by William Smead, Smead Capital Management
We believe there is a severe lack of liquidity in the stock market and it shows itself both directions. Good news is overly capitalized to the upside and bad news is more heavily punished than in prior eras. One week ago, when Walgreens (WBA) shares were getting battered, we were reminded of what having over 50% ownership of large cap stocks by indexes means to liquidity in the U.S. stock market. In our eyes, Walgreens is one of the most stable companies in the world (they fill one in five prescriptions in the U.S., for example) and had been in a price downtrend for months. However, two very difficult quarters of business performance caused investors to flood out of the stock. A 13% fall of a staple stock like WBA in one day has only happened a few times in the last 40 years.
Fortunately for us, Joanna Ossinger from Bloomberg interviewed Marko Kolanovic, a researcher at JPMorgan. His work shows that what we have been feeling in our gut and observing with our eyes is real. Kolanovic argues that “price swings create a ‘feedback loop’ that exacerbates fragility.” He adds that the “decline of active management is a major stability risk.”1
Let us explain. Forty years ago, interest rates were historically high and market volatility was also high. When you could earn a double-digit return by sitting in cash, investors were happy to run to the closest exit. Value investors flourished because high interest rates kept a cap on price-to-earnings (P/E) ratios. Index investing was a tiny part of the stock market and common stock ownership in our society was at very low levels.
Today, interest rates are historically low. Sitting in cash has been a terrible alternative for many years. Relatively speaking, volatility is low. Second, growth investments have stomped value choices as P/E ratios move higher and higher. Third, the indexers have control of over 50% of the ownership of large cap U.S. stocks. It appears to us that active investors, especially active value managers, control the smallest percentage of total capital as anytime in my 39 years on Wall Street.
Here is how Kolanovic explains today’s environment:
A shift from “slower” human market makers, who often rely on valuations, to faster programmatic liquidity that rely on volatility measures to determine risk-taking and position sizing, can strengthen momentum and reduce day-to-day price swings, according to Kolanovic. However, it increases the risk of market disruptions such as that seen in October, he noted.
Let me put this in laymen’s terms. Over half of investors are agnostic. Among those who are active, value managers who hunt bargains control the least capital in our careers. Indexing is popular and growth stock investing is popular. When things go right for a stock, the upside explosions are bigger than in the past and the declines to the downside have a hard time attracting buyers.
You might think we are writing this to complain. This would be a mistake, because it spells opportunity at Smead Capital Management. Our motto is “Only the Lonely Can Play.” Fewer active bargain hunters, nirvana for growth stocks and more agnostic investors than ever puts us right where we want to be. There are cycles to the stock market and in our economy. The next-up cycle in the economy should be accompanied by a substantial increase in interest rates. All the things which got us here can be reversed in time. We like to remind everyone that the stock market always does whatever will frustrate the most investors.
The depletion of market-reversion forces was driven by a decline of value investors as money moved to passive and systematic strategies,” he wrote. “Liquidity has become to a large extent driven by market volatility.
We like to buy meritorious businesses at prices which are exacerbated to the downside and relish waiting for the era of growth stock investing to get its historically usual spanking. In the meantime, we like Wells Fargo (WFC), Walgreens (WBA), Kroger (KR) and other bombed-out businesses which trade lower than normal from bad news. We believe time is our ally.
The information contained in this missive represents Smead Capital Management’s opinions, and should not be construed as personalized or individualized investment advice and are subject to change. Past performance is no guarantee of future results. Bill Smead, CIO and CEO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. Portfolio composition is subject to change at any time and references to specific securities, industries and sectors in this letter are not recommendations to purchase or sell any particular security. Current and future portfolio holdings are subject to risk. In preparing this document, SCM has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.
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