In October 2008, Warren Buffett penned an op-ed piece in the New York Times entitled, “Buy American. I Am.” He declared he was buying U.S. stocks for his personal account. He said he was bullish for two reasons: stock prices were very attractive, and most major corporations would be setting profit records in 5, 10 and 20 years.
Buffett was right, despite missing the bottom by a few months. Including reinvested dividends, the S&P 500 has roughly doubled since he published his op-ed.
The U.S. economic outlook has improved thanks, in part, to quantitative easing. Corporate profits are broadly higher and investors have warmed to markets again.
In fact, many investors are wondering if they have missed the run in U.S. stocks or if it’s time to take money off the table, considering the S&P 500 has recently hit 52-week highs.
But rather than reacting to overall stock prices, investors should look at individual opportunities and ask, “Am I getting more value than I am paying for?” Micro opportunities within a market will exist for opportunistic investors, regardless of the overall stock market or the macro backdrop.
Value-seeking investors search for discrepancies between the estimated intrinsic value of a business and the price of that business in the market. Intrinsic value is defined as the discounted value of the cash that can be taken out of a business during its remaining life.
Intrinsic value is a highly subjective figure based on fluctuating estimates of future cash flows and interest rate changes. Despite its lack of precision, intrinsic value is an extremely important and rational way to evaluate the relative attractiveness of different investments and businesses.
Basing decision-making on intrinsic value allows investors to see through Wall Street’s ongoing obsession with short-term quarterly performance. Stocks are regularly punished when they have small earnings hiccups or when revised outlooks miss expectations.
The subsequent overreaction often represents a terrific opening for further investigation. Then there are mispriced stocks that are ignored or misunderstood by Wall Street. Sometimes those stocks hit 52-week highs, yet are still undervalued and poised to outperform.
How to find mispriced securities
Finding mispriced securities is the key to compounding wealth over time. There are two paths to compounding wealth: closing the discount, and intrinsic value growth. The first path can be described as “buy low and sell high” and the second path is “ buy low and let grow.”
Many value investors focus their research on the first path. They are seeking to buy the proverbial dollar of intrinsic value for fifty cents. The vast majority of potential opportunities in the stock market are in this category.
The intrinsic value of a company may not be growing, but investors may receive good returns when a catalyst or change in market sentiment causes the stock to trade at its underlying value.
A fifty-cent stock that moves to its one-dollar intrinsic value over three, four or five years represents a healthy 26%, 19% or 15% annualized return, respectively. Cheap stocks in this category tend to have poor near-term outlooks and are often disliked by the investment community. Cisco Systems was a good example a few years ago, as investor impatience during a multi-year turnaround resulted in stock price depreciation. The stock has seen a strong rebound as growth picked up again.
Today, Apollo Group fits into a similar mold. Like Cisco, Apollo Group has a superb balance sheet and remains profitable, despite being in the late stages of a turnaround that has depressed the stock price. There is sizable pent-up potential in turnarounds.
Finding great opportunities through the second path is rare, but potentially most lucrative for wealth creation over time. These well-run, high-growth stocks can often look statistically expensive, but are nevertheless occasionally undervalued and poised to deliver excellent returns. A classic example is Berkshire Hathaway.
Investors assessing the many different businesses of Berkshire Hathaway in 1970, 1980 or 1990 may have seen no unusual value, but they were missing the most important long-term driver of the stock. Berkshire’s outperformance was a product of Buffett’s investment and capital allocation skills. He had invested Berkshire’s incremental cash flow at high rates of return in different businesses.
Our research suggests Wall Street systemically undervalues companies run by great capital allocators. As a result, they outperform over time. Today, we believe the new Leucadia fits into a similar category. Led by aligned and accomplished investors, Leucadia now owns a leading investment bank (Jeffries) with a merchant-banking focus, is tax efficient and maintains a healthy cash pile.
Why the U.S.?
Beyond the need to be more opportunistic, the U.S. should appeal to Canadian investors for four important reasons:
01 The opportunity set available through U.S. exchanges is vast.
U.S. stock markets are the largest and most transparent in the world. At the end of 2012, the New York Stock Exchange and NASDAQ collectively accounted for more than a third of the global stock market value. And while many companies may be headquartered in the U.S., their growth opportunities are increasingly global. Investing in U.S. stocks is no longer a country strategy.
In fact, the S&P 500 continues to outgrow the U.S. economy because, thanks to globalization, corporate earnings power has decoupled from U.S. GDP. In addition, most of the largest companies in the U.K., Japan, Germany and Canada are also available through U.S. exchanges as American Depositary Receipts (ADRs).
Including cross-listed foreign companies, over half of the world’s stock market capitalization can be accessed through the U.S. exchanges. There will almost certainly be some undervalued stocks to own within such a large
02 Familiarity with the U.S. helps Canadians stay the course.
Investors obtain better results when they’re familiar with their holdings. If all you know about a company is its stock symbol, you’re far more likely to sell low when that company hits a speed bump.
Unfortunately, the choices of TSX-listed stocks are limited outside the financial, resource and telecom sectors. The good news is there are few countries in the world that have as much in common as the U.S. and Canada. This familiarity provides Canadian investors with a psychological edge.
03 The U.S. has a culture of innovation.
Hardly any other country celebrates entrepreneurship, risk-taking, innovation and capitalism like the United States.
According to the latest World Bank Survey, the U.S. ranks 4th out of 185 countries for “ease of doing business” and the three countries ranked ahead of it are tiny (Singapore, New Zealand and Hong Kong).
By comparison, Canada ranked 17th. It is no accident that America has been a reliable generator of wealth for decades. The U.S. has a cultural edge that should continue to be a reliable competitive advantage for American companies.
04 U.S. rule of law and protection of property rights helps investors.
The U.S. has a long history of protecting and enforcing private property rights, which allows companies to risk capital with the confidence that their property rights will be upheld.
In contrast, many fast-growing economies have weaker investor and property rights protections, so emerging markets often trade at low valuation multiples.
The heightened risk of potential draconian royalties, double taxation and, occasionally, outright confiscation of property remain hazards in many emerging countries, not to mention the fallout from potential political turbulence, which further elevates risk. For many investors, a high risk of permanent loss of capital is not worth a few percentage points of extra potential return.
Investors who bought the S&P 500 index back in October 2008 did well. Investors did not need any special stock-picking abilities then; just the courage to deploy cash or stay invested.
Although the market is more fully valued today, attractively priced stocks still exist and may be found when their prices are trading below their conservatively estimated intrinsic valuation. Investors should still buy American stocks, but be more opportunistic.
Disclosure: The securities mentioned in this article may be/are current holdings of the Pender US All Cap Equity Fund and the Pender Value Fund at the time of the writing of this article.