Equity Valuation Methods Matter

How KCR’s Valuation Models Make a Myth of “Cheap at the Peak”

Happy Friday everyone! This piece is going to be brief, brutal, and to the point.

Over the past two years, some readers have complained that the cheapest stocks that dotted our top-ranked companies “were at the peak” and destined to collapse. Counter to intuition, some have come to believe expensive stocks are safer than cheap stocks.

For many of these names, earnings did not peak, the world did not end, and many of these stocks ran higher. Remarkably, many of these stocks are cheaper now, after their prices have risen, than when we first began hearing complaints that their earnings were at peak levels. Here’s what we’ll say about that type of pushback:

• If you can predict earnings peaks and troughs, good on you, we’ve been at this for over 70 years combined and never met anyone who can do that with any reliability
• Our own research has noted that margins are at 100-year highs and prone to mean reversion, so this is not some macro call for perpetually high profits
• When a large cap stock has a 10%+ FCF yield, cash-rich balance sheet, and the market’s FCF yield is ~3%, a lot can go wrong for that company and, over the long-term, the stock still might do quite well

There is so much emphasis out there on equity valuation models that focus on price-to-book, asset-based valuations, price-to-earnings ratios, free cash flow, estimated future free cash flow, discounted cash flow models, etc. It can be hard to figure out which ones to choose from or combine.

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KCR has done what we believe is a solid job of creating a balanced blend of value factors in the valuation module of our stock ranking tools. For those that disagree – please talk to us. We are open-minded and love engaging with our readers. Together we are better!

Today’s piece is going to pretend we are all perfect market timers. We all knew exactly when the market was going to crash. Then we will see if using KCR’s equity valuation module provides a margin of safety. Let’s go – the chart below shows every drawdown of 10% or more in the S&P 500.

The chart below shows the following performance of KCR’s valuation module vs. the index:

• Navy Blue Bars: how the bottom quintile (most expensive) stocks fared in each drawdown
• Gray Bars: the peak to trough performance of the S&P 500
• Light Blue Bars: how the top quintile (cheapest) stocks fared in each drawdown

What do we see here? The KCR valuation module, which combines a variety of factors assessing valuation, has, without exception, provided investors with a meaningful margin of safety. In every single drawdown, you were better off owning the stocks our model ranked as “cheap” compared to either the index or the stocks we scored as expensive.

This strikes us as intuitive but contradicts many folks’ preconceived notions today.

So, what’s the cost of owning KCR’s cheapest quintile? Surely, after the crash bottoms, they underperform. The chart below shows that while not nearly as effective in providing downside protection, KCR’s cheapest stocks have served investors reasonably well even when bouncing off the bottom of crashes.

The bars below show the returns from the trough of each crash to the point at which the market recovered from the drawdown for:

• Navy Blue Bars: the most expensive stocks based on KCR’s valuation score
• Gray Bar: the S&P 500 Index
• Light Blue Bars: the cheapest stocks based on KCR’s valuation score

Conclusions:

1. KCR does not believe anyone can time peaks or troughs with any reliability
2. KCR’s Valuation Score has provided investors with a powerful margin of safety when market dislocations occur
3. This outsized defensive characteristic of KCR’s cheap stocks suggests the concept of “cheap at the peak” is more myth than observed reality

Next week’s paper will show the empirical facts that the diffusion of market prices relative to fundamentals has not been this high in nearly 40 years and explain how investors might capitalize on this unusual opportunity.

Notables:

KCR is an open-minded organization that loves to read. We recently found tremendous enjoyment from Cove Street Capital’s Strategy Letter. Our team readily admits that this is confirmation bias at its finest. For the record – we do not know anyone at Cove Street or have any commercial relationship with them.

Their article predicted “Peak Private Assets and Peak ESG.” As investors who are drooling over the dispersion within equity markets today, we have to admit we’re a bit miffed to be defending the idea that it is better to pay less for healthy and profitable enterprises. This is just common sense, in our view. The concept of “cheap for a reason” flies in the face of the in and out of sample reality of our core ranking models.

We think the very need to defend and explain the obvious – that valuation matters in corrections – is because private equity has manufactured downside protection. We do not know if PE shops achieve this alchemy through a discounted cash flow method with exorbitant assumptions for future cash flow or what, but KCR has been fairly ruthless in hammering private equity’s dubious returns.

What we do know is that we agree most emphatically with Cove Street’s comment that (emphasis ours):

“…the idea that select groups of companies can be taken private with highly incented management teams guided by capital allocation geniuses and get superior outcomes has been buried by hundreds of billions of new dollars, ruining the returns of what was a good idea served in smaller portions. Conversely, opportunities are staring you in the face and trading every day for purchase or sale in public markets. And I will say this again, owning 25% of a small-ish public company with commensurate board representation is EVERYTHING that you are being pitched in Private Equity, but with more liquidity and optionality and less reliance on leverage.”

As long-time readers know, KCR has been pounding the table on value and quality spreads across the market-cap spectrum. But we have placed particular emphasis on small-cap investing strategies and small-cap quality stocks while pillorying small-cap index funds. Cove Street’s comments about board representation on small-cap public companies being identical to the PE shops’ pitch with less leverage and more optionality are a fabulous reminder that there are alternatives.

Happy Friday again, we are deeply grateful to all our subscribers and wish everyone a wonderful weekend!

Please find the Top Quintile of Stocks based on KCR’s proprietary Valuation Score below.