The market’s fundamental backdrop remains supportive for equities. Despite the fact that the prospect for earnings growth has declined structurally, low risk-free yields are likely to remain broadly supportive of valuations. While lower total returns should be expected even as volatility (expressed as the sensitivity of stocks to cyclical shocks likely being larger) is expected to rise, we think returns of stocks over bonds are less likely to be affected in the long run by the secular decline in nominal growth, with Quality, particular Dividend Payers and Revenue Growers outperforming.
High Quality, Large Cap Equities Over Lesser, Smaller and Fixed Income
It is our view that valuations can remain elevated in an environment where yields remain subdued (albeit with more volatility than this Summer’s unprecedented lackluster range) given the long-term decline in inflation expectations as well as expected anemic revenue and earnings growth. Such an environment implies lower expected total returns on both an absolute and riskadjusted basis and a market more likely to discriminate among stocks within sectors, tilting toward Quality – strong and growing businesses whose financials imply lower volatility and a strong ability to return cash to shareholders. Our metrics as a determinant of Quality, therefore, include Free Cash Flow (“FCF”), stable to growing Gross Margins, and hopefully, Revenue growth (a rarer item these days).
Revenue Growers – Market Participants Will Pay Up For It (and Yield Too)
Revenue growth can provide a portfolio with what positive beta there might be in a sideways trading market. Companies are getting punished for not growing revenues despite what deck chairs they re-arrange to hit earnings per share (EPS) targets. Nonetheless, there are companies, sectors that are growing top line – these companies’ securities should be rewarded in an era, as former US Secretary of Treasury, Lawrence Summers described as secular stagnation. To the extent we can identify company securities that meet our methodological and mandate criteria and are Revenue Growers, we pick up an additional way to win, or in potentially capped markets – to not lose. It is important to note that in a time of lackluster revenue growth, the equity of companies that are Revenue Growers, should trade at heightened valuation, and for good reason.
Dividend Payers – Income Equities in a Time of Low Yield
Rate hikes can potentially damage market prices of securities that are bought for yield…only. But we will prefer Quality equities that have both a plausible Revaluation Catalyst, which could reprice the security to our target price in a step-function change and pays us income in the form of a dividend while we wait. If the company meets our free cash flow (FCF) coverage requirements, the company’s FCF covers the dividend payment sufficiently, the position shouldn’t get badly beaten up by a rise in interest rates. Many pundits are talking about risks in dividend paying stocks given the potential for interest rate hikes and the seeming cap on market price expansion. However, there is a big difference between Dividend Payers with larger FCF than dividend payments, and those frail companies who often also borrow to make dividend payments (in fact, this is an attractive short theme).
Agnosticism, Flexibility and Events (The Revaluation Catalyst)
The elegance of the Fund’s mandate is that plausible Revaluation Catalysts give us the prospect of large gains from price movement regardless of markets. While many investment funds are decidedly long only (some short only) and equities (or debt) only, we are agnostic directionally and among securities types. Finally, among event-driven managers, many are really just Merger Arbitrage investors. This is one, solitary event and requires that companies have ample access to capital markets. There can be market conditions that crush Merger Arbitrage. For BEVIX, the broad array of events – from asset sales, to divestitures, sum-of-the-parts trades, lawsuits won or lost, scandal and fraud, product launches, failures, liquidations, and yes, Merger Arb, give us many alternative value-unlocking catalysts as afforded by market opportunity, and not narrowed by mandate self-identification. We can fail to make money in diverse markets, but it will not be due to the moral hazard of too narrow or biased a mandate or strategy.
Putting It All Together
All things being equal, we would like to own Quality company’s equities that are cheap, or at least fair priced given a rarefied Revenue Grower classification. Many such companies ideally pay reasonable dividend payments which we believe to be safe, given the company’s FCF. Finally, there is additionally a plausible Revaluation Catalyst that can move the company’s shares to our estimated target price in a near-term step-function change. The converse of the above is the universe of potential shorts for the Fund.
The above post has been excerpted from a letter of Tiburon Capital Management.
Watch Peter Lupoff talk about applying his BRACE methodology: