Quarterly Updates - October 2019

Volatility leading to opportunities

Markets were once again volatile during the third quarter, which from our perspective brought signs of encouragement.

Slowing economic data and continuing trade issues between the US and China caused wild price swings within and across asset classes. Equity markets notched small gains in North America, but were weaker internationally as European and Emerging Markets continue to be buffeted by slowing global growth and a strong US dollar.

In contrast, fixed income returns were strong as investors sought the safety of government bonds amid fears of a synchronized global recession. This rush to safety saw bond yields plunge, causing the amount of negative yielding debt worldwide to hit a new record. Nearly one-quarter of the sovereign bonds issued globally now have a negative yield. In effect, holders of Japanese and European government bonds are paying for the privilege of lending these countries money, a phenomenon that is almost without precedent.

Perhaps surprising to some, stock markets around the world have not made much headway for the past several years, although the returns vary from country to country. Even the US market, which has led all other major stock markets around the world for the past 10 years, is only marginally higher than in January 2018 – over 20 months ago.

This period of flat market returns has resulted in a growing sense of fatigue amongst investors. For investors who have adhered to a value investment philosophy, frustration is probably a more appropriate description of sentiment over the last few years.

Figure 1 compares the performance of the MSCI World Value Index to the S&P500. Although value investing tends to outperform over the long-term, in the past five years it has clearly underperformed.

The recent five-year drought is in stark contrast to the period from 2003 to 2008, when value stocks handily outperformed. It should also be noted that over the very long term, the record favours value by a fair margin. Not shown in Figure 1 is the more famous period following the tech bubble of 1999 – the last time growth and momentum investing reigned supreme. In fact, from early 2000 to 2002, value stocks rose roughly 35- 40% as a group, while the technology sector dragged the S&P500 to a loss of over 33%. Similar to the late 1990s when growth stock valuations became extremely stretched, we believe we could once again be on the cusp of a rotation away from a growth and momentum-led market.

An Encouraging Rotation in Equity Markets

Indeed, during September we saw early, yet encouraging signs of such a rotation when quantitative momentum strategies (quants) suffered their worst bout of negative performance in over a decade. In the past, these sorts of quant meltdown events tended to signal broader regime shifts in markets. As predicting these shifts is next to impossible, we make a concerted effort to be invested in companies trading at attractive valuations, rather than betting on stocks where extended valuations leave little margin for error.

Another encouraging sign during the last quarter was the continued deterioration in more speculative parts of the market. In areas such as cannabis, cryptocurrency, and even plant-based meat alternatives, share prices of highly valued, yet unprofitable companies are starting to come under pressure as investors begin to realize that expectations for these stocks may be too high.

This weakness also extends to the market for IPOs (Initial Public Offerings). Notably, the popular ridesharing apps Uber and Lyft are both respectively trading well below their IPO prices from earlier this year. In addition, during the quarter there was a spectacular reckoning for WeWork, a commercial real estate company that provides shared workspaces particularly for technology start-up companies. WeWork was a highly anticipated “Unicorn” IPO (a start-up worth more than $1 billion) and was projected to issue shares to the public at a valuation of $50 billion – a shocking figure given the company’s $3 billion operating loss is almost equal to its revenues! WeWork’s egregious corporate governance has resulted in the company now contemplating a much-reduced IPO valuation of $10-12 billion – a reduction of up to 80% since their last round of financing.

Over the last decade, an incredible amount of venture capital money has gone to fund unprofitable businesses.

If the slowdown in the IPO market is any indication, this could have important ramifications for other areas of the market. According to Morgan Stanley:

“There has been a lot of money directed toward private, unprofitable business ventures during this decade in search of the next successful start-up and we think that the large amount of money chasing this trend has likely found its way into the real economy. A lot of that money has been spent on web services, software, and advertising to ramp their “platforms”. Now, if profitability is once again important, many of these companies will need to cut back. This could accentuate some of the negative trends already apparent in the broader economic data and be especially disruptive to some of the strongest areas – i.e., web services, software and advertising.”

