Talk Your Book: Valuation Still Matters

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The Animal Spirits with Michael and Ben. Back in 2016, when I was writing my book and doing research on The chapter of the year. I think I was reading uh articles that he wrote in I think it was fortune in like the nineteen And they're used to being 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 the stock or bought all the stock?

And then took the cash and liquidated whatever assets it had, you could have made money. Yeah. Now he's he's bought a bunch of those, right? The cigar bot? Yeah. So th I think those disappeared probably like Pro Buffalo was doing that. They probably disappeared in the sixties or seventies, certainly. By that point they were gone.

So that's sort that style of value investing, long way behind us. That stuff doesn't work anymore. So we actually spoke about this today with Don and Scott that the the value portfolios of today, forget about 50 years ago. They look different than even 20 years ago. S substantially so. It's also cool to think that you can 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 and all the he had this whole all these different metrics. And I remember thinking, like, if I tried 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 i if you're 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 much professionally managed. It's it's it's kind of amazing. So on the show today we talked to Don San Jose, who's a managing director and and CIO of the US value team at JP Morgan. And then Scott Blasdell, who is also managing director and portfolio manager responsible for large cap value portfolios. So JP Morgan has a whole suite of value portfolios up and down the income spectrum and up and down the market cap spectrum.

Um 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. I don't know if that's a baby in the bathwater thing, but it 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 Dow stocks or blue chips or whatever, but there's a lot of stocks out there that still seem reasonably priced.

That that just probably weren't wasn't the case, I don't know, 20 years ago or something. Anyway, here is our talk with Scott and Don from JP Morgan. Scott and Down, welcome to the show. Thank you. Yeah, thanks for having us.

So just this past week I was actually looking at the JP Morgan Guide to the Markets and That uh presentation always has a good job of of showing valuations across broad spectrums, price to book and price to sales and price to earnings and all these different and then it kinda weights shows it against the historical averages. And I want to make a uh a case for you. I'm not saying I believe this case, but I wanna hear your sort of rebuttal. And it it seems like for the past,

Five, ten, fifteen years that valuations just haven't mattered very much at all. And it seems like flows have sort of trumped valuations. in 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 uh fill in after that. But you know, I think valuations still do matter. I mean when you look at sort of where uh stocks are trading, I mean the value benchmark. uh the Russell large cap value benchmarks trading at a thirty percent discount to growth.

uh versus a typical twenty percent discount. I mean you've got PEs for the benchmark around 16, 17 times. Uh that compares to about 25 times for the Russell large cap growth. Uh and maybe what's different versus like the last five years that you mentioned. Uh, you're just seeing better earnings breadth these days. I think we all know, you know, the Mag Seven uh really has shown that the earnings growth is there and people have gravitated towards that.

Um, but I think in the last four quarters you're starting to see some earnings breadth beyond just the mag seven. Um I think another thing, uh, beyond maybe valuation is just diversification matters. Uh and I think you've seen a couple of times in the last year where uh, you know, there are times where having a diverse portfolio really has distinct advantages. Um maybe one of the more recent ones would be Deep Seek Monday.

uh where the mag seven did sell off but but value names actually did quite well. And you saw something similar last summer. when we saw sort of a soft CPI print and maybe beginning in July, right up through the election, again, uh 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 of things here at JP Morgan Asset Management. I think first of all, we have uh

full breadth of products across the value platform. Um, you can really view us as a one size fits all. Uh we've got everything from Equ an equity income fund, a large cap value fund. We have small, mid-cat value funds. And I think what separate 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. And so when I look across

the US equity platform here at Asset Management. Uh we've got over fifty 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 analysts Experience, the portfolio managers partnered with those analysts really makes a difference. I think that was the question might have been poorly worded. Uh 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. Sure. I think, you know, one of the other hallmarks of what we do is it's it's active management. Uh and so I think what we're really focused on is more the the quality names within the value benchmark.

Um obviously all value managers are thinking about valuation, thinking about value. Um, 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. Uh 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. Um you need to do the research. It goes back to those analysts that I mentioned. And so that does tend to go back to our differentiator and competitive advantage, having that that deep knowledge behind every investment decision. That 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?

