Value Stock or Value Trap…Trick or Treat | Stock Talk Podcast

The Investor Advice:

We’ve all done it as investors, even the great Warren Buffett. The “It” is buying a stock or holding on to a stock based on valuation, holding on to it because it’s down -30 to 50%, or thinking it’s “cheap” only to be massively disappointed by its stock returns going forward. The poster child for this kind of value trap over the last four quarters has been the stock of Facebook, now known as Meta.

The culprit behind META’s stock plunge in the last four quarters is a peaking and rollover in its revenue growth, post-Covid boost; at the same time, Mark Zuckerberg has taken the position of spending $19 billion on capex
in 2021, $32.5 billion in 2022, and even more $34 to $39 billion in 2023 on building out his vision for the Metaverse. This is with zero cash investment return on the horizon and most people seeing its tipping point to consumer adoption outside of gaming 5-10 years away.

Stocks don’t like declining or plunging free cash flow like this. Much like the old baseball adage, “hit em where they ain’t,” the best value stocks, or groups, like max negative sentiment; they like troughing, not declining revenue growth, trough margins, and peak capital spending, not a continued ramp of spending into uncertain returns. The subject of this week’s podcast? Is that a value stock or group? Or a value trap?When to be a contrarian and not be too early.

I am Chris Perras with Oak Harvest Financial, Group in Houston, Texas and welcome to our, weekly stock talk podcast, keeping you connected, to your money.Before we get into this week’s topic, Contrarian Investing, value stock, or value trap? Please take a moment to click on the subscribe button and click on the notification bell so you will be alerted when our team uploads our latest content.

Being Early:

Value investors like to be early. But if you are too early, you can be very wrong on both an absolute basis and a relative basis. What do I mean?

Every investor’s public stock investment alternative is being in a low-cost index fund. I want to cover two groups that have had a large outperformance in the last 18 months and posture a third that may be on the cusp in 2023. Contrary to many investors’ way of thinking, both of the first two groups were directly confronted by the current White House administration on the campaign trail in 2019 and upon President Biden taking office.

Think back two years because many investors said these two groups were “uninvestable” back then. The first group. Energy stocks. First off, a confession, we own some but not enough given their outperformance in the last 18 months. Investors, these stocks were in a bear market for their very normal 12 years. They were dogs on a relative basis versus the SP500 from their peak in June of 2008, when the Olympics opened in China, to March of 2020 when oil traded at a negative -40+ because of Covid shutdowns.

• Take a look at the chart of Exxon as the poster child for the energy industry.

The blue line in the background is the stock’s performance vs the S&P500. From June 2008 through March 2020 the stock fell almost 69% from peak to trough. Now you did get a near 4% dividend along the way, but even so you lost almost -40% on a total return. This while the price return of S&P500 was over +100%, and with dividends reinvested, it was almost 160%. The story here was with Joe Biden running for office in 2020 and eventually taking office in 2021. The story was you couldn’t invest in them because of the ESG movement, and the push by the Biden White House to support green and renewable energy sources to the detriment of old line, “dirty” fossil fuels.

We had clients and prospects directly tell us they didn’t want to own them because of the new President. What happened? Since mid-2020, the energy sector, more specifically, old line fossil fuels, not the heavily hyped and newly subsidized renewables, have been one of the best-performing groups in the stock market. And this was happening even before Russia invaded Ukraine.

Why? 2 words, capital allocation. More specifically, the ESG, anti-fossil fuels movement, pushed and restrained old-line energy managements capital investment in future production growth just as demand growth resumed. And miraculously, these companies’ free cash flow exploded higher.  And with output expansion in oil and gas measured in terms of years, not months and quarters, management teams in the energy business have been guarded about taking on new major, unknown ROIC, expansion plans. This is quite the opposite dynamic from Facebook, Mark Zuckerbergs accelerating investment plunge into his future metaverse vision.

Many investors see accelerating capital investment as a good thing. As a land grab of opportunity. The public markets rarely reward, unconstrained, unquantifiable investment in projects whose future return is years away. They didn’t for energy companies post 2008 as those companies spent 10’s of billions of shareholder capital on future production growth, and they aren’t now on Facebook’s investments in the metaverse. The second case study, in contrarian value investing, the 18 months lies in the healthcare sector, more specifically in the drug and pharmaceutical industries. In this years “Inflation Reduction Act,” the White House celebrated the long-term goal of the Democratic party to regulate and negotiate prescription drug prices inside the Medicare program.

Medicare spends almost $180 billion a year on drugs accounting for more than a third of the country’s total drug spending. These new powers allow the federal government to negotiate discounts directly with drugmakers for some of the drugs that cost Medicare the most. Many shorter-term investors and traders sold the group off broadly in August on the back of this announcement without reading the fine print and details. Those details are that Medicare won’t announce its first ten drug targets until September 2023, and the prices negotiated for those drugs won’t take effect until 2026.

That’s a long way away. The law allows Medicare to target additional drugs each year thereafter, adding up to as many as 60 by the end of this decade. However, that’s a long runway for implementation.

• Take a look at the XLV Healthcare ETF chart.

