3 Contrarian Buying Opportunities in Quality Land
+ multiple expansion & contraction, index concentration, and ECB rate cut
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Topics to discuss:
Multiple contraction and expansion
Index concentration: discussing the findings of Michael Mauboussin
ECB rate cut
3 contrarian buys
Multiple contraction and expansion
Seth Klarman was highly-reputed for his thoughts on behavioral finance and his strong hedge fund returns. Two of his lessons: don’t chase the hottest things, and it doesn’t matter what price you paid (as the investment thesis won’t remain unchanged).
People who chase growth and highfliers inevitably lose because they paid a premium price. They lose to the people who have more patience and more discipline.
Assuming that your targeted yearly return is 12%, your average compounded daily return will be 0.045%. The stock market rarely ever moves by such small percentage. Every single day, investors either pay up or tame their enthusiasm for their investments. As such, those who cannot stand volatility (both upward and downward) are likely to miss out on decent returns.
As we model our IRRs, we focus on a realistic input and exit multiple. What’s particularly problematic in this environment is the amount of upside volatility in certain areas (AI-driven investment themes) and investors believing multiples (current and exit) won’t go down anytime soon. The opposite is true, and frankly, too much upside volatility doesn’t add much value to a long-term quality investor’s total returns.
We like steady compounding: only then we’ll be able to deploy much more capital into great companies at good or very good IRRs. When valuations are supposedly high (in the sense of really high relative to the expected (e.g. 5-year) growth rate), the IRRs won’t be that tempting. Taking more risk for the same amount of earnings growth. If our stock portfolio were to double over the course of 1 year with “just” 12% earnings per share growth, that wouldn’t feel right. Ignoring multiple expansion and extrapolating it well into the future will make us over-confident.
Some stocks and sectors can defy gravity for a long time, until something starts to crack. For the Nasdaq, unprecedented concentration will lead to more volatility, but also in non-tech stocks as fund managers will no longer be able to stand the heat of underperformance… This isn’t about betting against the Nasdaq, Nvidia or AI, it’s more about questioning relative valuations, herd mentality, and the investment outcome for those putting capital to work periodically in products that have seen a considerable re-rating tailwind.
Fund managers have become increasingly bullish, but not on defensive quality growth stocks (that are trading at a discount to the S&P-500), on the contrary.
Bank of America
If one expects tougher times, factor investing could (and hopefully should) be a bright spot.
Defensive quality with relative value and below-average volatility provided meaningful cushion in 2022, but lagged in 2023 (and the combo has been lagging so far in 2024). Now, we mean lagging versus a market-cap weight index, as there’s been meaningful outperformance versus an equal-weight ETF.
Even in defensive quality and temporarily more cyclical companies (related to COVID), one can simply overpay for a proven multi-decade track record. Let’s look at two examples.