I I think a lot of people have been saying for the past at least for this cycle that listen, the the tech stocks are overvalued, but they're overvalued for a reason because they're higher quality, right? And stocks that have lower valuations are have those lower valuations for a reason.

And obviously the difference is just the expectations and what is priced in. So how do you consider something like that in terms of the the stocks we own are much cheaper, but the market is is missing something on the expectation. Like how do you understand what it actually is priced into those numbers?

Yeah, I can uh weigh in here on the on that subject'cause Yeah, I started twenty five years ago as a uh real estate stock analyst here at JP Morgan and um Our approach what I what distinguishes JP Morgan, and I think what you really need to do to make uh value investing work um is

look far out into the future. Um so part of what we're doing, you know, we're modeling uh company earnings out um six, seven years. Um And it's not like we're gonna get the future that far out perfectly uh correct in in our estimates, but what thinking that far out does do for you is that it helps you avoid some of the secular losers um that that Don was mentioning, um, 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 forty and as they get older, they're gonna be drinking less wine. I we all we all drink less as we get older. Uh that just makes it harder uh for someone. Okay. Well uh this is we're talking averages here, but uh uh Michael's an outlier. Yeah. Um But the the the point being that, you know, there's just some headwinds to that business that

kind of st make it harder for a company in that business to to do well over time. And if and if you're looking out six, seven years when you're modeling companies forces you to ask those questions about the long term trends. So, you know, versus passive investing, you're gonna own everything. You know, we can weed out the ones that that um that 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? Like does do higher interest rates favor value stocks? Because a lot of the conversation for the past decade was yeah, free money. Uh, you know, d doesn't matter if you get your money back today, five years, twenty years, what's the difference? And we'll just go out and uh take more risk. Do you do you buy into that at all? I do. I mean I think it's just a a a a matter of of math. Um

that uh yeah, you typical growth stock, a lot of the payoff is is far out 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 twenty twenty two.

Uh when we had uh the beginning of um, you know, the post pandemic inflation and and then the spike in interest rates, the growth stocks got crushed. But then you didn't see it in twenty three and twenty four. This is true. Um so you know, um I'd say that it's it's uh it's definitely valid principle, but you know, it it uh it works over long periods of time. Maybe maybe not every year. How do you think about competing against the algorithms and just com competing against simple rules-based?

formulas that say um we're gonna buy all the stocks that trade under this and trade below this and have numbers that do this. How 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 Of cut cutting these formulas yourself, it's much easier to just put these into a a formula and have them spit out a list of stocks.

Well I'd say, you know, again, this is where looking in far out into the future gives us an advantage'cause if they're just, you know, looking at uh published numbers maybe by the sell side, the sell side's going out maybe one year, maybe two years max.

And um they're not thinking about long term growth rates. They're not thinking about what we call normal earnings, what a what a company should earn at a normal part of the cycle. And Yeah we have a lot of evidence that um that our approach of looking far out into the future does make a difference to return.

What are you looking at exactly when you think about like quality? So uh are you looking at some metrics like return on equity or assets? Or are you thinking about quality in the in the uh non-financial term, like, oh, it's a quality business. Uh yeah, I think I I think Michael it's a little bit of both. I think there's definitely financial characteristics you're gonna look at, whether it's return on equity, return on invested capital.

leverage on the balance sheet, you know, all those things you can look at and sort of make a quantitative judgment. Okay, this is quality. But then you have to say, step back and say, what are the qualitative things, right? So consistency over time. What's the company's ability to deliver You know, pretty outsized. returns through a cycle um and just maybe maintain profitability levels that are um either above peers or above industry norms. Like 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? Uh, and then are they able to allocate capital in the right way? You know, whether that's acquisitions, buying back their own stock. paying a dividend or even reinvesting in the business. You know, 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. And 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, um, that doesn't mean your equality. Like you really gotta just look over the long term. Don, you mentioned the diversification piece before, and I totally agree with you that there there have been times in this cycle, even though the big tech stocks and SP five hundred and NASDAQ one hundred

have have sort of dominated th this past cycle. There there's been counter trend rallies and you've seen especially earlier this year, other types of stocks did much better. I'm curious how you think about diversification within your own fund in in terms of of weighting the positions and and having enough stocks to um be diversified, but also, you know, have enough concentration to try to outperform the the index.

