Scott Black says market is '10 to 15% overvalued,' reveals where to find opportunities

Published Thu, Oct 27 20161:36 PM EDT

Value investor Scott Black, the founder of Delphi Management, a money management firm he started in 1980, says extended valuations could keep the market at bay. "Even if you've factored in a 10 percent increase [in earnings] next year to $120 or $121, you're still looking at the high 17s on a multiple basis ... the historical norm is about a 16 P/E, which says that the market is maybe 10 to 15 percent overvalued," Black told CNBC's Mike Santoli during this exclusive interview. "Now, let's look at the homogeneous classes of small and mid cap. The Russell 2000 right now is 27 times earnings, and the Russell 2500 is 25 times earnings. I mean, these are nosebleed territories. So, again, you have to rely on individual stock selection," the money manager said. In this wide-ranging conversation, Black, who has over 40 years of financial and investing experience, reveals his top investment ideas, and discusses: Why his formula for picking stocks hasn't changed. Areas of the market that remain attractive. Three of his favorite value picks. Investment lessons from his multi-decade career. PRO subscribers can also read the entire transcript of the exclusive interview below. (Editor's note: The content below is from a third-party service and there may be some minor transcription errors. Watch the video for the exact quotes.) MIKE SANTOLI: Scott Black is the founder of Delphi Management, a value investing firm that he started in 1980. He has over 40 years of financial and general management experience, beginning with corporate finance and international treasury positions at Xerox and Joseph E. Seagram. He's also held prominent roles at Merrill Lynch, where he was responsible for the company's diversification activities. His first entrepreneurial venture, restructuring the William O'Neil Company in 1978, was followed in 1979, with managing equities for Sunkist Growers, Delphi Management's original account. He's been featured in Fortune Magazine, Business Week, Forbes, The Institutional Investor, among other publications, and has participated annually in the Behrens Round Table since 1998, where Scott and I first met several years ago. And Scott, thanks for being here. SCOTT BLACK: Well, thank you for inviting me Michael. MIKE SANTOLI: Appreciate. So talk about the plight of a value investor in today's market right now. SCOTT BLACK: Well, we stick to the same strategy we've always had of finding companies with high return on equity, strong balance sheets, generate cash, and sell at low multiples, either the price of the break-up value or PE ratio. The formula hasn't changed, but the dynamics of the market have changed markedly over the last, maybe, five-ten years. And if you look, firstly, large cap growth has outperformed large cap value for one, three, and five, ten years. And what's interesting, as well, because I went back and studied for you, over the last three, five, and ten years, small and mid-cap stocks have significantly led large cap as well. So the old premium for owning small cap stocks, which is in the former French model seems to have been dissipated. I think you can attribute a lot of that to indexing ETF's both industry wide and index wise because they buy bad stocks, but buy good stocks and they push them up homogeneously. But we believe that ultimately value will out as Ben Graham used to say. MIKE SANTOLI: So in other words, you don't feel there's a need to adjust your methodology. Eventually these things kind of tend to be cyclical, and you should be rewarded for it? SCOTT BLACK: Ultimately, look, if you go back to January first of 2000 through September of this year, and I went and did the calculation, the S & P 500 with dividends reinvested did only 4.4%. Delphi, with Gibbs accounting, we did 9.4% compounded. That's five percent compounded over 16 years. That's a huge difference. But we've been unpopular over the last few years. And it's interesting. French or former French came out with a study recently and pointed out, "This has been the worst period over the last seven or eight years for value since the 1920s." MIKE SANTOLI: It's interesting because among the other developments in the industry has been people trying to package up different strategies or different characteristics of the market into a fund, into an ETF. So you would think all these demonstrated factors that outperformed like value or like small California, they package them into an ETF, and yet still the market is still not really responding to that? SCOTT BLACK: Well, that's true. And you have to remember, you know, a year ago was Fang driven by four large market caps, and there have been, you know, aberrations. And then, these types of things like tilts, equal weighted, or smart bait, or I really think a