Talk Your Book: Valuation Still Matters

0:00Today's Animal Spirits Talk Your Book is brought to you by J.P.Morgan. Go to jpmorgan.com to learn more about the J.P. Morgan Active Value ETF. That's ticker Java, J-A-V-A. It's jpmorgan.com to learn more. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions.

0:36Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:44Welcome to Animal Spirits with Michael and Ben. Back in 2016 when I was writing my book and doing research on the chapter of Ben Graham, I think I was reading articles that he wrote in Fortune. I think it was Fortune in like the 1930s. And there used to be companies, listed companies on the stock exchange that were trading at a lower valuation than cash they had on the balance sheet. So in a hypothetical world, had you just bought this stock or bought all the stock and then took the cash and liquidated whatever assets it had, you could have made money. He's bought a bunch of those, right? The cigar butt approach?

1:26Yeah. So I think those disappeared probably like, Buffett was doing that. They probably disappeared in the 60s or 70s, certainly by that point they were gone. So that style of value investing, long way behind us. That stuff doesn't work anymore. So we actually spoke about this with Don and Scott that the value portfolios of today, forget about 50 years ago, they look different than even 20 years ago, substantially so. It's also cool to think that you can, And I remember reading the Ben Graham stuff too. And then I read early in my career, I read What Works on Wall Street by Jim O'Shaughnessy. And he was talking about building a portfolio of 50 names and finding the ones that are cheap based on price to book and price to earnings and price.

2:04And he had this whole, all these different metrics. And I remember thinking like, if I try to model this and do this on my own, I would never be able to do it. And this is before free trades and before ETFs. And now the fact that you can just buy, if you're wanting to buy a basket of cheap stocks, you can just do it in the ETF. Professionally managed. Yeah, it's pretty important. Professionally managed. It's kind of amazing. So on the show today, we talked to Don San Jose, who's a managing director and CIO of the U.S. value team at J.P. Morgan. And then Scott Blasdell, who is also managing director and portfolio manager responsible for large cap value portfolio.

2:36So J.P. Morgan has a whole suite of value portfolios up and down the income spectrum and up and down the market cap spectrum. And yeah, the point you made was just that a lot of the companies are more blue chip these days that tend to be cheaper. And I don't know if that's a baby in the bathwater thing, but it does seem like a lot of the biggest NASDAQ 100 type stocks have gotten more and more expensive. And a lot of the other names just really haven't. So I don't know if you call that Dow stocks or blue chips or whatever, but there's a lot of stocks out there that still seem reasonably priced that just probably wasn't the case, I don't know, 20 years ago or something.

3:15Anyway, here is our talk with Scott and Don from JP Morgan.

3:22Scott and Don, welcome to the show. Thank you. Good to be here. Yeah, thanks for having us. So just this past week, I was actually looking at the J.P. Morgan Guide to the Markets. And that presentation always has a good job of showing valuations across broad spectrums, price to book and price to sales and price to earnings and all these different. And then it kind of shows it against the historical averages. And I want to make a case for you. I'm not saying I believe this case, but I want to hear your sort of rebuttal. And it seems like for the past 5, 10, 15 years that valuations just haven't mattered very much at all.

3:56And it seems like flows have sort of trumped valuations in a lot of areas of the market. And I just want to hear your take that, yes, valuations actually do still matter. Yeah, I'll start off and Scott can certainly fill in for that. But I think valuations still do matter. I mean, when you look at sort of where stocks are trading, I mean, the value benchmark, the Russell large cap value benchmarks trading at a 30 % discount to growth versus a typical 20 % discount. I mean, you've got PEs for the benchmark around 16, 17 times. That compares to about 25 times for the Russell large cap growth. And maybe what's different versus like the last five years that you mentioned, you're just seeing better earnings breadth these days.

