The Next Big Thing

While waiting to board a recent flight I struck up a conversation with a guy who was on standby hoping to get on the same flight. While we waited, he proudly shared that his business was booming. His company sells surveillance software. His recent travels have taken him all over the world, driven by the insatiable demand from governments, corporations, and municipal organizations to monitor what people are doing and to protect information. The enthusiasm with which he shared his story made me feel like Dustin Hoffman in The Graduate, listening to Mr. Robinson explain how “plastics” was the next big thing. Could surveillance software be the next big thing? If so, that would be wonderful for the standby guy. For the rest of us, I’m not so sure…

Part of our stock selection process is to identify the next big thing, or what we prefer calling “sustainable secular trends.” Currently, “mistrust” is certainly a secular trend. While this trend may benefit companies that sell surveillance software, it is a burden for the overall economy and creates all kinds of imbalances and unintended consequences. Neither an economy nor a country can long thrive with mistrust as its foundation post. But that, in my view, is where we are at. Our political process is in shambles, producing the two most unpopular candidates for president in our nation’s history. Meanwhile, our collective faith in government and belief in the integrity of big business is extremely low. Our country is polarized and frustrated. Hence, one result is the explosive growth in surveillance software.

Yet, the stock market is very close to an all-time high. How can this be? In a nutshell, extremely low interest rates are supporting higher stock prices, despite relatively weak earnings. In our view this is a “valuation bubble.” Virtually all valuation bubbles have two characteristics in common. First, they tend to inflate to a much larger size than expected. Second, they tend to inflate longer than expected. In other words, this current low-interest-rate-induced valuation bubble could continue to drive stock prices higher, especially in the near term. Eventually, however, this bubble will burst.

The S&P 500 currently trades for approximately 18.2x trailing earnings, toward the high end of its 8-year range of 12x – 20x. Meanwhile, corporate earnings have declined in recent quarters and have shown virtually no growth over the past 2 years. This challenging economic environment is unlikely to change prior to the election. Given this backdrop, we remain cautious near term, concentrating on disciplined valuation analysis across our portfolios, and continue to focus on identifying very high-quality companies that enjoy sustainable competitive advantages (SCAs) compared to their peers. As we have mentioned in the past, these SCAs can include: product innovation, cost-cutting, technology, financial strength, mergers & acquisitions, market position, cash flow, strategic vision, and management expertise. Even after doing this analysis and identifying sustainable competitive advantages, it is important to overlay the external factors that can impact a company’s performance. These are much harder to predict, but include, regulatory and legislative risk, political pressure, and geopolitical uncertainty. It is simply the world we live in at the current time.

A few hopeful cross currents… There are several post-election potential catalysts that could improve the overall economic and investment outlook. First, corporations continue to build massive amounts of cash, with a huge percentage held overseas. Tax reform could be the catalyst for this cash to be brought back to the U.S. where it could fuel capital investment spending, dividend increases, share repurchases, and overall economic growth. Second, the U.S. continues to have important strategic advantages compared to most of the developed world, including its rich natural resources, diverse economy, younger population, and world-class universities. In my opinion, effective leadership in Washington could unleash these forces through tax reform, and by reversing the era of over-regulation. When this might happen is very difficult to predict.

Despite this rather guarded assessment and outlook, I remain hopeful that positive change will eventually come. Change is the one constant in our country, from plastics, to the Internet, to whatever is coming next. While we and the world face many daunting challenges, our country has never failed to produce the leaders it needed to meet the challenge of the time. We will do that again, eventually. And when that person emerges, he or she, will undoubtedly be The Next Big Thing.