Wesley Chapel, FL
““The world makes much less sense than you think. The coherence comes mostly from the way your mind works.” ”
In the interest of telling you what I would want to know if our roles were reversed, what follows is an overview of a good chunk of our investment selection process. If I were you, I’d wonder how the stocks that find their way into my account get there and why. I’d probably wonder how the current level of craziness in the markets impacts that and what Elevate is doing to stay level-headed amidst the chaos.
Before I move on to that, though, I want to take a quick moment just to note that the Fed decided to hold its policy rate steady at its meeting that concluded today. This came as no surprise to the market, but likely disappointed President Trump, who has been “encouraging” Chairman Jerome Powell to cut interest rates.
Inflation, as measured by the Consumer Price Index (CPI), for March was reported on April 10th at 2.4%, down from the February print of 2.8%.
Meanwhile, inflation expectations in the University of Michigan survey skyrocketed.
These expectations are a reflection of tariffs, but the truth is that tariffs are price increases via taxation, not a symptom of an inflated money supply. I won’t dig into the difference here, but as Milton Friedman said:
“Inflation is always and everywhere a monetary phenomenon.”
Anyway, the main takeaway for now is that the rate of change in inflation is down.
According to the advanced estimate of GDP in the first quarter, it is also falling. Another estimate is forthcoming before it is finalized, but for now, GDP is showing a decline of 0.3%, marking the first decline since the first quarter of 2022, which initiated the last bear market.
Again, the big takeaway here is that the rate of change in GDP is down.
So, the rates of change in both inflation and GDP were down in the first quarter. A little later in this commentary, you’ll see why that is important, and shouldn’t be surprised that those conditions preceded (or perhaps led to) a substantial drop in the stock market.
Finally, a brief technical analysis of the S&P 500.
As noted last month, the SPY has fallen out of its long-term upward-sloping channel (yellow shaded area) and has declined decidedly below the 200-day moving average (light blue line). What’s more, the 200-day moving average line, which defines the long-term trend, also started to fall. In fact, it fell for 20 straight days, just one day short of my normal signal to call it a downtrend. It has since started to turn back ever so slightly higher on the violent bounce we’ve seen from the lows, but for now, it is stuck moving sideways (purple box).
The 200-day moving average will likely act as resistance to any further upside, at least in the short term, but there are no guarantees.
The intermediate-term trend is decidedly down, as indicated by the 50-day moving average (bright red line at 554.55). The only good news here, other than the massive bounce from the lows at 496.48, is that the index now trades above the 50-day moving average. I am looking for some sideways consolidation between the 50-day and 200-day averages before the market chooses a direction.
I will continue to monitor the 200-day moving average and whether it is rising or falling. That IS the trend.
In headline-driven markets such as these, anything can happen at any time. All it takes is a social media post. Thankfully, the 200-day moving average doesn’t bounce around the way the price does.
I will not be surprised if the market reverses from here to make new lows, but I am not betting the farm on it.
All that said, we can proceed to the commentary as originally written.
I find it very challenging to write something coherent to you when the economic, market, and geopolitical environments are totally incoherent and changing by what seems like the minute. It generally takes more than one minute to compose, edit, post, and distribute this commentary, so I guess just don’t be surprised if something has changed (in a big way) by the time you read this.
I have answered more questions with a simple “I don’t know” recently than I can ever remember. Not that I usually know everything, or that I suddenly know even less, but the questions are more focused on what is going to happen in the future than usual. Pair that with the fact that more policies in an incredibly wide range of categories are changing more rapidly than any one person could possibly keep up with, and anyone being honest is bound to have more “I don’t know” responses than usual.
So, if you ask me what will happen with tariffs, I don’t know. Nobody knows. I increasingly don’t even think the Trump administration knows. For example, the “Rapid Response 47” Twitter account posted on April 29:
NEW: @POTUS just signed an executive order to avoid the cumulative effect of overlapping tariffs on certain articles, such as automobiles and automobile parts.