4:48I think we all know, you know, the MAG 7 really has shown that the earnings growth is there and people have gravitated towards that. But I think in the last four quarters, you're starting to see some earnings breadth beyond just the MAG-7. I think another thing beyond maybe evaluation is just diversification matters. And I think you've seen a couple times in the last year where there are times where having a diverse portfolio really has distinct advantages. Maybe one of the more recent ones would be Deep Seek Monday, where the MAG7 did sell off, but value names actually did quite well. And you saw something similar last summer when we saw sort of a soft CPI print.

5:35And maybe beginning in July, right up through the election, again, value names did pretty well. There are a lot of options for investors looking for a value-oriented strategy. Why should they consider yours? Yeah, so I think a couple things here at J.P. Morgan Asset Management. I think, first of all, we have a full breadth of products across the value platform. You can really view us as a one-size-fits-all. We've got everything from an equity income fund, a large cap value fund. We have small, mid-cap value funds. And I think what is pretty consistent across all of those is that they're backed up by a portfolio management team and dedicated research analysts, all with decades of experience.

6:30And so when I look across the U.S. equity platform here at Asset Management, we've got over 50 analysts. About a third of them are dedicated to value, which means they're just looking at those value stocks. And I think that's really important when they're paired up with value-focused portfolio managers. And so the analyst experience, the portfolio managers partnered with those analysts really makes a difference. I think the question might have been poorly worded, so forgive me. I guess, specifically on the strategy, what is different about what you're offering or tell us about the strategy versus what they can get from the Russell 1000 value index, for example.

7:08Sure. I think, you know, one of the other hallmarks of what we do is it's active management. And so I think what we're really focused on is more of the quality names within the value benchmark. Obviously, all value managers are thinking about valuation, thinking about value. But what we do is combine that valuation with a quality focus. And so I think there's a reason that you need to do that. It's really not just finding the best opportunities, but also avoiding those value traps. And so valuation alone doesn't tend to be a great indicator of a great stock always. You need to do the research.

7:49It goes back to those analysts that I mentioned. And so that does tend to go back to our differentiator and competitive advantage, having that deep knowledge behind every investment decision. The value trap idea is interesting to me because I think one of the hardest questions to answer is, you know, what's priced in to a stock? And I think a lot of people have been saying for the past, at least for this cycle, that, listen, the tech stocks are overvalued, but they're overvalued for a reason because they're higher quality, right? And stocks that have lower valuations have those lower valuations for a reason.

8:23And obviously, the difference is just the expectations and what is priced. So how do you consider something like that in terms of the stocks we own are much cheaper, but the market is missing something on the expectation? How do you understand what actually is priced into those numbers? Yeah, I can weigh in here on that subject. because I started 25 years ago as a real estate stock analyst here at J.P. Morgan. And our approach, what distinguishes J.P. Morgan, I think what you really need to do to make value investing work is look far out into the future. So part of what we're doing, we're modeling company earnings out six, seven years.

9:06And it's not like we're going to get the future that far out perfectly correct. in our estimates. But what thinking that far out does do for you is that it helps you avoid some of the secular losers that Don was mentioning, which can be the value traps. So, you know, for example, I just was at a presentation talking about the wine industry and the, you know, turns out most wine drinkers are over 40. And as they get older, they're going to be drinking less wine. We all drink less as we get older. That just makes it harder for someone. Sleep for yourself. Well, okay. Well, we're talking averages here.

9:48Michael's an outlier. Yeah. But the point being that there's just some headwinds to that business that kind of make it harder for a company in that business to do well over time. And if you're looking out six, seven years when you're modeling companies, it forces you to ask those questions about the long-term trends. So versus passive investing, you're going to own everything. We can weed out the ones that have those secular headwinds. When you're discounting cash flows, interest rates are a big component, obviously, to the discount rate. So is that something that people just say, like I did, or do you really believe it?

