Opportunity Set From Hell

Depending on your valuation measure of choice, stock valuations are near or at record highs. The valuation measures that I prefer, such as price to sales, are at record highs. The price to sales ratio on my 300-name possible buy list exceeded 2x at the end of Q2 – the highest I can remember, while its P/E exceeded 30x! Many of the mature small caps I follow typically sell closer to 1x sales (makes sense as 1x sales would equate to 15x earnings using 10% EBIT margin). In May, Goldman Sachs noted median stocks trade at the 99th percentile of historical valuations, with EV/Sales at 100% percentile. Bond prices and yields are beyond belief. Over $11 trillion of global bonds now provide negative yields, while the 30-year Treasury recently reached a record low yield, dropping to as low as 2.14% on July 5. Alternative investments aren’t screaming value either. Residential and commercial real estate has appreciated significantly, with cracks beginning to show in higher end properties such as in New York and San Francisco. Private equity returns looks great, as all asset classes do in the rearview mirror of a boom. Some pensions and asset allocators are firing their hedge fund managers and “diversifying” (or performance chasing?) into alternative assets.

To be fair, it’s not an easy environment for asset allocators and it’s even more difficult for absolute return investors. Let’s face it, it’s an opportunity set from hell. With asset prices so high and yields so low, are adequate absolute returns possible? While I can’t speak as confidently about other asset classes, I believe at current prices, small caps will struggle to provide sufficient absolute returns (sufficient = positive returns that appropriately compensate for risk assumed). I believe small cap stocks are extremely overvalued. Assuming the price to sales ratio of most mature small cap stocks revert to more normalized and justifiable levels (2x sales declining to 1x sales), I believe many small cap stocks could be cut in half. While large declines are uncommon and may sound extreme, small caps saw similar declines in the bubbles of 1999-2000 and 2008-2009.

What is an absolute return investor to do in such an environment? Be patient and remain safe and liquid is the best answer I can come up with and it’s what I am doing. Participating and playing along is great if you can time markets – I can’t, I don’t, and I won’t. Is this why the investment management industry has become so obsessed with relative investing? Relative investing provides cover for professional investors to stay fully invested even when valuation metrics are flashing red. Relative performance investors (most professional managers) have few options, but to play along. They have inflexible mandates and may fear losing assets under management, so they stay invested and practice relative value investing (buy overvalued securities, but not the most overvalued).

We can debate why prices are where they are in another post, but I believe most value investors would agree that many assets are artificially inflated and expensive. I have no special insight on when this cycle ends. Again, I can’t time markets. Nonetheless, if we are in fact in the third asset bubble in only 17 years, I believe it too will end as no amount of touting T.I.N.A (there is no alternative) can keep overvalued markets inflated indefinitely. In investing, although it may feel this way, we do not have guns to our heads that force us to overpay. We don’t have to do it. There is a choice. There is a decision. As an absolute return investor, I’m saying no and refuse to invest in the current opportunity set from hell. There will be better ones in the future – that I’m confident of.