Yeah, I think, you know, across value, I think most portfolios have, you know, roughly eighty to a hundred stocks in them. some a little bit more. Um, but that's tends to be where, you know, from a diversification standpoint, um, we get there through the number of names, but then from a sector standpoint People are gonna look at each sector and decide to overweight and underweight specific ones depending on both their macro views.

and and what they're finding on a bottom up perspective. Uh and so, you know, that's gonna vary portfolio manager to portfolio manager. So for instance, you know, 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, you know, that's where in 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 diversity uh d diversification is not such a There's a there's a bunch of rules that we have. Um uh as managers that ensure that we remain diversified. So for example, I have position limits, uh number the the percent of a stock that I can have in the portfolio versus its benchmark weight, for example, is will be regulated.

uh depending on the strategy by various amounts. Uh also sector weights will be uh you know, supposed to be kept within certain ranges and that's one of the ways that you know, simple ways you can use um to maintain uh the diversification. And yeah, but I will take um, you know, larger positions in some sectors when there's particular opportunities.

And uh, you know, underweight sectors where I'm having trouble finding good opportunities um all the time. Uh so that's one thing you do at the sector level and then um on you know 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 it, I'll ask this first. Have value portfolios changed over the years in terms of composition of quality and what they look like? Because I'm looking at your portfolio and um there's a lot of I'm searching for what other than quality. There's good names in here. These aren't like junk stocks. And back in the day, um

Scott, you're you're you're bald like I am and Don, you have grey hair. So you guys have been around for a while. But back We've been around, yeah. But back in the day you wine drinker after all. You used to be able to build portfolios of value stocks that traded probably below ten times earnings. Um

that were just n not that were just baby maybe baby thrown out with the bathwater and then along came algorithms and the embarrassment premium went away because you had all of these quantitative investors And uh maybe maybe management has gotten better over time, but this does not look like like, I guess, uh what I would think is like a traditional value, junky portfolio. There's good names in here.

I know, it can be kind of a surprise for people. Um, and I think that uh'cause, you know, yeah, th there is that that that uh connotation of value of of really just buying um anything. But really there's so many

There so many losers that you you need to avoid, I think, you know. Um we we talked about uh wine drinkers, but I mean y there's any number of industries where the Chinese have um, you know, decided that that's what they want to expand into, whether it's steel, aluminum, you know, solar panels, you know, where

Right now they're they're uh really stepping up their investments in petrochemicals where the odds are just so against you because uh there's a a big cost advantage uh that they have. So, you know Uh yeah, yeah, I could pay, you know, less than ten times for uh for a steel company, but you know, do do I really want to? Where where am I gonna be in five years? So I think that um I I have seen some analyses that, you know, suggest that certainly on the small cap side, the small cap universe is

has just gotten uh less quality over the years. You know, there's um there's more leverage. Um so that that could be part of it. But I I think when when we're looking again, when we're looking out and looking what at what is sustainable in terms of a company's earnings and cash flows and and and looking for at least some growth, you you you uh weed out uh the the the lowest quality names that maybe, you know, thirty years ago people would have been more open to.

So part part two of the question is, um 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 that they're 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, that's I know it's kind of funny because I'm responsible for the Amazon.

Amazon, surprisingly, is is cheaper than Walmart. You know, we had uh Walmart in the portfolio for a while, but if you look at uh Amazon on uh Eva de Eva Tars like, you know, eleven times, which uh and the and Even the forward the forward PE I saw is below Walmart, which is kinda wild to think about. And the forward PE, which rarely happens. And if you look over if you look ever since Amazon went public, I mean the PE got has gotten down to a as low as about uh thirty times earnings.

