The case for ketchup

The S&P 500 rose 2.1% to end the week at 2892.74, creeping ever closer to its all-time closing high of 2930.75 reached last fall. The bull market that started back in March of 2009 is up 328% since its March 2009 low and has already celebrated its 10th anniversary. It is the second longest bull market of all-time; only the bull market of 1987 – 2000 was longer. Since 1949 the average bull market has lasted 5 years and 4 months, according to Ed Yardeni of Yardeni Research. There is an adage on Wall Street, however, that bull markets don’t die of old age. Rather, the more typical catalyst for the demise of a bull market is recession.

The Federal Reserve continues to play a large role in the current bull market. Dropping the Federal Funds futures rate to 0% and following up with the first-ever quantitative easing program in its history ensured enough liquidity to force stocks higher regardless of economic fundamentals. Now the Fed has apparently put an end to the interest rate hiking cycle and indicated that balance sheet shrinkage (Quantitative Tightening) may be coming to an end soon as well. Meanwhile, real interest rates (nominal rates minus inflation) continue to be very low at only about 0.6% for the 10-year Treasury inflation indexed security, according to the St Louis Fed. “Financial conditions, as measured by the Chicago Fed, are now the easiest since 1994,” wrote Peter Boockvar, chief investment officer at Bleakley Advisory Group.

And what has the continued easy money Federal Reserve policy meant for investors? It’s meant that commodities have soared at an 84.8% annualized rate year-to-date, exceeding the 1973 pace, which was the best year ever for commodities. Global equities have leaped at a 67.9% annualized rate, better than in 1933, which was the best year ever for stocks. Meanwhile, bonds continued to forecast no inflation and slower economic growth, with the 10-year Treasury ending the week at 2.495%. Furthermore, the corporate earnings forecast for Q1 is for a decline of 4.2% while Q2 earnings estimates are predicting a flat quarter. Not exactly the type of earnings growth that one would assume, given the big gains in U.S. stock markets so far this year.

Investors would do well not to expect the U.S. stock market to continue its current trajectory.

People don’t like to buy stocks that are falling. They much prefer to buy stocks that are rising. The problem with the latter strategy is that there’s no guarantee that a stock will continue to rise after you buy it, but it is a certainty that you’re paying a higher price for the company’s earnings than you would have prior to the stock moving higher. 

Value investing works because you are paying less for the company’s earnings after the stock price has dropped. Value investing works because people systematically underprice stocks that are falling. One common heuristic among investors is that a good company equals a good investment and a bad company equals a bad investment. The problem with this rule of thumb is that it fails to take price into account. The data shows that value investing beats growth investing by 4.8% annually on average (using the Fama-French data on the ratio of book-equity to market-equity over a 90-year period running from the 1920s through 2017).

But that doesn’t make value investing easy and Kraft Heinz is exhibit number one as an example of why. A consumer staple stock and traditionally, at least, thought of as a blue-chip dividend paying company, KHC has fallen from $92 per share less than two years ago and was a $65 stock within the last year. We started buying it last year for clients in the high 50s. We have fair value for the company at around $65 per share. KHC was paying a $2.50 per share dividend for a yield of around 4.3% at the time of purchase. Now it sits at $33.17 after having set a 52-week low of $31.53 just a few weeks ago. A kitchen sink type of quarterly earnings announcement that included a sharp reduction in expected earnings in 2019, a major write-down of goodwill, and an SEC subpoena sent the stock sharply lower in late February.

We still have fair value for the company at around $65. Morningstar has fair value at $60. CFRA has a 12-month price target of $40. Value Line rates it 2 for safety on a scale of one to five with one being the safest and gives KHC an A+ for financial strength (although they may lower both in their next report). Value Line also sees the stock between $80 and $110 three to five years out (although that price range is likely to come down as well). 

We bought additional shares for clients (and me) at $32.65 last week. Are we sure that all the bad news is out and priced into the stock? No, we are not. Do we think that we are paying a sharp discount for the mac and cheese and ketchup company when viewed as an ongoing business that is likely to survive and grow over the coming decade? Yes, we do. Furthermore, even at the reduced dividend rate of $1.60 per share, we are being paid 4.9% to wait for better times. 

Regards,

Christopher R Norwood, CFA

Chief Market Strategist