Here is the text of the order:
By the authority vested in me as President by the Constitution and the laws of the…
If you knew what you were doing ahead of time, why would there be a need for a post-hoc executive order to address the unintended consequences?
They are making it up as they go.
Before you send me an angry (or happy) email, please understand that this deductive logic doesn’t reflect any political opinion that I hold. It is just an unemotional assessment of the incoming data.
If we implement tariffs (after the 90-day pause) as currently proposed, I don’t know how we avoid a massive rise in prices and probably a recession, perhaps of epic proportions.
I also don’t know how any of our trading partners would end up with a surplus of dollars to lend back to us in the form of buying our Treasuries, on which our current economy is dependent. Remember, we are going to spend $2 trillion more this year than we will have in income. We must borrow that from someone.
If we don’t do something to meaningfully reduce our trade deficits with the rest of the world, I don’t know how we avoid going further and further into debt to the point that all our trading partners someday lose confidence in the dollar and refuse to accept dollars as payment for the (relatively cheap) goods they export to us.
I don’t know how we can go back now that so much damage has been done to our trading relationships. I am not saying whether that is good or bad. I just don’t know.
I don’t know if or when the Fed will cut interest rates.
If the unemployment rate rises too much, which would likely happen if the proposed tariffs were implemented, it will probably cut rates, leading to additional inflation and upward pressure on prices.
If prices go up too fast because of the tariffs, without an accompanying rise in unemployment, it will probably hike rates.
I don’t know if we have seen the lows yet for the major stock indexes.
I could go on and on about all the things I don’t know and all the different ways that I don’t know them.
But I have good news. There are some things that I do know! And I know them for sure!
Probably the most important thing is that I do know that there are many things I don’t know, including those described above.
And even the things that I think I know for sure, I maintain a healthy dose of skepticism about. As one of my favorite quotes, usually misattributed to Mark Twain, says,
“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
All this is what leads so many investors and advisors to simply throw in the towel and volunteer to serve a life sentence in “Pie Chart Prison,” no matter the circumstances. For those who don’t know, this is how we at Elevate refer to the 99% of our competitors that look at a brief risk tolerance questionnaire and assign you a pie chart of funds based on Modern Portfolio Theory and the Efficient Frontier (jargon), and then go to their next meeting without every having to consider the intrinsic value of any investment they make with your hard earned capital. That would be way too much work.
In fairness, we also offer passive strategies to those who want them. They are every bit as good, if not better than any other pie chart you are likely to find anywhere else, since there is no real edge in Pie Chart Prison. The most important factor in passive investing is cost. It isn’t what you make, it’s what you keep! Passive strategies will earn the market return, minus a fee. The lower your fee, the better your net return. So, rather than charging a full “management” fee for doing as close to nothing as possible, we offer our passive strategies at a 50% discount.
However, just because some people lack the discipline or work ethic to manage portfolios successfully doesn’t mean that nobody can. The truth is that most investors and advisors can’t actively manage portfolios successfully. And they shouldn’t even try.
Over long periods and many market cycles, bear markets, recessions, pandemics, you name it… We have demonstrated the ability to identify and purchase great companies at fair prices, in appropriate proportions, and hold them either forever (so far) or until our rules-based exit prices are reached.
We use both top-down and bottom-up frameworks to analyze fundamental valuations of businesses as we look for the great ones in the right sectors and industries for the prevailing macroeconomic environment.
What does that mean?
Our top-down framework is based on the rate of change in Gross Domestic Product (GDP) and the rate of change in inflation (CPI). Each can be either increasing or decreasing. There are four different possible outcomes on a rate of change (ROC) basis:
GDP growth is rising or accelerating (even if only to a less negative level, like from -2% to -1%), and the inflation rate is falling or decelerating (even if to a less positive level, like from 3% down to 2%).