You know, so it's never been a quote unquote value stock on PE and yet, right, it's been a great investment. And um right now it's about thirty three times or something like that. So uh what happens with Amazon is that they invest so much of their um free cash flow into into new businesses all the time. And, you know, that investment um depresses earnings. So yeah, you're you're making a bet that their current investments are going to pay off. Um

more times than not they have. I mean, look at how they've grown AWS and um uh gotten into um you know made made a success of so many things. Now, you know, they're replacing UPS and FedEx with delivery and, you know, the the business keeps evolving and getting stronger. Um 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 um a value period right now.

Are there any 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 X Tech stuff? Like where where are you finding cheap stocks these days? Well well we could talk about uh HMOs if you want. Uh you know, we where we you know, there's just uh swirling controversy right now. Um and um and part of it is just the Trump administration uh has

uh said a lot of things, talk about getting rid of uh healthcare middlemen uh that have um for example that have cast a a cloud over the whole sector. So right now I'm seeing a lot of uh controversy in that sector and a lot of uh inexpensive companies, even if you're not ready to wade into United Healthcare, which is um particularly uh in focus right now. I mean, I think Cigna is is very cheap. They don't do any Medicare advantage. Um and uh trading at eleven times earnings. Um uh

that uh, you know, we think, you know, still has good very good growth opportunity uh going forward. Um so Yeah, so that would be one area. I don't know, Don, if uh you want to chime in. Yeah, I I mean I think there's also opportunities in financials. I think right after the election. Um, you saw just, you know, a lot of euphoria over, you know, deregulation, the fact that there was gonna be more M and A, more IPOs, just general capital markets activity.

um really starting to 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 and A come together. You're starting to s see some IPOs. start to file again. And so I think when we look at financials and and banks in particular, where credit still looks pretty good, um, you know, there there's opportunities to pick and choose amongst amongst those banks as well.

So Bank of America and Wells Fargo are two of the biggest holdings. Um, and it's been a long time since Wells Fargo, the stock. was performing well.

So I looked at these a couple months ago and I was a holy moly, even Citigroup, no offense. But a lot of these stocks are performing really, really well. What do you do you think this is expectation of capital market formation? Is it a healthy consumer? Is it I know all, you know, not 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 uh in anticipation of deregulation by the you know Trump administration. We haven't really you know, we've we've heard a lot of rumors about it.

I think when you say deregulation, is that is that inside the banking system or broader or just leading to more MA? W like what does deregulation mean for the banks? Well, for example One thing would be um I don't know if you've heard of the Basel three end game, but there were, you know, uh under the Biden administration there was Is that the new Mission Impossible movie? Well it uh

Under Biden it was kind of impossible to avoid. Uh, but it turns out under Trump, um, you know, it's likely that capital uh requirements will not be raised um at least as high as was contemplated initially. uh under the Biden administration. So that's one way and it and if and if banks are not required to retain as much capital, then they can use uh the funds to buy back stock instead.

So that would be one uh one way that it's uh it matters. I think another uh thing that folks are looking for and we're already seeing a pickup in mergers and acquisitions, but uh you know, we have over four thousand banks in this country. Uh there's there's a lot of reasons, um, whether it's technology spending or just meeting the costs of higher regulation, uh, where uh you know you we should

be pushing for economies of scale and mergers, but it was really impossible under uh prior administration. So if if there's some relaxation of M and A rules for banking, then I think you're gonna see a lot of uh a lot of deals announced and that Typically good for sentiment and uh should ultimately help uh earnings for the whole um sector if we get some uh economies of scale. Aaron Powell A lot of value investors

over the years have said, you know, I ignore everything that's macro. I ignore politics. I just focus on the financials. And you've mentioned policy a couple policies a couple of times now. Um how 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 gonna be a death knell for this sector, but then wait, things change in a week. So like how do you try to to model that out when things are changing seemingly so quickly? Yeah, that's a great question, you know,'cause when we're looking at earnings for companies, yeah, like I said, we're looking out long term and so you tend to discount um

Near term policy changes. On the other hand, um some things like uh capital requirements for banks are are so important, you know, it could really move the long term earnings uh for a bank up or down. So you have you have to pay attention. What I typically do, you know, is when it comes to and I do spend a lot of time thinking about kind of top down issues.

