The Dividend Cafe - Growth, Value, and Tom Brady

Episode Date: February 5, 2021

Last week, I wrote about investors’ reality (especially professional investors) being a by-product of the era in which they came to be. The intent was to set the table for how much of my investment worldview was formed. I live with a deep fear of excess valuations, and I live with a deep cynicism of the madness of crowds. Both of these things come from years and years of abundant research. But at the foundation of that research was the experience of living through something that provoked such impulses. I won’t re-hash all of it this week. What I want to do this week is go beyond those two topics (i.e., valuations and crowd madness). We will look at these two things and seek to understand something about both concepts, but more importantly, we will seek to apply what it may mean to the present investing landscape and what it doesn’t mean. This week’s Dividend Cafe wants to analyze a handful of present investing landscape realities, consider the lessons of history, assess where certain things are clearly different right now, and apply what it ought to prudently mean for real-life investors with real-life goals and real-life emotions, right now. It is, indeed, our thesis that a rotation is in motion within investment markets. But I believe that means something very different than what many are saying it means. This week’s Dividend Cafe seeks to provide clarity around what is a truly important subject in 2021. Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Hello, welcome to this week's Dividend Cafe podcast and video. I'm recording from our studio here in the Newport Beach office. Beach office. And for those of you that are on the East Coast or were in the storm this week that I beat as I left New York last week, I just want you to know that it's something like 69 degrees and not a cloud in the sky right outside my window here in Newport. So there is some kind of rationalization in the universe, I suppose, for real estate prices here in Southern California. But the reality is it's been a very interesting week and I'm not going to talk about much of it. That's sort of what DC Today is for as we're sitting here recording in the middle of the market day on Friday. Looks like it's going to be a pretty strong week up in markets. More or

less every day this week up and some days up quite a bit. But combining together for one of those, you know, thousand point week type of deals in response to where there was a sell off late last week in markets. So we might be in a bit of a trading range. I don't have a whole lot of opinions on any of that stuff. I just share it with you to kind of set things up because I ran out of time last week to really go all the way with where I wanted to go. And I think that it worked out better. Similar to that inflation deflation discussion we had a few weeks ago.

I think it was better to have broken it up into two parts. And we did the same thing here. But what are the two parts I'm talking about right now? Well, the historical background that I freely admit is somewhat biographical or certainly meant to provide a kind of personal context was last week I was making the case that virtually every investment advisor, every portfolio manager, everyone engaged in some form of financial markets is going to be sometimes at varying degrees of self-awareness informed by the era in which they kind of came to be. There's that sort of period of time at which one becomes, they kind of earn their stripes, you know, in investment, the investment profession. And for myself, being a product of the late 90s and the technology boom,

and then coming into what was really a world changing period of time that not only world-changing period of time that not only coincided with the change of the millennium, the century, the decade, new presidential administration, a lot of different things were happening. But obviously, technology was moving very quickly and really redefining a lot of aspects of modern life. And yet, from an investment standpoint, it just blew the heck up. And you had these periods of robust returns across all equity markets in the late 90s, not just tech, driven by higher P.E. ratios, by really robust economic growth, by some degree of post-Cold War realities. There was a little bit of a Cold War risk premium that was able to be removed. And you have, I think, the realities that were

accurate of advances in software, hardware, semiconductor, microprocessor, and of course, semiconductor, microprocessor, and of course, ultimately, broadband. That changed the world. And figuring out how all that stuff got priced into capital markets created excesses. And it revealed a lot of human nature. And people got in over their skis and things blew up. And yet, this wasn't a case of standard market volatility. The NASDAQ went down over 70 percent and it stayed down for over 15 years. Well, all the way through the next decade, the financial crisis ended up ending

out that decade. And then in the last 10 years, we've had various events politically. We've had global uprisings of populism. We've had the Trump era. We had Brexit, you know, all these different things. I could talk about all of it. I kind of do a lot. I care about all of it. I actually believe the biggest economic story playing out is the one I've talked about regarding the Fed, excessive sovereign wealth debt, and then what that means in the inflation versus deflation discussion. But as it pertains to equity markets, we face right now a discussion kind of in the weeds that a lot of people want to force in boxes of, are you in the growth box or the value box? And so I thought it important in Dividend Cafe this week,

