matter how busy the beach may be, but in the peak summer months on popular beaches, the good shells don’t last long. Either tourists grab them up or they get stepped on during an errant frisbee toss.

Instead, the best searches take place in two settings, and ideally together – on secluded beaches and after storms. Our best haul came years ago when we ventured out on kayaks to a remote part of a remote island in North Carolina where we found an elusive intact Scotch bonnet.

Author’s photo

To increase your odds of finding the highest quality shells, you need to do the work others don’t want to do and be willing to see storms as opportunities.

There’s no question that the last six months have been rough for quality-focused investors and particularly so for our strategy. With the benefit of hindsight, the beaches (if you will) for quality stocks became overrun with tourists and the storm of stagflation rolled in, sending them running for shelter and aloe vera for their burns.

While it seems many beachgoers have called it a day, intending to return next summer only when the sun is bright and the sky is clear, we’re back on the beach looking for what treasures the storm has left behind.

We consider some of our housing stocks, such as homebuilder NVR and retailer Home Depot, trading with price/earnings ratios unseen since the depths of COVID lockdowns in 2020 and see opportunity. We don’t believe either company’s recent earnings will be their peak over the next three to five years.

The velocity with which mortgage rates have risen in 2022 is indeed concerning, but it doesn’t have anything to do with the fact that the most populated age cohorts in the US are 29 and 30. As those peak millennials enter prime earnings and household formation years, the odds are good that they will look toward single-family homes to set down roots in the coming decade.

Work-from-home flexibility has increased in the “post-COVID” era, with McKinsey reporting that 58% of Americans surveyed saying that they can work from home at least once a week. This massively opens up housing options for families that can now live further away from city centers since their commuting time has been reduced. NVR specializes in building communities in the exurban areas around second- and third-tier cities, so we believe they are well positioned for this trend.

As many of us experienced during 2020, the longer you’re in your home during the day, the more you start noticing things that need repair or improvement. That leaky faucet, once tolerated when you were away 10 hours each day, is now unbearable. Working from the kitchen table with kids running around doesn’t lend itself well to productivity, so it’s time to convert a room to an office space. And so on.

We think Home Depot will continue to benefit from home renovation and repairs, both with do-it-yourself customers and their important pro contractor customers that use Home Depot as a materials supplier.

Despite the rise in mortgage rates and the doom-and-gloom headlines about the housing market right now, this does not appear to be anything like the 2008-2009 housing crisis. For one, the bulk of US homeowners currently have fixed rate mortgages, rather than adjustable-rate mortgages, and used the opportunity in recent years to refinance at low rates. The risk of mortgages “resetting” higher due to rising rates and impacting affordability is far lower than it was in 2008-2009.

Second, the amount of home equity in the US has surged well beyond levels seen before the housing crisis. As such, homeowners have considerable project financing options for remodels and renovations.

Finally, if a homeowner needs to sell their home due to job loss or some other unforeseen event, it is unlikely that they will need to offer deep discounts to entice buyers, especially with limited existing home inventory and strong demographic tailwinds.

NVR and Home Depot are just two examples of high-quality businesses that have been tossed about in this stagflation storm. We see many more opportunities across sectors left behind by fleeing quality tourists. It may not seem like it right now, but it’s a fine time to be on the beach looking for treasures.

Below is the Q2 2022 quarterly letter sent to separately managed account clients. You can find historical Investor Communications HERE and information on how to invest HEREEnjoy!

The performance of securities mentioned within this letter refers to how the security performed in the market and does not reflect the performance attributed to the core equity portfolio. Please see the chart at the end of letter, which reflects the full list of contributors and detractors based on each security’s weighting within the core equity portfolio.

You can request a copy of Ensemble Capital’s equity strategy performance presentation here. The presentation is updated by the end of the month after each quarter end.

The first half of 2022 has been particularly challenging for Ensemble’s investment strategy. On a year-to-date basis, the Ensemble Equity Composite is down an estimated 32.7% vs the S&P 500 down 20.0%. Due to our very strong returns in 2019, 2020 and 2021, even after this year’s decline, our strategy has returned an estimated 7% annually over the last three years, and 10% annually over the last five years. However, these results are less than the S&P 500’s return and are not an outcome we are satisfied with (final composite calculations will be available at the end of this month. You can download a copy of our composite performance track record here).