10:29Do higher interest rates favor value stocks? Because a lot of the conversation for the past decade was, yeah, free money, doesn't matter if you get your money back today, five years, 20 years, what's the difference? And we'll just go out and take more risk. Do you buy into that at all? I do. I mean, I think it's just a matter of math that, yeah, typical growth stock, a lot of the payoff is far into the future. So higher interest rates will everything else equal make near-term cash flows more valuable. So that will tend to favor value stocks. You certainly saw that in spades in 2022 when we had the beginning of the post-pandemic inflation and then the spike in interest rates.

11:13The growth stocks got crushed. But then you didn't see it in 23 and 24. This is true. So I'd say that it's definitely valid principle, but it works over long periods of time. Maybe not every year. How do you think about competing against the algorithms and just competing against simple rules-based formulas that say, we're going to buy all the stocks that trade under this and trade below this and have numbers that do this? How do you think about the qualitative aspect of value investing when it's easier than ever to just calculate these things? It's not the Ben Graham days of calculating these formulas yourself.

11:51It's much easier to just put these into a formula and have them spit out a list of stocks. Well, I'd say, again, this is where looking far out into the future gives us an advantage. Because if they're just looking at published numbers, maybe by the sell side, the sell side's going out maybe one year, maybe two years max. And they're not thinking about long-term growth rates. They're not thinking about what we call normal earnings, what a company should earn at a normal part of the cycle. And we have a lot of evidence that our approach of looking far out into the future does make a difference to returns.

12:26What are you looking at exactly when you think about quality? So are you looking at some metrics like return on equity or assets, or are you thinking about quality in the non-financial term? Like, oh, it's a quality business. Yeah. I think, Michael, it's a little bit of both. I think there's definitely financial characteristics you're going to look at, whether it's return on equity, return on invested capital, leverage on the balance sheet, all those things you can look at and make a quantitative judgment. Okay, this is quality. But then you have to step back and say, what are the qualitative things?

13:05Consistency over time, what's the company's ability to deliver pretty outsized returns through a cycle? And just maybe maintain profitability levels that are either above peers or above industry norms. You're looking at things like the management team. Do they have a long-term track record of success? Are they able to execute on the ups and the downs of the cycles? And then are they able to allocate capital in the right way? Whether that's acquisitions, buying back their own stock, paying a dividend, or even reinvesting in the business. There's not one way that defines quality when it comes to capital allocation, but you do need to think about how a management team does that.

13:50And then sort of to Scott's point, we're looking at those things over the long haul. Just because you have a high ROE one year or maybe you did one good acquisition in the past year, that doesn't mean your quality. You really got to just look over the long term. Don, you mentioned the diversification piece before, and I totally agree with you that there have been times in this cycle, even though the big tech stocks and S &P 500 and NASDAQ 100 have sort of dominated this past cycle. There's been counter trend rallies and you've seen, especially earlier this year, other types of stocks did much better.

14:24I'm curious how you think about diversification within your own fund in terms of weighting the positions and having enough stocks to be diversified, but also have enough concentration to try to outperform the index. Yeah, I think across value, I think most portfolios have roughly 80 to 100 stocks in them, some a little bit more. But that tends to be where, from a diversification standpoint, we get there through the number of names. But then from a sector standpoint, people are going to look at each sector and decide to overweight and underweight specific ones, depending on both their macro views and what they're finding on a bottom-up perspective.

15:09And so that's going to vary portfolio manager to portfolio manager. So, for instance, we're very overweight industrials because we find that we're finding lots of opportunities there. They've gotten beaten down over the last year. we want to add a little bit of cyclicality to the portfolio. So that's where, in more recent times, we've been looking to add. Scott, I'll let you talk about sort of what you're doing in your portfolios. Yeah, maintaining diversification is not such a... There's a bunch of rules that we have as managers that ensure that we remain diversified. So, for example, I have position limits, The percent of a stock that I can have in the portfolio versus its benchmark weight, for example, will be regulated depending on the strategy by various amounts.