You know, when it when it comes to a controversy a political controversy or or something else, uh just a couple of years ago we had a bank crisis, you know, with Silicon Valley and the value of commercial real estate um uh threatening balance sheets of many banks.

Um Yeah, that was like a four day bank crisis. That was terrible. Well it did I mean it seemed it seemed bad at the time, but then it's one of those things that just sort of washed over. It turned out it was a it was a fantastic opportunity, which is you know what we what we concluded it you know that Typically what you have to do is just say, okay, you know, is is everyone else discounting this already? Um and you know, if you if you see evidence, um, you know, if it if it's

if it's like six months after the the crisis, you know, typically by then people have absorbed whatever the the controversy is and and sort of factored it into valuations. And if you know, so I'd say that it's it's really Uh you know, just getting a sense um and and I think when we you do as much modeling as we do of of company earnings, you get a a pretty good feel for uh when something um really dramatic has been discounted into a stock or not.

And and that that's really kind of the art of it. Um having gone through a bunch of crises definitely helps in this business. Scott, this is a maybe a hard question to a answer, but Are you more likely to sell a stock on the way up because you feel like it's fully valued or the risk reward becomes asymmetric at that point? Or are you more likely to sell a stock as it's going down because the thesis is wrong? It's no longer quality, it falls out of your favor, whatever.

Yeah, I I guess I I should say that it's uh the first. I mean, you know, we uh we only buy stocks that go up. But the um I think um uh you definitely Uh yeah, I d I definitely tend to be trimming things and you know, we're ranking all the stocks, um Using a a uh a a ranking system that we have here um every day. And so yeah, as something gets more expensive and and unless I can find

or a good reason to raise my long term estimates, I'll I'll be tending to sell it. But yeah, then you also have situations where yeah, typically if uh a company if you know the thesis isn't working out or or you know management does something you didn't expect that you don't like, be like, Okay, that's not what I thought. You know, time time to move on. So I'd I'd say that um those

Those kinds of negative surprises don't tend to happen as often. I mean they can be very painful when they do, but um yeah, it tends to be more you're just trimming things that have done okay. Buffett's old maxim is our our favorite holding period is forever.

What ends up being what ends up being your guys' favorite holding period? You know, obviously you you want to just buy and hold something and hope that it keeps going up and that's great, but what tends to be your holding period for the stocks in your portfolio? Should I start? Yeah, I it um I manage a couple of portfolios here. You know, we have I have I have um Uh one, large cap value, which has a um pretty high turnover rate. Um, usually like uh

I don't know, a hundred hundred twenty percent or so. So pretty short uh period of time, you know, it's'cause we're I'm looking at rankings every day and as stock prices bounce around, um, you're you're you're trimming and adding. Um Uh pretty often. then another strategy I have much more quality oriented portfolio.

where, you know, your your hope is to just hang on to the winners until it they become uh truly uh unjustifiably expensive. And in that portfolio the uh the turnover is uh closer to fifty percent. Yeah, I think, you know, and especially as you go down cap on some of the small and mid cap portfolios where Turnover can be twenty percent or less.

Uh, you know, so you're really looking to own this thing for three to five years minimum. And if you own it for eight to ten years, that's actually not really a surprise either. Um, but you know, right around that five year tends to be kind of the the most common sort of time frame that will will hold a stock.

So guys for people that want to learn more about the JP Morgan active value strategy, where do we send them to find more resources? You can certainly um you know go to our JP Morgan Asset Management website, uh find some uh materials there. We've got plenty on there in terms of uh fact sheets, uh historical per performance. uh and and just kind of slide deck on sort of portfolio construction, a little bit more about the team.

process and philosophy. Uh and then, you know, certainly helps to be on shows like yours. So thank you again for having us. Oh, appreciate it. Don, Scott, thank you. Okay, thank you very much. Done. Remember, check out jpmorgan.com to learn more about all their different value strategies and the jpmorgan active value. Email us animal spirits at the compounds dot com.