GDP growth is rising, and the inflation rate is rising.
GDP growth is falling (even if to a less positive level, like from 3% to 2%), and the inflation rate is rising.
GDP growth is falling, and the inflation rate is falling.
Visually, it looks like this:
These different macroeconomic (macro) environments lead to predictable responses by the Fed. The idea is that we can “front-run” what the Fed is going to do by knowing which environment we are in.
As the Great One said, “Skate to where the puck is going to be.”
With this framework, we can gain insight into which asset classes, sectors, and industries are likely to perform the best and the worst. We do this with the understanding that the best business in the worst sector will still probably outperform the worst business in the best sector in any given environment. Each environment has its nuances, so we don’t just turn our brains off after determining the rates of change in GDP and inflation.
Perhaps the one exception in our suite of strategies is our Permanent Portfolio. This strategy is built much like the largest and most successful hedge fund in the world, the All-Weather Portfolio from Bridgewater Associates, which is run by Ray Dalio, whom I mentioned earlier.
Back in 2017, Ray Dalio said:
“Each [GDP and inflation] could either be rising or falling, so I saw that by finding four different investment strategies – each one of which would do well in a particular environment (rising growth with rising inflation, rising growth with falling inflation, and so on) – I could construct an asset-allocation mix that was balanced to do well over time while being protected against unacceptable losses.”
In the Permanent Portfolio Strategy, we have built a portfolio that has performed well under each of the four macro environments, and we make minimal adjustments aside from regular rebalancing.
Similarly, our bottom-up approach to analyzing businesses is intended to, and over time has demonstrated an ability to identify great businesses that perform relatively well in any macro environment.
That doesn’t mean the stock price of these businesses will always go up…
It does mean that the intrinsic value of these businesses generally increases over time. What the market is willing to pay for them (stock price) is totally independent of what the business is really worth (intrinsic value).
Our job is to identify when the market prices of great businesses align with their intrinsic value, and then buy as much of them as we can without putting too many eggs in one basket.
How do we do that?
We use several methods to analyze businesses. The most reliable methods vary from one sector or industry to another, but there are a few methods that are applicable to most industries.
Our first framework is called “the Pods.” It complements the Quads above, and the term was coined by our friends at Hedgeye. Again, with the Pods, we are focused on the rate of change, not just the nominal values.
Pod 1 is Revenue Growth. Is the rate of change in Revenue Growth accelerating or decelerating? Accelerating is better.
Pod 2 is Margins. Are margins expanding or contracting? Margins are various measures of how much of the revenue is converted into profits after paying expenses.
Pod 3 is Capital Allocation. How are the profits being used?
If you can find a business in the best sector for the given macro environment that also has revenue growth accelerating, margins expanding, and high shareholder returns, that is probably a winner. But it is also probably expensive. It may even be too expensive to want to buy at current prices.
After examining the Pods, we can decide whether a business is worth continuing to analyze. If it isn’t growing its revenue, expanding its margins, or allocating its profits effectively, there isn’t much reason to continue.
When we decide to move forward, we start with a price implied expectations (PIE) method. In the PIE method, we don’t try to predict the future revenue, margins, or cash flows like many old-school Wall Street analysts do. What sense does that even make in a world like today, when we don’t even know what tariffs are going to look like tomorrow, let alone what cash profits will be 10 years from now?
I learned about the PIE method from several people over the years, but the original source of the method is a book called "Expectations Investing" by Michael J. Mauboussin and Alfred Rappaport. Here is how they explain it:
“Rather than forecast cash flows, expectations investing starts by reading the collective expectations that a company’s stock price implies. By reversing the conventional process, you not only bypass the difficult job of independently forecasting cash flows, but you can also benchmark your own expectations against those of the market. You need to know what the market’s expectations are today before you begin to assess where they are likely to move in the future.”
Essentially, we mathematically and objectively uncover what the market currently expects and then evaluate the reasonableness of those expectations.