16:02Also, sector weights will be supposed to be kept within certain ranges. And that's one of the simple ways you can use to maintain the diversification. And yeah, but I will take larger positions in some sectors when there's particular opportunities and underweight sectors where I'm having trouble finding good opportunities all the time. So that's one thing you do at the sector level. And then in addition to that, you're looking within sector for the best stock ideas. Have value portfolios – I have a second part to this question, but I'll ask this first. Have value portfolios changed over the years in terms of composition of quality and what they look like?

16:46Because I'm looking at your portfolio and there's a lot of – I'm searching for other than quality. There's good names in here. These aren't like junk stocks. And back in the day, Scott, you're bald like I am and Don, you have gray hair. So you guys have been around for a while. We've been around, yeah. But back in the day – Wine drinker after all. So you used to be able to build portfolios of value stocks that traded probably below 10 times earnings that were just maybe maybe thrown out with the bathwater. Along came algorithms, and the embarrassment premium went away because you had all of these quantitative investors, and maybe management has gotten better over time.

17:27But this does not look like, I guess, what I would think is a traditional value junkie portfolio. There's good names in here. I know. It can be kind of a surprise for people. And I think that because, you know, yeah, there is that connotation of value of really just buying anything. But really, there's so many losers that you need to avoid, I think. You know, we talked about wine drinkers, but I mean, there's any number of industries where the Chinese have decided that that's what they want to expand into, whether it's steel, aluminum, solar panels. Right now, they're really stepping up their investments in petrochemicals where the odds are just so against you because there's a big cost advantage that they have.

18:13So, yeah, I could pay less than 10 times for a steel company, but do I really want to? Where am I going to be in five years? So I think that I have seen some analyses that suggest that certainly on the small cap side, the small cap universe has just gotten less quality over the years. There's more leverage. So that could be part of it. But I think when we're looking, again, when we're looking out and looking at what is sustainable in terms of a company's earnings and cash flows and looking for at least some growth, you weed out the lowest quality names that maybe 30 years ago people would have been more open to.

18:58So part two of the question is, I don't see NVIDIA in this portfolio, but I do see Microsoft and Amazon, which traditionally people think of them as growth stocks, but certainly the case could be made at their value. I mean, you guys do because it's the portfolio. So what's the case? You don't have to get specific on them per se, but what is the case for including companies like that in the portfolio? Well, I know it's kind of funny because I'm responsible for the Amazon. Amazon, surprisingly, is cheaper than Walmart. We had Walmart in the portfolio for a while. But if you look at Amazon on EBITDA, it's like 11 times.

19:33Even the forward PE I saw is below Walmart, which is kind of wild to think about. And the forward PE, which rarely happens. And if you look ever since Amazon went public, I mean, the PE has gotten down to as low as about 30 times earnings. So it's never been a quote unquote value stock on PE. And yet, it's been a great investment. And right now it's about 33 times or something like that. So what happens with Amazon is that they invest so much of their free cash flow into new businesses all the time. And that investment depresses earnings. So yeah, you're making a bet that their current investments are going to pay off more times than not they have.

20:17I mean, look at how they've grown AWS and gotten into, you know, made a success of so many things. Now, you know, they're replacing UPS and FedEx with delivery and, you know, the business keeps evolving and getting stronger. So we would say that, you know, based on what we're seeing for the future, but also looking at valuation metrics from the past, it's actually a value period right now. Are there any sectors that stick out to you that are like, man, we're just finding so many cheap stocks in this sector, Or is it just almost, is it mostly just ex-tech stuff? Like where are you finding cheap stocks these days?

20:51Well, we could talk about HMOs if you want. You know, there's just a swirling controversy right now. And part of it is just the Trump administration has said a lot of things, talked about getting rid of healthcare middlemen that has, for example, that have cast a cloud over the whole sector. So right now I'm seeing a lot of controversy in that sector and a lot of inexpensive companies, even if you're not ready to wade into UnitedHealthcare, which is particularly in focus right now. I mean, I think Cigna is very cheap. They don't do any Medicare Advantage and trading at 11 times earnings that we think still has very good growth opportunity going forward.

