The Impact of Declining Valuations

The 2018 Q4 letter discusses the fallout that can occur when there is a “divergence” between the price and value of a company’s shares resulting from investors losing sight of a company’s fundamentals or becoming fearful about “how some macro event will impact the world economy.”

“At the end of 2018,” the letter states, “we believe both of these causes have been at play,” asserting that investor attention has been focused on “trade negotiations, government dysfunction, the potential of an upcoming recession, and the path of interest rates.” As a result, it contends, “we perceive that many investment decisions have been made for reasons disconnected from companies’ long-term fundamentals. Thus, a setting has emerged that is ripe for creating bargains.”

While negative returns in the short-term are unpleasant, the article explains, the current market decline can offer healthy long-term returns. The article points out that if the market decline represents a move away from the “recently exuberant market regime,” there are important takeaways regarding how different strategies perform during “more pessimistic times.”

The letter recalls a study conducted by Euclidean five years ago that divided the past 40 years into “optimistic” and “pessimistic” 10-year periods based on whether valuation multiples (using the Shiller P/E) increased or decreased during those periods. The study then compared the simulated returns of three different 50-company portfolios to the S&P 500’s return.

Here is a summary of the results:

The letter concludes that the “relative results varied depending on the market environment. During optimistic times, you may have done well by being insensitive to price and investing in the best companies (the 100% weighted ROIC portfolio) while ignoring the value opportunities. On the other hand, investors sometimes are less willing to pay premium valuations. When this occurs and overall market valuations come down, it appears that index investors would have generally realized poor returns. During these pessimistic periods, however, we believe a good place to hide has been with the overwhelming advantage offered by the least expensive companies (e.g., the 100% weighted EY portfolio).”