The next method we use is called “Reverse Discounted Cash Flow” analysis. It is a lot like the PIE method, but focuses only on Free Cash Flow (FCF). Free cash flow is what a company has left over after paying all its expenses and reinvesting in the business. As I have written many times in this commentary, the intrinsic value of anything is a function of the cash flows it will generate in the future. While a dollar today is worth a dollar, a dollar next year is worth less for many reasons, a couple of which are a) if I had the dollar today, I could earn risk free interest of 4% for a year and it would be worth $1.04 next year, and b) I might die and ever even get the dollar a year from now.
So, in the case of example a) above, the dollar a year from now is worth $0.96 today. If you came to me today and said, “I want to sell you $1. I will give you the $1 a year from now. What will you pay me for it right now?” My answer would be (at most) $0.96. That assumes I am almost certain that you will actually give me the $1 in a year. I need to earn the same $4 that I could earn by lending $1 to Uncle Sam for a year. If I think there is a risk of you skipping town, or otherwise not having the $1 to pay me in a year, then I will offer you (perhaps much) less than $0.96 to compensate me for the added risk.
So, the future dollar is “discounted” by some rate to account for interest and risk.
A Discounted Cash Flow (DCF) method attempts to forecast (or estimate) future cash flows, applies a discount rate to those future cash flows, and then adds them all up to arrive at an intrinsic value estimate for the business and its shares. People get really carried away with these guesses, and I think it is mostly a giant waste of time in any market environment, let alone the kind of uncertainty we are experiencing today.
Don’t take my word for it, here is what a few legends have to say:
“It is better to be roughly right than precisely wrong.” - John Maynard Keynes
“Some of the worst business decisions I’ve seen came with detailed analysis. The higher math was false precision. They do that in business schools, because they’ve got to do something.” -Charlie Munger.
Instead of trying to predict what the cash flows of a business will be like, most Wall Street analysts do, with essentially zero success, we just reverse the whole thing. Just like in the PIE method, we use the current share price to reverse the entire process. We start with the current price and the current cash flows as reported by the company in SEC filings, and from there, mathematically determine what the growth rate of cash flow must be over the next several years for the current stock price to be reasonable.
By the way, I do happen to be a CFA charterholder, and I am perfectly capable of designing extremely complicated and precise models. Most charterholders are very proud of their precise models, regardless of the poor results they lead to. I just know (from experience) that it is a giant waste of time.
So, we start with the current price.
From there, all we must do is answer the question, “Is that implied growth rate reasonable?” If so, “Does it also offer a margin of safety in case we are wrong?”
Most of the time, the answer is “no” to both.
When the answer is no, but the business is a great one that we would like to own if we could ever buy it at a reasonable price, we set an alert at a price that implies realistic FCF growth for several years with a nice margin of safety, and then set an alert at that price. If the stock price ever drops to that price, we can confidently buy it.
Next, we examine an Expected Earnings Growth model, which consists of three components.
Expected Earnings Growth
Looking at historical growth rates and considering management’s guidance for the future, how fast or slow do we think net income and shares outstanding will grow or shrink? Earnings per share (EPS) is net income divided by the number of shares. So, a company can increase earnings per share without an increase in actual profits if they are buying back shares. See the following item.
Shareholder Yield
Again, looking at historical rates of change and management’s guidance for dividends and share repurchases, what do we expect over the next 5-10 years?
Multiple Expansion or Contraction
How does the current price-to-earnings (P/E) ratio compare to history, and what do we think the ratio will reasonably be over the next 5-10 years?
Each of those components is expressed as a percentage. For example, if we expect:
EPS to grow by 10% for 10 years.
The dividend yield to be 2% and 1% of the shares will be repurchased annually for 10 years.
