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More Notes from the CSC Underground

by Ben Claremon, Principal and Research Analyst

Before you start rolling your eyes, this is not what you might think it is. Sorry, you aren’t going to get any insightful political commentary from us. We are not spending any time internally lamenting about or cheering the outcome of the recent election. So, we will not do it here. We also spend very little time pontificating on what policies (and their associated impact on the world) could come out of a Trump-Republican Congress marriage. We will leave it to the financial press and the meticulous analysts at Sanford Bernstein to handle those topics. Instead, what we are focused on is trying to understand the market’s reaction to what was once unthinkable and how that has impacted—and will continue to influence—the valuation of stocks.

If you haven’t been paying attention, stocks are up. The S&P 500 closed at 2,139 on Election Day and is up around 5% since then. And don’t even talk to me about small cap stocks; the Russell 2000® is up about 16% during that period. I think it is fair to say that the market has perceived the results of the 2016 election to be a positive inflection point when it comes to economic growth and business profitability. It is impossible to know how much of that is due to the anticipation of lower corporate taxes versus expectations for a lighter regulatory touch and more aggressive fiscal policy. Whatever the specific reasons, the market has voted, and as money managers it is incumbent upon us to assess whether or not investors as a whole are properly discounting a number of events that have obviously yet to occur.

The bull case for stocks—as we see it—is as follows: there is a legitimate possibility that as a result of a combination of relying too much on ineffective monetary policy, some regulatory over-reach, and maintaining a negative tone as it relates to American business, the Obama administration effectively threw sand into the country’s economic growth engine and dampened the all-important “animal spirits.” As a result, the introduction of a more business-friendly administration that is hell-bent on lowering taxes and spurring GDP growth could actually unleash a tremendous amount of business investment that has been suppressed since the Financial Crisis. If that narrative is correct, it is not a stretch to say that our generally conservative assumptions regarding our companies’ future cash flow generation will be wrong and our estimates of fair value too low.

If only it were really that easy. In reality, while it is not hard to create the bull case, it is just one outcome of many. Specifically, if stocks have already begun to discount a rosy eventuality, what happens if policy changes take years to play out or the political process itself limits what can actually be achieved? And if the new regime does successfully boost economic growth and inflation rates, won’t interest rates rise as well? Looking out at the sea of green that appears on our screens each day, people seem to be pricing in a fair amount of future goodness and may be ignoring what will happen to sky-high valuation multiples in a rising interest rate world.

As we remind investors in just about every Strategy Letter, when the market starts discounting a particular outcome—either positive or negative—we tend to go the other way. We lean in when people are expecting the world to end and step back when they only see blue skies. Regardless, our north star remains the same: valuation. We know that we are not smart enough to consistently make money by predicting macroeconomic events or by correctly calling what the Fed is going to do. Accordingly, all we can do is rely on a margin of safety-oriented investment process that includes a constant reassessment of the risk-reward that we see within our portfolio.

So, the appropriate question is: in light of the recent rally, where are we today on the valuation front? As was articulated in our most recent strategy letter , indices and their associated valuation metrics can be skewed by any number of factors. As such, we don’t focus too much on the fact that Russell 2000® index trades at a nosebleed trailing P/E ratio. Instead, we keep close track of where our stocks trade relative to their historical multiples and our assessment of intrinsic value. And let me tell you that based on our pre-Trump expectations for growth and margins, a number of our “high quality” stocks have started to look especially expensive. In fact, a number of them have already surpassed our three-year-out price targets. Additionally, the same cyclical stocks that we bought after they got smashed in late 2015/early 2016 have more than recovered their losses and the valuation now reflects an end market rebound that has for the most part yet to occur.

Stocks tied to U.S. infrastructure spending? Up. (See MLM and VMC.) Companies that will benefit from an assumed lighter regulatory touch? Way up. (Ummm…small cap banks). Stocks dependent on industrial production? Up a lot. (Look at the charts for CFX and MSM). Even one of the sectors that has been a mainstay on our weekly cheap stock screens, for-profit education, is no longer in the doghouse—behold the incredible three month charts for CPLA and STRA. These are just a few examples that stand out in my mind of companies that have seen their market caps rise significantly, solely based on what people anticipate that the Trump administration can accomplish. The corollary is that this somewhat indiscriminate rally has seemingly left value-oriented investors to sort through a dustbin of stocks that are cheap for a reason—such as brick and mortar retailers, grocery stores, and companies with too much leverage.

The wildcard here is that if you throw in 5% GDP growth and a 15% U.S. corporate tax rate, all of a sudden stocks don’t look quite as expensive. As a result, we are forced to create upside scenarios that analyze what fair value would look like if topline growth accelerates and more of that flows down to the bottom line. But, we certainly don’t want those to be our base case. Also, we refuse to put much stock in policies and legislation that are currently no more than sugar plums dancing in the heads of politicians this holiday season.

And this gets us back to why it is so important to remember that what moves markets is changes in expectations. Stocks can bounce when companies report seemingly terrible results and can tank when they report incredible earnings growth. It all depends on what people were expecting. Right now there are clearly a lot of investors who are betting that the election of Trump will be an overwhelming positive for U.S. companies. That hypothesis may turn out to be perfectly accurate and yet stocks could still go nowhere (or even go down) if current expectations are not exceeded. Not surprisingly, we’re a little nervous and, as you would expect from us, we have quietly put our #MakeAmericaGreatAgain hats back in the drawer.

This report is published for information purposes only. You should not consider the information a recommendation to buy or sell any particular security, and this should not be considered as investment advice of any kind. The report is based on data obtained from sources believed to be reliable, but is not guaranteed as being accurate and does not purport to be a complete summary of the data. Partners, employees, or their family members may have a position in securities mentioned herein.

Past performance is not a guarantee or indicator of future results. The opinions expressed herein are those of Cove Street Capital and are subject to change without notice. Consider the investment objectives, risks, and expenses before investing. These securities may not be in an account’s portfolio by the time this report has been received, or may have been repurchased for an account’s portfolio. These securities do not represent an entire account’s portfolio and may represent only a small percentage. You should not assume that any of the securities discussed in this report are or will be profitable, or that recommendations we make in the future will be profitable or equal the performance of the securities listed in this report. Recommendations made for the past year are available upon request.

CSC is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. Additional information about CSC can be found in our Form ADV Part 2a.

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