New highs again this past week for the Nasdaq, as broad U.S. indexes all drifted higher. Not much in the way of economic news this past week as U.S. companies move into the earnings reporting period. Thus far, companies are almost unanimously beating consensus estimates. But this is to be expected. Since 2011, the broad market has not fallen during an earnings reporting season. The little macroeconomic data we saw this past week showed no signs of weakness for the economy. The New York PMI (Empire Manufacturing) for July edged higher, industrial production picked up (+0.6% in June, +3.8% y/y), while housing starts unexpectedly pull-back (which didn’t bother the homebuilder stocks, which recorded a strong up-week). More cheerleading from Fed President Jerome Powell (“the economy remains strong”, yada yada yada….) was also credited with helping push the equity indexes higher.
Readers probably have heard that companies, awash in cash, have been using their War Chests to buy back outstanding company shares on the market. This use of cash has been much more prevalent than returning cash to shareholders via increased dividends, which is deemed sub-optional due to the tax consequence. Share buy-backs have also dominated “economically useful” methods of deploying company cash, like increasing workers/wages and CAPEX (this is a subject for an entirely different debate). We looked back historically at the quantity of share buy-backs on the U.S. market since 1988 (maximum data Bloomberg offers). Never have we seen has many U.S. companies buying back shares in a quarter than occurred in Q2 2018. For those curious, here is the full hit list.
Interestingly, at the same time, company insider selling is surging over the past months (notably since the February wake-up call on the equity markets). We counted 2016 U.S. companies reporting insider selling over the past 3 months. Below is the most recent page of companies seeing executives (insiders) dump their shares to giddy investors. At least some people are “taking advantage” of the share buy-back binge. Amazing how the investing public can’t put one and one together!
Unfortunately, share buy-backs of more than $5 billion in daily transactions are keeping the game of Musical Chairs in motion. For now. With the belief that at some point within a year or so interest in momentum investing would fade, we started on May 11 this year to model a new portfolio called WMA Deep Value.
This portfolio seeks 25 companies in our fundamental rankings with the most attractive forward P/E ratios, lowest company valuations to market capitalizations, and what we believe to be reasonable price-to-book values. To be selected, the company finances must be solid (i.e., cash flow positive, low debt ratios) and the stock must not be a value trap (i.e., weakening guidance from management such that analysts are revising down sales and EPS forecasts). Our selections include a range of sectors/industries and sizes of market cap.
For purposes of this article, we included 17 or the 25 selections so that our readers could do quick studies using FinViz.com. The other 8 are traded US OTC or in international markets (not available on FinViz.com) as are many in our universe of 4105 companies where we rank numerous fundamental scores weekly from best to worst.
We find FinViz.com and StockCharts.com to be excellent research tools.
For the week ending July 13, 2018, the scores and rankings of the 17 companies in the DEEP VALUE PORTFOLIO are as follows:
A quick review of these tables shows that the average score and ranking of the 17 selections for Value was 87.1 (highest score of 4105 companies was 96.1) and 149 (average was 2045 which meant 4090 companies received scores). That means the average Value ranking of this peer group was in the top 4% of all the 4105 companies we study. In fact, the average Growth and Yield rankings were well above average as well.
So much for the fundamentals. As you know, a company is not a stock. There are good companies and bad. There are good stocks and bad. Sometimes good becomes bad and vice versa. Often a good company is a bad stock and vice versa.
Moreover, investor sentiment changes over time in that sometimes, such as in the present, Momentum investing is more popular than Deep Value investing.
Value is just one indicator of quality and, like a stock price, value is not a constant. Buying value and holding onto the stock indefinitely will result in gains turning to losses, which can be extreme in the volatile market conditions of the present.
To actively manage a portfolio, we believe investors must continuously study evolving company fundamentals and stock prices. For a case study let’s look at one of our holdings in the DEEP VALUE Portfolio to show you how decisions are made.
Kulicke and Soffa Industries, Inc is a quality company we like for Value. In our proprietary database system, the company’s current Value rank is 248 out of 4105. That’s top 6% of our tradeable universe. The stock (KLIC) has been in our DEEP VALUE portfolio for months – that is, until this week.
We sold KLIC for various reasons.
Without getting too much into the details, we are concerned about certain management practices that involve legal issues that might result in a class action suit against the company. We are also concerned about the company’s quite extensive share buy-back program, one that was started in August 2017 ($100 million) and enacted again ($100 million or 5.6% of the stock) as reported July 10.
Besides, the stock has soared this month — from under $24 to over $28 in just seven or eight trading sessions from July 3. We question why management would use treasury funds to the huge extent it did to purchase a stock that is rocketing higher; but perhaps they have an explanation.
When in doubt we sell. We also sell into strength when prices are rising much faster than we anticipated.
In another article, we will discuss our concerns about share buy-backs, particularly with respect to banks and broker-dealers. But we will leave you these facts to ponder. In the 100 weeks (2006-2008) leading to the market collapse and global financial crisis of 2008, Wall Street banks used their treasuries to buy more than $200 billion of their common stock. The S&P 500 companies bought in more than $500 billion. In fact, in just months before the largest financial bankruptcy of all time – Lehman Brothers – that particular bank bought in $1 billion of its stock. Friends and family (and the best clients of Wall Street) were the sellers – at the long-cycle top where they profited greatly. Those purchases and sales were set-up trades designed to not put selling pressure on the market.
So, while the public was buying vast amounts of stock and so too were the companies buying vast amounts of stock using shareholder funds, it was the insiders and closely associated sophisticated people and organizations who were selling massive amounts to them.
How this process is not a blatant conflict of interest is beyond us.
Conclusion
Late in the long-cycle is typically the best time for investors to rotate out of Momentum stocks and into Deep Value stocks. It is always the best time to buy Quality stocks.
Our DEEP VALUE portfolio is holding its own this month.
Since the portfolio start-up on May 11, we are also competitive in a Momentum market environment.