The P/E Ratio will increase from 25 to 30 (20%) over 10 years (2% annually)
We just add those percentages up and arrive at our expected annual return over 10 years. So, in this case, we get:
10% EPS growth
+2% dividend yield
+1% repurchase yield
+2% PE multiple expansion
=15% annual return
Finally, we examine the historical price-to-earnings (P/E) and price-to-sales (P/S) multiples. If a business's P/E ratio has averaged 20 over the past ten years, we start with that as a fair value. If its P/E ratio today is 20, it is fairly valued. If its P/E ratio today is only 10, it is cheap, at least relative to the past decade. Likewise, if its P/E ratio today is 30, it is expensive.
We perform the same analysis with the P/S ratio, and often evaluate other ratios in the same manner. Additionally, we examine these ratios in relation to their competitors.
Year-to-date index performance
By doing all of this work, we tend to find that the methods begin to tell a coherent story as they converge on one another. Usually, at least lately, the coherent story is that the stock is very expensive, and even if it is a great business, we don’t want to overpay since the most critical factor in our return is the price we pay.
April index performance
However, occasionally, we come across a great business that is trading at a very reasonable price. It is easy to identify these outliers after doing this valuation work on dozens of businesses every quarter, when the latest earnings are reported.
Believe it or not, that isn’t even where it ends. Additional considerations before we decide to hit the buy button on a business include figuring out how much of the business to buy and whether now is a good time to buy, otherwise known as position sizing and momentum.
However, given the number of words this commentary has already reached, I will save that for a later commentary, hopefully next month.
What I hope that you will glean from this commentary overall is that we aren’t just guessing. When we select a business to own in your portfolio, we do so with great care and appreciation for the job you have hired us to do. We do not take it for granted. We utilize multiple methods, layers of frameworks, we listen to company conference calls, we do our own thinking and our own analysis and all this serves to help us tune out the noise that is part and parcel of a headline-driven market like the one we are in today.
In honor of Warren Buffett (who also tuned out the noise by doing his homework) deciding to retire as the CEO of Berkshire Hathaway over the weekend, I will leave you with his parting words.
“We are operating at a fiscal deficit now that is unsustainable. Over a very long period of time – we don’t know whether that means two years or 20 years, because there’s never been a country like the United States. But, you know, if something can’t go on forever it will end, to quote the famous economist Herbert Stein. We are doing something that is unsustainable and it has the aspect to it that it becomes uncontrollable. You just give up on it. Paul Volcker kept that from happening in the United States – we came close. We’ve come close multiple times. We’ve still had very substantial inflation in the United States, but it’s never been runaway – yet. That’s not something you want to try or experiment with, because it feeds on itself. So I wouldn’t want the job of trying to correct what’s going on in the revenue and the expenditures in the United States with roughly a 7% gap when probably a 3% gap is sustainable, when the further you get away from that the uncontrollable begins. I think that it’s a job I don’t want… but it’s a job that should be done. And Congress isn’t doing it… I’m going to quit while I’m ahead.”
-Warren Buffett, May 3, 2025
Sorry, one more quick thing before I sign off… Bloomberg actually published the chart below, saying that the Buffett Indicator was flashing a buy signal because it had fallen a teeny tiny bit from its all-time high… This is just crystal clear evidence that you shouldn’t believe everything the financial media publishes…
The Buffett Indicator fell to 187.4%… within sneezing distance of the all-time high. It is still categorized as “Significantly Overvalued” by buffettindicator.net (yes, it is so widely followed that it has its own website!)
The indicator wouldn’t “flash a buy signal” until it dropped below 110%… that’s a LONG way down!
As always, we’ll just keep unemotionally playing our game and executing our time-tested process while tuning out the noise.
Until next time, I thank God for each of you, and I thank each of you for reading this commentary.
Clients, I encourage you to click here to access your personalized performance portal and see how your portfolio performed compared to the markets last month.
Shane Fleury, CFA
Chief Investment Officer
Elevate Capital Advisors
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