I tried to unpack the definition of what a lot of these things mean. And I think that value being defined as investing in boring companies or investing in companies with really low valuation because they're kind of out of favor is a bit inadequate. The context has always been really quite academic, quite definable. It's quite objective. Now, with Buffett, he took more of a discounted cash flows method of defining value, meaning they would take future anticipated cash flows of a business, discount them into a net present value, and look to see if that intrinsic value was higher or lower than where a company was currently trading at.

I think the Ben Graham model, who was Buffett's mentor, was more balance sheet driven. It was more to be kind of crass. Liquidation value is a company potentially trading at less than it would be if you sold all its parts. And I think that there was benefits to both of those methodologies. The book value aspect is tricky for a lot of more complicated companies. And it's the financial sector that really revealed that back at the time of the financial crisis, because companies are carrying an incredible amount of assets in their balance sheet and certain values, not to mention

so many companies have what we call intangibles or goodwill on their balance sheet, which is really, frankly, very messy to try to value. That whole methodology of looking at just the sum of parts of what a company's worth, if you were selling it all off, and determining if there's a value there or not, is a bit more practical, a bit more usable with real estate, with factories, with inventory, maybe with brands and IP. There's always some subjectivity, but it lends itself to some sectors more than others, is what I'm saying. but it lends itself to some sectors more than others is what I'm saying. But I believe that a dichotomy has been created that says there's value,

which has all these unattractive pieces to it, and then there's growth, which people are defining growth now really apart from any objective standard. They're just simply saying it's the belief now that some company is going to be magical into the future. And my argument is that whether one has a favor, a bias towards growth oriented or what is more traditional value oriented, there needs to be a process by which a value is being determined. And that has varying degrees of bandwidth, of subjectivity, and of qualitative judgments. You may not be able to predict

who the next Thomas Edison is, but when you're trying to value a company based on assuming that so-and-so, the brainchild behind the company is, you're still having to do some sort of valuation. You're factoring that in. There has got to be an understanding that no matter what the hope is, the belief, the optimism, the confidence in future business model, the confidence in something special, in accelerated growth, in a particular catalyst, that you are still measuring a capacity of future earnings.

And when you don't do that, without getting to the name of the company, there was the story the last 10 years that I think I could use so many examples. Okay. It's not even funny. I'm using this one because it was cartoonishly stupid and offensive where gazillions of dollars were being invested into a company that was a shared office space company with a big brand. And it was whenever discussions came to rents and future value and future capacity for earnings, it was always, no, no, no, no, no. We're not doing any of that stuff. We're going to generate world peace.

We're going to generate nirvana. We're going to generate some sort of Zen consciousness across the universe. And it was almost like the way someone like myself might make fun of it, except for it was literally that type of mentality. And I understand that a lot of large cap growth and FANG and technology and NASDAQ is not in that stratosphere. People are not being that silly and absurd about it. But see, this is what I called in Dividend Cafe this week, the limiting principle. in Dividend Cafe this week, the limiting principle. If you assume that attempts at valuation don't matter when you go into what you call the growth bucket, that you literally don't have to have any rationale other than either this sort of, oh, the future we're going to bring about world peace,

or even worse, that just in the future, we believe more and more people are going to like it. There's this sort of eternal popularity momentum thesis. There isn't a limiting principle, and you have set yourself up for what was the dynamic that tore down NASDAQ out of the kind of pets.com silliness of 20 years ago, 21 years ago now. silliness of 20 years ago, 21 years ago now. And I don't believe one has to be opposed to growth investing or technology investing to note that that was a danger that was inevitable once one was divorced from such rationality and coherent way of understanding investment markets. I don't believe that principles of value investing, if you will, are obsolete. There is a school of thought trying to talk that way now. I'd always be very skeptical of people saying the time-tested