Although no two periods are the same, there are striking similarities between what we are seeing today and what we saw in 1999 when the “” party ended. In the late 90s, the first companies to fall were the unprofitable start-ups. After that, the bloom came off the rest of the technology sector. For those who doubt the frothy state of the venture capital / start-up world at the current time, look no further than the three Privately backed start-up companies currently racing to be the first to reach the planet Mars!

Company Spotlight: AT&T

AT&T is the world’s largest telecommunications company, the largest provider of mobile telephone services, and the largest provider of fixed telephone services in the United States. AT&T has been intriguing to us for quite some time. Its collection of world-class telecom and media assets were trading near historically low absolute and relative valuations. Yet up until this point, we were not able to make the case for owning it as we had concerns about its balance sheet and secular challenges in the wireline business overall. Other key deterrents for us were the increased complexity of the business (after nearly $200 billion of M&A), lack of a cohesive strategy, chronically poor operating performance, and a seeming disregard for capital discipline. AT&T became a great deal more interesting in early September when Elliott Management announced it had taken a $3.2 billion stake in the company (its largest investment ever in any one company) and publicly disclosed a letter it sent to the board outlining ideas for how to improve the business and maximize value for shareholders.


For those not familiar with Elliott, the company is a $38 billion investment firm founded in 1977, whose long-term investment performance rivals some of the most successful investors in history. Elliott deploys capital across a number of different investment strategies and in recent years, they have had good success bringing enhanced strategic focus and operational discipline to large high-quality companies that have lost their way. We believe their involvement might be just the catalyst this value stock is in need of.


Although AT&T’s first reaction to Elliot’s offer was predictably defensive, we suspect most active shareholders will roll out the red carpet for Elliott. Elliott’s ideas range from a comprehensive review of the current asset base with a commitment to jettison non-core businesses and use the proceeds to reduce debt and invest in the highest-value strategic initiatives, to a shift in management/board focus from acquisitions to execution, to rationalizing the cost structure to bring it into line with peers, and even the implementation of a formal capital allocation framework. Even though we do not think all of Elliott’s suggestions are gospel, nor do we believe all of the financial impact they suggest will materialize, we do think on balance their ideas do seem to point AT&T in the right direction. We can be sure of one thing, however. Regardless of whether Elliot will end up with an actual seat at the table, board meetings will never be the same again!


The path laid out by Elliott is simple, but not easy. Should the company be successful in de-levering, improving profitability and reducing the share count, we believe there may be a path towards meaningful EPS growth and multiple expansion. In fact, we believe it is not difficult to envision a 40-50% upside from the current share price over a three or four-year period. What is particularly interesting about this situation is that the valuation (10.5x EPS, 10% free cash flow yield, 5.4% dividend yield), and the defensive profile of the business (subscription-based business models, domestic revenue base, strong cash flow generation) should serve to limit the downside on the stock even if they are not as successful as we expect in executing this plan. This unique combination of limited downside and significant upside potential is particularly compelling against the backdrop of an expensive equity market and uncertain global economy.

Closing comments

At this time last year, market participants were fairly positive about the outlook for markets and still quite unaware of the economic slowdown that was fast approaching. Today, after a year of sub-par economic news, increasing trade-war related disruptions and extremely volatile markets, the market tone is more negative. We find this encouraging as it results in greater opportunities to deploy capital.

While it is possible that recent economic weakness develops into a recession in the coming quarters, it is by no means a certainty. To be conservative, this possibility is reflected in our relatively cautious asset mix of just over 50% in equities in our Balanced Funds. However, unlike last year when central banks around the world were tightening monetary policy by raising interest rates, today most authorities around the world are cutting rates in order to avoid a deeper downturn. In the meantime, the North American economy continues to plod along, surprising many observers by its resilience.

From our vantage point, parts of the market look reasonably attractive, while other parts look quite expensive. We continue focus on the former and avoid the latter. Finally, we have plenty of dry powder in our portfolios to take advantage of opportunities as they come our way.

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