Morning Notes — Rotation and Multiple Compression

For the past three months, we’ve argued in favor of cyclical stocks with sustainable dividend yields.  These are cyclical companies with 2019 EBITDA numbers at 4x the cost of their dividend.  You could cut the EBITDA numbers in half and still have plenty of room to pay the dividend or even increase it.  When we started, these yields were over ~4.5%.  They’re now at ~2.25% because the stock prices doubled without causing rotation out of growth stocks.  The decision to invest in cyclical stocks via high sustainable dividend yields was/is an easy one.  The 10-year Treasury yield or risk-free rate was ~0.70% (now ~0.50%), which was discounting fairly easy future cash flow estimates. With bond yields at ~0.70%, investors using a 10-year Discounted Cash Flow model don’t really care if cash flows normalize in 2020, 2021 or even 2023.  The only leap of faith is that cash flows should normalize sometime in the future.  But moving small amounts of assets earmarked for bonds with ~0.70% yields into sustainable dividend yields of ~4.5% is also an easy call.  While there’s ample cash on the sidelines to accommodate increased demand for cyclical/value stocks, you’ll probably still see healthy multiple compression in growth sectors once a more linear recovery begins due to crowded positioning.  This isn’t a call on the S&P 500 because overall equity positioning remains light.  This is a ‘heads up’ because the last rotation out of growth and into cyclical/value was more than 4 years ago and investors may have forgot what multiple compression feels like…especially in software companies with negative operating margins.  The secular adoption trends in most ‘work from anywhere’ names is lasting.  For example, if you’re now running a call center remotely, there’s absolutely no reason to return those employees to the office environment.  There are many companies where multiple compression becomes an opportunity to add to positions.  But there are far more companies within Tech to avoid at these levels.