principles. The way in which these principles get applied has to constantly be modernized and updated and thought through. We work ridiculously hard at trying to do that, to try to always be very diligent in the way that we are applying the principles we believe in. But people that dismiss out of hand principles generally are begging for trouble. But what I'm simply trying to say is that the principles don't contradict the allowance of growth investing. If one looks at growth investing as, I got to pay up a higher valuation because I believe a company has higher growth outlooks

in the future than the market's appreciating, even if the market's already giving a high valuation. And my belief is that when you actually are talking about asset allocating, creating a pie chart for a client and dividing up various assets that are going to have a combination of risk and reward characteristics for the purpose of delivering on real life financial goals. At that point, it's not just simply a matter of is this new tech stock going up or not? That's one conversation. And that's fun. And there's a lot of Monday morning quarterbacking that goes on. But when you actually have to apply what you're doing in the context of risk and reward to the context of financial goals, cash flow needs, risk appetite, liquidity, risk appetite liquidity all of the things that make an investor investor it is my belief that when one absorbs an appetite for for higher volatility willing to pay up higher valuations for what they believe will be certain special scenarios innovations higher rates of growth

maybe trying to invest in that next Thomas Edison, those kinds of things. I think that that still has to be done in the context of coherent rationality, as some attempt to quantify and economize what it means into the future. That just simply doing it out of hope or doing it out of that kind of Zen nonsense or doing it just simply trend following. All of those things, I think, are big mistakes. And I think a lot of that's going on right now.

Look, I think that if the S&P 500 hits its best case scenario for profits this year, the S&P is trading at 23 times those profits. It's pretty expensive. If you take technology out of the S&P altogether, it's trading about 20 times. So the tech sector is a big part of an elevated return premium. The return premium should, that valuation should be higher, as I've talked about over and over again, because of Fed policy, because of very low interest rates, you're discounting it against a lower rate. But I don't think you're discounting it against a rate that's going to be going lower still. That justifies ongoing multiple expansion. You've

had multiple expansion from a decreased rate. Now you're stuck with kind of a level rate. That takes away a lot of ongoing multiple expansion. I think that certain clients with certain goals that check a few boxes around what is appropriate in their specific individual situation can withstand the risk, but then also appreciate the opportunity in what we call growth enhancements. Now, we look to enhance growth in this bucket for those specific situations with a lot of emerging markets, with small cap, where we think there's underappreciated stories. We've gone more into the kind of forward innovation side of things that we are taking active approach with the money manager we're using there. So there's a couple of different

strategies that all put together in aggregate represent growth enhancement. And it's not for everyone. It shouldn't be for everyone. But at the end of the day, the challenges of applying what I'm talking about, a value and growth investing to a core portfolio, whether it be the accumulation of capital, which is always and forever about letting compounding take place, or to the withdrawing of capital for people in a more mature life cycle that are needing to yield fruit from their portfolio tree, we believe dividend growth better juxtaposes these tensions about growth and value than simply picking one versus the other. I'm not an index investor, but if I were, do I believe the index that is called the Russell 1000

value is going to do better than the Russell 1000 growth in the years ahead? My guess is it will. I base that just simply on starting point right now, present valuations, and reversion to the mean realities that the delta between the two has been allowed to separate to ahistorical levels. But that's not really core to what we're doing. What we're doing is so bottom-up driven and I believe really is divorced from the tensions of classifying something as growth or value. We are doing discounted cash flow analysis, which is Buffett's method of value. We oftentimes are doing balance sheet analysis, looking at the cheapness of a company relative to its own book value, which is more Ben Graham-like investing. of his own book value, which is more Ben Graham-like investing. We specifically do that with some of the REITs that we've owned and bought and other asset-specific type companies.