dumb bait to be frank with you-- MIKE SANTOLI: Yeah. Uh-huh. As you do your basic work of looking for these types of attractive name, does it seem like a target-rich environment out there? Are there a lot of names to pick from? Are there parts of the market that seem pretty much neglected that you can actually shop in? SCOTT BLACK: Well, we don't own any energy stocks. And maybe it's time to start looking at some natural garden companies again, but we've been out of energy for over two years which saved our clients quite a bit of money. We don't buy utilities because the returns on total capital are so low. We look for a 15% return on equity, and most of them are on 15. But if they were leveraged even one to one, that's a seven and a half percent return on capital, means they're destroying capital year in-year out. They've been popular because people have significantly gone after dividend in terms of yield. But those aren't the types of businesses. Really, we're still doing bottom-up item selection. Interestingly enough, the large cap sector is pretty much fully-priced, you know. If you look at the S & P 500 based on yesterday's close, there's 2141. The estimates now are about 10997, and if you remember correctly in January, the bottom-up estimates were $126. I was in Behrens at 114. I was pressing it, but I wasn't smart enough. That puts you at a 19 plus multiple on this year's earnings. We've had six down quarters in a row in earnings per share. And even if you strip out energy from that sector, the earnings are still down 2.6% on an operating basis year over year. We're finding better values in smaller and mid cap names at this point. MIKE SANTOLI: Uh-huh. And just in terms of the overall market as it looks from here out, I guess the buller's case would be absolutely right, earnings have come down significantly from what people thought they'd, but the stock market, the S & P, is trading at the same level it was at in May of 2015 approximately. And at that point, we were embarking on five or six quarters of declining revenues. Maybe now, we have a rebound in earnings, or do you think that's too optimistic-- SCOTT BLACK: Well, the S & P estimates are close to $130, which would augur for a 20% increase. Now, you do the math. If real GDP grows somewhere at two percent, and inflation's one and a half to two, you got nominal GDP at three and a half to four. Unless my math is incorrect, I don't see how you get 20% growth and earnings on a three and a half to four percent GDP nominal numbers-- MIKE SANTOLI: Sure. SCOTT BLACK: It's just not there. And every year, at the beginning of the year, people really much too ebullient, and the numbers come down as the year progresses. So even if you've factored in a ten percent increase next year to 120 or 121, you're still looking at the high 17s on a multiple basis, and as you know, because you've been in this industry for a long time, the historical norm is about a 16 PE. MIKE SANTOLI: Yeah. SCOTT BLACK: Which says that the market is maybe ten-15% overvalued. Now, let's look at the homogeneous classes of small and mid-cap. The Russell 2000 right now is 27 times earnings, and the Russell 2500 is 25 times earnings. I mean, these are nosebleed territories. So, again, you have to rely on individual stock selection. MIKE SANTOLI: Do you attribute the full or maybe overvaluation of some sectors to just this environment that we're in? I mean, obviously, everyone's pointing the finger at the Fed and saying, "You know, corporate bond yields are three percent or something for an investment grade." So why wouldn't multiples be up where they are? SCOTT BLACK: No, you're right. It's a liquidity push. There's no question about it, you know. If you got the long bond at one six and one seven, it doesn't offer you much, and the dividend yield on the S & P's about two percent, and you're hard pressed to find good companies that are yielding three or four percent. And then, the other issue we talked about, the ETF's. The money flows into the Russell 2000 or the Russell 2500. You can buy ETF's from index funds on that, so they push up the valuations. MIKE SANTOLI: Yeah. As you look at names, before we get to some specific ideas that you have, have they typically just had one disappointing quarter? Why did they get cheap, for the most part, the companies that you end up owning? SCOTT BLACK: Well, I think there's several factors. I have a small one that we'll get to. Celestica, it's about 1.5 billion market cap. It's not a household name. It's been overlooked. A company like Foot Locker, they threw the baby out with the bathwater. They've had five years, no breaks in earnings, year in and year out. They do over 20% on book, 20% on total capital. When Nike did poorly, the stock went down because 70% of their revenue happens to be Nike and retailing and box-type stores are out of favor right