It’s broader than just the drug stocks, but you can get the picture. Focus on the blue line. That’s the sector’s relative performance vs. the S&P500. A flat line is keeping up with the S&P500, an up-trending line is outperforming, and a blue line in a downtrend is a stock or group underperforming.

As one can see, although the rhetoric out of Washington DC has been anything but friendly with this administration, the group kept up with the S&P500 in 2021 when economic growth was good, and it has been outperforming all of 2022 as investors have gotten concerned about economic growth. The only blip on the chart versus the market this year is the two months around the announcement  of the Inflation reduction act and drug price controls.

Since then?

The healthcare group and many drug stocks have been outperforming the markets handily. Why did they sell off for a few months? Sentiment. Not fundamentals or a change in marginal returns. The law actually benefits many drug companies over the next few years. How? There is a provision in the law that reduces how much seniors, who are covered by Medicare, are required to pay out of their own pockets for prescriptions, which could encourage greater use of high-price medicines thus allowing many drug companies to prosper from higher volumes before the price negotiations kick in. So, while over the much longer term, this act will likely lower company profitability, over the next few years it could be a sort of backdoor windfall.

This is similar to how the “affordable care act” passed under President Obama, has turned into a windfall for many HMO providers. So, the question going forward for 2023 is: are there sectors that might be setting up for turns up in 2023 in their marginal returns on cash? Are there groups at peak pessimism, trough revenue growth, peak inventory, and peaking or declining CAPEX, so shareholders see more cash in 2023? Are there groups newly under attack by politicians and or regulators?

There is one group I can think of that is starting to fit this bill. Which is it? Semiconductors. Now I don’t know if it’s going to be the turnaround value group in 2023 or not, but, Here’s the idea for you to ponder.

• Take a look at the SMH etf chart.

it’s a basket of semi and semi-equipment stocks. Investors on TV hate semis right now. Why? The economy is slowing, there is an ongoing inventory correction from double ordering during the Covid work from home demand sugar high, and the White House has now attacked end chip demand and supply chains by restricting Chinese use of some of the most highly sought-after chips. But here is where it gets interesting. Look at the relative strength line on the SMH.

When did it peak? For general purposes, it peaked in March of 2021! Which is quickly approaching two years ago. Even though the group made new absolute highs in 2021, it barely kept pace with the S&P 500. If you listened and watched TV throughout 2021, you would remember the almost daily talk of insatiable and unmet end market demand as well as the big ramp in capacity by semi manufacturers to meet that demand. And what happened?

The overall group barely kept up with the market in 2021 and has been awful in 2022. Why? Because the big money investors were already worried back in early 2021 about double ordering, overspending, and peak “marginal returns on cash investment” as the industry sold older lower priced inventory into high end user demand and took the proceeds to “invest” in new equipment with the hope of ongoing strong demand.

And in 2022? The demand evaporated. Now, guess what is happening? A vast retrenchment in semi cap spending due to the crackdown on China and global slowdown. But investors, that is where long-term dynamics and thinking might set up for higher long-term, returns, when demand returns. Are we using fewer semis in society? No. What happens if the economy has a softish landing in 2023 or 24 and demand reverts back to its historic 5-15% growth rate, double or triple GDP, just as all the CAPEX expansion has been cut back?

Further Implications:

What happens if electronics users restock in 2023 just in case China decides to invade Taiwan down the road? Or if China circumvents trade restrictions, end runs them, and sucks up all the current excess inventory in the channel? Doesn’t this sound a lot like the dynamic of what has happened in the energy markets over the last two years as we restrained CAPEX due to the White house’s vilification of fossil fuels? And then the globe reopened post covid? And then Russia invaded Ukraine?

Right now, many semiconductor companies are cutting capacity. China’s economic growth is slow currently, and there is increasing rhetoric toward Taiwan, which supplies the world with advanced manufacturing. What if 2023 is a soft landing in the economy? Or China reopens to get their economy on an upswing in 2023, for an invasion in 2024 in front of our elections? Don’t you think that would be good for both demand and pricing in semis? Right after they all cut CAPEX.

That’s how an institutional value investor thinks. They don’t think in the term of, a stock is down -50% its “cheap.” They think in terms of, are marginal cash returns near an inflection point. Are cash returns Peaking? Or troughing?

They search out industries with cutbacks in CAPEX and headcount reductions because on the other side? In a secular growth industry? There is more free cash available to shareholders. They like to hit them where they ain’t. If the ongoing market volatility is making you feel uneasy, give us a call, and schedule a meeting with an Oak Harvest advisor.

Our team does have insurance-based tools that do not have the volatility of public markets. However, we remind you, that these investments may also have lower long-term expected returns.

At Oak harvest, we think our clients are best served by us helping them plan for their future needs instead of focusing on the past. The future and stock markets are always uncertain and that is why our retirement planning teams plan for your retirement needs first and your greed second.

Give us a call to speak to an advisor, and let us help you craft a financial plan that helps you meet your retirement goals. Call us here at (877) 896-0040, and schedule an advisor consultation. We are here to help you on your financial journey into and through your retirement years.

• I’m Chris Perras and from everyone here at Oak Harvest, have a blessed weekend.