21:43So that would be one area. I don't know, Don, if you want to chime in. Yeah, I mean, I think there's also opportunities in financials. I think right after the election, you saw just a lot of euphoria over deregulation, the fact that there's going to be more M &A, more IPOs, just general capital markets activity, really starting to pick up. And then obviously this year, that's sort of been put on hold for a bit. you're starting to see some M &A come together. You're starting to see some IPOs start to file again. And so I think when we look at financials and banks in particular, where credit still looks pretty good, there's opportunities to pick and choose amongst those banks as well.

22:29So Bank of America and Wells Fargo are two of the biggest holdings. And it's been a long time since Wells Fargo, the stock, was performing well. So I looked at these a couple of months ago, and I was like, holy moly, even Citigroup, no offense. But a lot of these stocks are performing really, really well. Do you think this is expectation of capital market formation? Is it a healthy consumer? I know not all these banks do the exact same thing, but what do you think is contributing to the strength in these names? I think a lot of the financials have benefited in anticipation of deregulation by the Trump administration.

23:05We haven't really, you know, we've heard a lot of rumors about it. I think - When you say deregulation, is that inside the banking system or broader or just leading to more M &A? Like what does deregulation mean for the banks? Well, for example, one thing would be, I don't know if you've heard of the Basel III endgame, but there were, you know, under the Biden administration, there was - Is that the under Biden, it was kind of impossible to avoid. But it turns out under Trump, it's likely that capital requirements will not be raised at least as high as was contemplated initially under the Biden administration.

23:44So that's one way. And if banks are not required to retain as much capital, then they can use the funds to buy back stock instead. So that would be one way that it matters. I think another thing that folks are looking for, And we're already seeing a pickup in mergers and acquisitions. But we have over 4 ,000 banks in this country. There's a lot of reasons, whether it's technology spending or just meeting the costs of higher regulation, where we should be pushing for economies of scale and mergers. But it was really impossible under prior administrations. So if there's some relaxation of M &A rules for banking, then I think you're going to see a lot of deals announced.

24:29And that's typically good for sentiment and should ultimately help earnings for the whole sector if we get some economies of scale. A lot of value investors over the years have said, I ignore everything that's macro. I ignore politics. I just focus on the financials. And you've mentioned policies a couple times now. Yeah. How do you build that into your models? Because obviously, you have to pay attention to it because it could impact specific companies and specific sectors more than others, but it's also ever-changing. And sometimes it seems like this is going to be a death knell for this sector, but then wait, things change in a week.

25:05So how do you try to model that out when things are changing seemingly so quickly? Yeah, that's a great question. Because when we're looking at earnings for companies, yeah, like I said, we're looking out long-term. And so you tend to discount near-term policy changes. On the other hand, some things like capital requirements for banks are so important, it could really move the long-term earnings for a bank up or down. So you have to pay attention. What I typically do is when it comes to, and I do spend a lot of time thinking about top-down issues, when it comes to a political controversy or something else, just a couple years ago, we had a bank crisis with Silicon Valley and the value of commercial real estate, threatening balance sheets of many banks.

25:56Yeah, that was like a four-day bank crisis. That was terrible. I mean, it seemed bad at the time, but then it's one of those things that just sort of washed it over. It turned out it was a fantastic opportunity, which is what we concluded. Typically, what you have to do is just say, okay, is everyone else discounting this already? And if you see evidence, if it's like six months after the crisis, typically by then people have absorbed whatever the controversy is and sort of factored it into valuations. So I'd say that it's really just getting a sense. And I think when you do as much modeling as we do of company earnings, you get a pretty good feel for when something really dramatic has been discounted into a stock or not.