now. And the other one is Carnival Cruise Line, which is selling at the much lower P than it has historically. It's still within two points of its low here. What's pushing it is that energy prices have come down. It's really they're a very efficient producer to begin with. They have over 30% margins, but it's been out of favor because of the fact, you know, people say, "Maybe it's a non-recurrer. If the oil prices go back up, it's going to punish their earnings." MIKE SANTOLI: Okay, so we can go into some more detail there. We'll go in reverse order. So Carnival, as you mentioned, people maybe think it's a little too leveraged to energy prices, but what else is going on in the business in terms of the bull case-- SCOTT BLACK: Okay. All right, firstly, they represent 47% worldwide share of all passengers that take cruises. I mean, they're dominant. The other thing is they've segmented the market. The mainstream for the average American is fine, which is Carnival, which Ted Aaronson founded. It was brilliant. He created a strategy to make it available to the masses. Then, you move up to what they call the luxury, and that's Holland America, P and O, Peninsula and Oriental, Princess, and then, at the high end is Seaborne. And they really do a lot of demographic studies. They do focus groups. They have databases on their repeat customers, and it's formulaic to some degree. Roughly, 75-76% of the revenue comes right from ticket sales. The other 24% comes from casino gambling, buying wine onboard, and the excursions, and they have it down very well. And if you look on a constant currency basis, if you look at the yield factor, similar to, like, occupancy in a hotel, between pricing and occupancy, they're up about three and a half percent this year, and not counting fuel, the operating expenses are only up one and a half percent. And so they've had positive operating leverage. And they should do close to 375 next year. The stocks about 45 and change. It's a 12 and a half multiple. Now, we've talked about return on capital in the past. You have to go back many years since they've earned a decent ROE. So I had a long discussion with the management about this. And they had committed that by 2018, two years out that their return on total capital will exceed ten percent, and they're on path to do that. At ten percent, you're no longer destroying capital. So we think, you know, it's legitimate. The revenue growth's about four or five percent on the top line. As I said, they have marginal improvement, and they are getting a nice benefit obviously from energy prices. MIKE SANTOLI: Sure. You know, you bring up something that's actually interesting to drill into. You said you talked to management. Obviously, a lot of these sort of quantitative approaches, they just look at the numbers and to the historical fundamentals, and say that's going to be in my portfolio. What's the value you get from actually speaking to the managers? SCOTT BLACK: Okay, 100% of the cases since 1980, we either talk or visit with the management. What do we get out of it? The most important criteria qualitatively after we run the numbers, "Does the management have integrity?" We're not talking about Enron. Do they steal? But do they willingly tell you what's wrong with the company, where they've made mistakes? And you look people in the eye and say, you know, "Where did you falter?" And then, we ask them if they really have a sense of strategy. Can they articulate it? After I went to business school, there was a fellow named Phil Cottler (PH) at Northwest, and he talked about SWAT. Strength, Weaknesses, Opportunities, and Threats. And we really go down the whole gamut of all those four aspects with the management, eyeball to eyeball. Where are you competitively strong? Where are you weak? If it's a high tech company, and we own them, like Lamb Research, you have to ask them. Is there some new technology out there on the horizon that could totally obsolesce what you do? I mean, a good case in point, a company that we sold a couple of years ago, it's lower today than when we sold it is Oracle. Yeah, they're going talk about that, you know, six percent of their company is growing at a 40% plus on the cloud, but software as a service isn't as good as selling the full suite at Oracle. And obviously, you know, the licenses are down 15%. So you have to see if they are a major tectonic shifts in business. In that case, you know, it's hurting a company like Oracle for example. MIKE SANTOLI: So for an individual investor out there who may want to consider trying to pick stocks on his or her own, you know, speaking directly to management is not an option in most cases. Does that put them at a big disadvantage? Are there ways around it? Are there general principles that you would say, "Hey, as an investor, here's what you want to do," whether it be disciplined