Fallen Angels: When Optimistic Projections and Growth Don’t Add Up

FallEN aNgElS

WhEN OPTiMiSTiC PROJECTiONS aND gROWTh DON’T aDD uP

I would define a “fallen angel” investment, as a stock or bond that was once one highly regarded with a high valuation, that has fallen to earth due to mishaps, or a changing of sentiment in regard to its future prospects.

Often these types of investments can be found after an industry or market has been bid up over several years, due to extremely optimistic projections, but then growth doesn’t add up to the implied growth needed to warrant the extended valuation. So much of short-term market performance is based on sentiment and flows, which often leads to distortions between stock prices and intrinsic value. Taking advantage of Mr. Market’s temperamental nature leads to fertile grounds for value investors. As Horace said, “many shall be restored that now are fallen and many shall fall that now are in honor.”

One classic example of a “fallen angel” is the case of Microsoft (MSFT). In 2000, the stock traded at around $60 per share, or 170x earnings before the Tech Bubble burst. Just a year into the bust, the stock had declined by 65% and it took 16 years before the stock saw $60 again. In the midst of that decline, there were multiple opportunities to buy Microsoft and between 10-13x earnings and free cash flow, including most of 2009-2013. Market participants had lost confidence in management, which had made some horrendous acquisitions and missed out on key opportunities such as mobile phones. Many were worried that the shift towards the cloud would relegate Microsoft’s dominant software franchises into obscurity, but those fears were unfounded, as consumers adjusted to the SAAS model. Satya Nadella’s elevation to CEO and his focus on expanding the Azure cloud platform put Microsoft on a huge runway of accelerated revenue and earnings growth, leading to the company once again becoming a glamourous stock to own. Microsoft has risen from trading at just over $20 per share in 2012, to a recent price of over $260.

The bear market of 2022 has indeed opened up opportunities to buy formerly glamorous stocks at 70-80% discounts to valuations seen just a year ago. Many of these stocks will not recover their previous price highs for many years, if ever, but others likely present fantastic opportunities. Stocks such as Alphabet (GOOG) and Meta (META) trade at around 20- and 18-times forward earnings, respectively, which are some of their cheapest valuations in history, despite attractive long-term growth rates. While I wouldn’t classify financial stocks as being glamourous over the last 13 years of zero interest rate policies, many of the highest quality banks and insurance companies trade at single-digit P/E ratios, and some at material discounts to tangible book value per share, despite being net beneficiaries of higher interest rates. This pessimism creates opportunities for long-term investors in that not a lot has to go right to make a lot of money due to the ridiculously cheap valuations. For example, Citigroup trades roughly 60% of tangible book value per share and just 7x forward earnings, despite seeing considerable net interest income growth due to higher interest rates. At this valuation, Citigroup should be a winner as long as the company and the global economy simply doesn’t blow up as they did in 2008, which I think is extremely unlikely. Banks have nearly double the capital and liquidity as they had then, and they have dramatically reduced the risky activities and underwriting that led to many of those issues. My belief is that after they show their improved strength and fortitude in the current economic downturn, that market participants will begin giving a bit more credit to the industry via higher valuations, especially as the benefits from higher rates filters through the income statements.

Tim Travis is CEO/CIO of T&T Capital Management, a California-based registered investment advisory. Tim is a deep value investor that performs extensive research and analysis to identify securities trading at deep discounts to intrinsic value. In addition to traditional value investing and asset allocation to stocks and bonds, T&T deploys income-generating options strategies such as covered calls and cash-secured puts. These strategies are designed to enhance income, reduce risk, and to instill a disciplined selling process, which is quite unique in the industry of relatively cookie-cutter asset management. Tim has written detailed research reports on investments for many years on sites such as Seekingalpha.com, while also appearing on various other media outlets such as CNBC and Bloomberg. Tim graduated with a BA in Business and Economics from the University of California Santa Barbara in 2004. He developed a solid understanding of the investment industry working at firms such as Scottrade, Vanguard Group, and several smaller brokerages. Tim’s lifelong appreciation for the rational and profitable investment philosophy’s of Warren Buffett, Benjamin Graham, Martin Whitman, Seth Klarman etc., have been immensely influential on the firm’s philosophy and Tim’s career. T&T’s obsession is truly providing a boutique investment management offering what we believe to be best-in-class strategies and security selection to retail investors, as opposed to many industry participants that are primarily focused on raising assets.

www.ttvalueinvesting.com

The author owns Google and Meta but not MSFT.

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