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Iron Capital Insights

  • Iron Capital Insights
  • August 13, 2015
  • Chuck Osborne

Keeping Up Appearances

A few years back I was playing golf with my minister. We teed off on the first hole and his drive went straight down the middle, while mine went to the right in long rough and behind a tree. I chopped my ball out of the rough and short of the green, while he hit a nice second shot just ten to twelve feet to the left of the hole. I chipped up to about eight feet from the hole. He made a good birdie putt that just missed and then tapped in for par. I sank my putt for par. We walked off with the same score, but he had hit three good shots and I had hit only one good shot. He put his arm around me and said, “You know, sinking eight foot putts will forgive a lot of sins.”

The market over the last year or so has reminded me of that moment. If one only follows the headlines and sees the returns of the large market indices, such as the S&P 500, then one thinks the market is doing fine. If on the other hand one looks below the surface, she will find that the market return has been bolstered by a few darling companies. Further, most of these companies are making little or no money, but they are hot growers with popular products. The two that really stand out are Amazon and Netflix.

Before I go further let me first say that as a customer of both I am a big fan. Over the last year I have gotten everything from books to underwear on Amazon. Their distinctive boxes sit in front of our house more days than not. We also have Netflix steaming service, which my children can operate all by themselves. They have discovered that the cartoons that were around when their parents were young were far less educational and far more entertaining. My wife and I also maintain the now-old fashioned DVD service, because Netflix is smart enough not to stream the movies we really want to see.

However, as an investor I am not a big fan of paying $276 for $1 in earnings for Netflix, nor do I wish to pay much more for a company that never seems to have earnings at all, even if it is Amazon. The stock of those two companies are up 90 percent and 69 percent respectively over the last year.

Meanwhile stocks of companies that not only earn money but that also pay a portion of that money back to shareholders in the way of dividends have been getting killed. We recently ran some numbers, and it turns out the top ten dividend-paying stocks in the S&P 500 are down more than 18 percent over the last year. None of those companies has a positive return. The top 50 dividend- paying stocks are down 15 percent, and only 11 of those companies have a positive return on their stock.

Sinking eight foot putts may forgive some sins. A few star performers may create the illusion of positive markets, but ultimately all one is doing is trying to keep up appearances and put off reality. My minister and I had the same score on that hole but eventually the player hitting more solid shots is the one who will prevail, and he beat me by more than 10 strokes. A market can only hide behind a few stars for so long.

It appears we may have finally started to see some cracks in this façade:  We could be due for a correction. Corrections are always painful, but they are necessary. There is a reason they are called corrections. Some stocks have already been overly beaten down, while others overly inflated. That needs to be corrected so that we can then re-start this bull market with most stocks participating. Good putting can hide a lot of flaws, but ultimately if one wants the good scoring to continue then he has to hit fairways and greens. Likewise, for the bull market to continue we have to see more companies participating. Correcting these flaws may be painful in the short run, but it does pay off in the end.

Chuck Osborne, CFA
Managing Director