We recognize that our investors are not used to this degree of underperformance from us, particularly during a market decline. Over our 18-year history leading up to this year, our equity composite only underperformed by a similar amount from mid-2012 to early 2013. Because that period of underperformance occurred during a rising market, we recognize that the current underperformance occurring during a declining market is more difficult for our clients.

Relative to the S&P 500, our strategy’s performance bottomed in early May and outperformed from then until the end of this quarter. While we expect our relative performance compared to the S&P 500 to fluctuate in the months and quarters ahead, the persistent headwinds we were experiencing did begin to dissipate almost two months ago and we are hopeful that our nascent recovery will continue in the medium term.

In this letter, we will discuss the current economic and market environment and then lay out the drivers of our underperformance as well as the reasons why we believe our strategy will return to its more familiar level of performance going forward.

Coming into 2022, the US economy was robust. Real GDP in the fourth quarter of 2021 grew 5.5% vs the year ago period. Inflation was running at between 4% and 7% depending on the measure of inflation used, but most economists and investors believed this inflation was primarily being driven by a shortage of workers, supply chain issues, and the relatively slow restarting of production that was shut down during the pandemic. Because capitalism is extremely good at producing whatever level of goods and services that customers demand, it was assumed that once the pandemic related constraints on economic production faded that supply would catch up with demand and inflation would decline.

In addition, because employment was still below pre COVID levels but growing quickly, wage growth was strong, and American households had low levels of debt and high levels of cash on their balance sheets, it appeared very likely that strong demand growth would continue.

But over the first half of 2022, a number of developments shattered confidence in this positive outlook so dramatically that today most people assume that a recession is inevitable and that even a contraction in demand may not bring inflation down to reasonable levels. With the growth outlook greatly diminished and inflation worries still raging, investors have greatly downgraded the valuation multiples they assign to most stocks, with a particularly dramatic reduction in valuations for high growth businesses or those whose fundamental results are economically sensitive.

Despite the market being down 20% so far this year, revenue and earnings for the S&P 500 increased by over 10% in the first quarter with continued growth expected in the second quarter. This has led to the PE ratio on the S&P 500 to contract by nearly 30% in the last six months with much larger contractions in higher growth or economically sensitive stocks.

Back in early March, two weeks after the Russian invasion of Ukraine, we authored a piece about the stagflation panic sweeping the stock market. The inflation prior to the invasion was a function of pandemic related supply and demand imbalances which meant that the inflation would be mitigated either through supply recovering or a contraction in demand. But the inflation related to the war in Ukraine is being driven by supply constraints that may not be resolved in the near term and these constraints are primarily on necessary products, such as food and energy, for which demand rarely declines even in the face of high prices. Thus, unlike typical inflation issues which can be cured via slower growth or a recession, the risk of stagflation, or periods when inflation remains high even in the face of slow or contracting growth, increased significantly.

In addition, after successfully preventing mass spreading of COVID over the past two years, China experienced new outbreaks in some of their major cities. With a population that is far more at risk to contracting COVID due to the relatively ineffective Chinese vaccine, low levels of vaccination among older people, and a population that has mostly not contracted COVID to date, the risk of a major, deadly wave in China is very real. This risk caused China to put some of their major cities into lockdown, limiting production of goods that the rest of the world would like to buy and putting further pressure on inflation. That being said, a slowdown or recession in China also reduces demand for oil and global transportation of goods, so there are also ways in which China’s COVID issue causes some parts of the inflation issue to dissipate.

But despite these major developments, the outlook for real economic growth and inflation are still uncertain. Recessions, inflation and the economy more generally are hard to forecast, as evidenced by how dramatically the economic outlook has changed over just the past six months. Just as the economic recovery of the past two years has been highly unusually, so too is the current slowdown and possible recession likely to look very different from historical patterns.

On the positive side, companies continue to report that supply chains are healing. The cost of moving goods around the world by ocean, air or truck have declined materially this year as supply and demand have become more balanced. The price of lumber, which soared as much as 400% in 2021 as home building activity increased sharply while lumber suppliers raced to restart production, has now declined by nearly 60% since early March of this year. Even the price of oil and wheat, two products facing significant supply constraints due to the war in Ukraine, have seen their prices decline significantly from post invasion highs.

Importantly, American households, whose spending makes up 70% of the US economy, have been resilient. With approximately 2.7 mil new jobs added[…]