3Q 2017 Quarterly Letter – Low Interest Rates Drive Stocks Higher

The S&P 500 and Russell 2000 Indices made new highs in the third quarter, gaining roughly 4.5% and 5.7% respectively.  The gains were widely attributed to renewed optimism regarding tax reform.  According to Ned Davis Research, the proposed change to a 20% corporate tax rate would lead to a 7.2% jump in after-tax earnings on the S&P 500 Index and 27% for the Russell 2000 Small Cap Index.  While tax reform could lead to a short-term pop in corporate earnings, betting odds for a corporate tax reform by the end of 2017 is just 33% according to Predictit.com.  Tax reform aside, we remain optimistic for our holdings going forward as we’ve accumulated a portfolio of stocks with superior management teams, strong balance sheets, niche businesses, and that trade at a discount to the market overall.

Stepping back and looking at the big picture, many clients are asking why equity markets have been so strong over the past few years?  Now that economic and employment levels are back to normal and interest rates have remained low for an extended period, it’s our opinion that investors have accepted the reality of low rates and bid stock prices up to commensurate valuations.  You can see on the chart below that while the yields on 10-year Treasury bonds have declined and stock P/E valuations have risen, the relationship between stock and bond valuations remains on its historical trend.  In other words, the seemingly high S&P 500 P/E ratio of 23x earnings is about right given 10-year Treasuries yield just 2.2%.

Historical Trend of S&P 500 Valuations Relative to 10-Year Treasury Bond

Source: Shiller Data as of 9/30/17. 10-year Treasury Yield = 2.2%, S&P 500 E/P = 3.65%, S&P 500 P/E = 23x.

Red Dot is September, 2017

While interest rate changes move markets, they are unpredictable.  Our strategy for success is to select a diversified portfolio of securities that will perform well no matter what the broad market indices do.  We spend each day conducting rigorous research to accomplish this goal.  Last month, David, Stan, and I attended the Raymond James Bank Investor Conference where we interviewed more than 40 managements teams of community banks.  Our conclusion was that we continue to be very positive for the banks and even found a few new great franchises trading near book value that we are trying to accumulate.  While our bank stocks have increased significantly, our top ten bank holdings still trade at an average of 15x earnings and 1.4x book value, which is a 20% discount to peers despite our handpicking the best management teams, markets, and culture.

We have found that companies that properly motivate employees, make raving fans out of their customers, and focus on shareholder return have delivered superior investment results.  With the goal to take our abilities to analyze culture to the next level, we partnered with Washington University’s Olin School of Business.  In conjunction with professor Anjan Thakor, one of the country’s leading experts on corporate culture, along with four master’s students, we are researching how to measure corporate culture to find and capitalize on investment opportunities.  I can’t wait to share the results of our study in the future.


This post is for informational purposes only and does not constitute a complete description of our investment advisory services. This post is in no way a recommendation of any security or a solicitation or offer to sell investment advisory services. Thisnewsletter should not be construed as advice to buy or sell any particular security. This post is not definitive investment advice and should not be relied on as such. It does not take into account any investors’ particular investment objectives, tax status, or investment horizon. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. Any forward-looking statements speak only as of the date they are made, and Eidelman Virant Capital assumes no duty to and does not undertake to update forward-looking statements. Certain investments mentioned in this post may not have been held by clients of, or recommended by, Eidelman Virant Capital.   Past performance is not indicative of future results.