But there's nothing that we believe we can do better than evaluate the growing free cash flows of a company and apply that to their distribution of those cash flows to us as shareholders. Now, obviously, that means that we're investing in more mature cycle companies a lot of times, and that there's a whole universe that might get left out that is really very investable and very opportunistic for some people in some situations. That's where the growth enhancement bucket comes in. But I believe right now there are a lot of people with, again, I use this expression a lot, varying degrees of self-awareness that are investing a core part of their portfolio,

a significant part of their financial outcomes are levered to the hope that what has been happening will continue to happen. Divorced from future fundamental analysis, it is rooted in just simply the repeating of the past. That's not growth investing, and it's obviously not value investing. It's rear-view mirror investing. Okay? And it can work until it doesn't. I merely am saying that's not what we do, and it's not what we're going to do and it's not what I recommend anyone do. way for us to go solve for the desire for future growth and innovation blended with buying,

as Charlie Munger famously says, great companies at good prices. That's what we want to do. I think that this whole subject is often polluted by the media with pieces that don't help the conversation. However, I want to provide as much info, enough historical context for you to appreciate the reality we're living in. If anyone believes investing in the S&P at 23 times forward earnings is the same thing as investing in it at 14 times forward earnings, they're just wrong. But that doesn't mean the S&P goes down from here. It just simply means that the way in which we're viewing risk and reward and making decisions on portfolio

composition is different. We have a different world. When you have growth and value that are performed in line with one another for 40 years, and yet all of a sudden their delta has gotten the highest it's ever been for the longest it's been. Those are things worth looking at. When the valuations by a whole lot of metrics, I talk about in DividendCafe.com today, margin debt levels, I do think there's some nuances that make it a little different. But the point is when margin debt levels as a percentage of financial transactions have gotten above where they were at dot com or pre-financial crisis. All of these things have to be looked at and understood.

And I do not come at this from the perspective of wanting to sort of be negative on a valid and legitimate part of an investment process. I come at it from the vantage point of trying to figure out where the superior process is when one has the responsibility as a fiduciary to marry risk and reward and also to really be self-conscious about what an investor is doing and what they're not doing. And in the present situation now, one can take a company trading at 200 times earnings and make the case that that valuation is warranted based on the things that are going to happen in the company over the next five or 10 years or what have you. There are some tremendous stories out there. There's tremendous execution, tremendous

innovation. I'm very bullish on that aspect of American economic life. But when we apply it all into a portfolio that is there for the purpose of delivering a financial outcome, I hope you'll consider what we have to say today in the Dividend Cafe. Thank you, as always, for listening, Dividend Cafe. Thank you for those of you that are watching it. And I hope you will all have a wonderful weekend. And by the way, I kind of made it up right as I was typing my conclusion away in Dividend Cafe. But as you get ready for your Super Bowl weekend, a little parallel here to how great companies sometimes cannot be called growth or value. It would be Tom Brady as a quarterback. You know, I think I guess now we're talking about 20, 21 years ago.

Was he an incredible value as a six-round pick? And did he warrant a very high multiple as a guy who would end up going on to win as many Super Bowls as he's won and maybe even another? And now he's sitting here only a few years younger than I am and playing for a Super Bowl, where every time I go run on a treadmill, I got to put ice on my knee or whatever.

I mean, look, this guy is a value stock, a growth stock. Should be a fun game. If that analogy doesn't work for you, then I don't really care. Okay. Have a wonderful weekend. And thank you for listening to Dividend Cafe. The Bonson Group is a group of investment professionals registered with Hightower Securities LLC, member FINRA and SIPC, with Hightower Advisors LLC. Thank you. Any opinions, news, research, analyses, prices, or other information contained in this research is provided as general market commentary and does not constitute investment advice. The Bonser Group and Hightower shall not in any way be liable for claims and make no express or implied representations or warranties as to the accuracy or completeness of the data and other information,

or for statements or errors contained in or omissions from the obtained data and information referenced herein. The data and information are provided as of the date referenced. Such data and information are subject to change without notice. This document was created for informational purposes only. The opinions expressed are solely those of the Bonson Group and do not represent those of Hightower Advisors LLC or any of its affiliates. Hightower Advisors do not provide tax or legal advice. This material was not intended or written to be used or presented to any entity as tax advice or tax information.

Tax laws vary based on the client's individual circumstances and can change at any time without notice. Clients are urged to consult their tax or legal advisor for any related questions.