Why conservative stocks will not keep you safe in this terrible market

 Inflation and interest rates rise, but stock ratings fall. How many times have we stated that a stock is currently trading at its lowest price in 40 years? Then it falls lower.

This is the first bear market since 1973 to be fueled by a re-rating. There will be no earnings collapse, no spontaneous illiquidity, and no bankruptcies in waves. Since 2010, our fund has had an average price-to-earnings ratio (P/E) of 15x trailing earnings. It is now at 6.4x with the same stocks. Surprisingly, we are also in the top quartile for financial strength (source: Morningstar). What makes this possible?

After 40 years of falling interest rates and rising P/E ratios, it's been jarring to examine stocks on a broad rather than specific basis. For all those touting the joys of an imaginative new enterprise, it must be disheartening to realize that the wondrousness no longer matters.

If P/Es are falling, lower P/E companies are a safer bet because the re-rating arithmetic damages them less. The second strategy is to aim for shorter time horizons, or durations, because this allows us to collect our revenue faster. The game was supposed to last 40 years. We began emphasizing on earnings before interest, taxes, depreciation, and amortization (EBITDA) rather than earnings per share in the late 1990s (EPS).

We stopped caring about earnings until Amazon came around. The benefits of holding shares were pushed further into the future, until revenues became a distant concept for Tesla as it soared to a trillion-dollar valuation in 2021.

If P/Es are falling, lower P/E companies are a safer bet because the re-rating arithmetic damages them less. The second strategy is to aim for shorter time horizons, or durations, because this allows us to collect our revenue faster. The game was supposed to last 40 years. We began emphasizing on earnings before interest, taxes, depreciation, and amortization (EBITDA) rather than earnings per share in the late 1990s (EPS).

This was a long way from 1976, when Chancellor Denis Healey reminded us that a stock's only value was the discounted total of its anticipated dividends.

As we return to increased uncertainty and higher discount rates, we may either remember EBITDA softly or cut to the chase and look at the torrent of short-term earnings that can now repay a full market cap in just a few years.

Given our concern of a recession, we may seek out strong stocks that can round the U-bend and still be with us on the other side. We can see this in companies with short durations as well, because the rapid payment of a cash gusher will overcome any debt on the way.

Despite previous erroneous overspending, the company might be strong.

What happened to the gushers? Is it necessary to limit this to oil and fertilizer, which are at the crossroads of war and politics, making reinvesting their large earnings difficult even if they do aim to defer rewarding shareholders?

Surprisingly, they can be found in a variety of other cyclical locations. Hold energy on 4x cashflow, promising to return all of it to shareholders via buybacks and dividends, but also examine the growing consumer stocks on 4x earnings. They don't have to keep it up for long before we return the investment.

We can acquire quality and low P/E by bringing in short time. This triangulation is working, and we are receiving valuations that have not been seen in years. How low can it get? BP's low in 1974 was 2.5x trailing and a 14% yield, implying that energy now is a wonderful deal relative to technology if that's where we're headed.

If you believe that the connection between the 1970s and 40-year cycles is oversimplified and incorrect, and that demographics and technology will soon return us to the deflationary path, you should disregard this essay.

However, in order to break free from P/Es at this level and four-year paybacks, consider how much peace and decorum must be restored, how severe a recession will be required to devastate consumer spending and commodity prices, and how transient inflation must be to restore confidence in the longer term. Triangulating in that short time frame appears to be the lower risk setup for us, and it has clearly been working since the November high.

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