about, you know, the value you pay or anything like that? SCOTT BLACK: Well, value, ipso facto, has worked since 1946 even though it's out of favor. But you really have to look behind the numbers. One of the other things we've had since day one in 1980 is conservative accounting principles. What you see isn't always what you get. I'll give you an example. I recommended US Bank Corp at the beginning of the year at Behrens. They're reserved 2.4 to one on the reserve to non-performing assets. Many of the banks out there, if you really looked at them, they're under-reserved against non-performing assets and other real estate owned. So if they come in, and they say, "Look, we earned 50 against 42," maybe they really didn't because they're overstating their equity and, you know, understating what the reality is there. So you have to be really careful-- MIKE SANTOLI: Yeah, so look behind the headline numbers. SCOTT BLACK: And that's difficult for the average investor. I mean, insurance accounting is very difficult with things like policy acquisition costs which is a fancy name for capitalizing the salesman's commissions on the left side of the balance sheet. You look at many insurance companies, especially life and annuity, and over 50% of the book is wiped out. So you have to be very careful. And that's the reason, to a large extent, you know, maybe ETFs, especially indexes, not industry because nobody's smart enough to know which industries are going to take off at a given time because you're making an ex-anti bet that you're smart enough to know if the steel industry's going to take off or gold mining's going to take off. But if you buy a broad-based index the S & P 500 or the Russell 2000, at least you participate secularly with the long-term growth of America. MIKE SANTOLI: Sure. Just to circle back a little bit to Foot Locker, it's an interesting case. You mentioned that those, you know, chain retailers, traditional retailers have been somewhat out of favor. And then, of course, Nike's had its own issues in terms of orders and things like that. Obviously, you're making the bet that structurally, this is not a business that is terribly challenged or is it? SCOTT BLACK: No, they don't have much competition. In the latest quarter, they grew the comps at over four percent. Year to date, they've grown the comps at three and a half percent. They really only expand square footage by one and one and a half by adding new stores or rebuilds. But they have operating leverage on SGNA, and they buy back shares, and they talk about we're going to do ten percent growth year over year. And they've actually done that. So if you look at the stock, they have $6.02 in net cash on the balance sheet. You back that out times the five and a quarter for next year, you have an 11 plus multiple for a company that does 24% on book, 24% on total capital. It's a well-run company, you know. They're reliable. They don't have quarterly misses. They've done a very good job. As I said 70% of the business is Nike, but one of the secular shifts that's important is now 13% of their revenue is online, e-commerce. So they've adjusted where some other people like Buckle, which we sold a long time ago, which has turned out to be a disaster, they don't really have a good e-commerce business. They don't have a good handle on their customer. MIKE SANTOLI: And I guess, let's just get to Celestica, which is a name you brought up a little bit. I remember the name for a while when it was a little bit more of a high-fire maybe, but what business are they in? How does it look interesting-- SCOTT BLACK: They're electrical contract manufacturer. They compete against people like Jabil, Sanmina, Flextronics. But unlike somebody like Jabil, where 40% of its business is Apple, only two percent of this company is consumer. The bulk of the company is Telecom and what they call diversified, aerospace and defense, industrial and medical. Now, it's not a barn burner in top line growth. We really only expect maybe four or five percent top line growth. The earnings did come out yesterday, and they shot out the lights, you know. They were supposed to make 30 against 22. Taking out the detached credit, they actually did 32 against 22. But what's nice about the company is they've done what they said. They want to raise the operating margin from 3.3% to 3.45%. You say, "15 basis points isn't much." Yes, it is because in this business, when you've $6 billion in revenue, 15 basis in electrical contracting is a huge increase. So we think they can probably earn $1.30-$1.35 for December 2017. They have $1.75 in cash. But you also have to take out stock-based comp to be fair. We do. Its 14 cents a share. You add it all up. You get somewhere between 7.8 and eight times next year's earnings. Flextronics is selling at about ten-ten and a half. Same with Sanmina. We happen to own Sanmina. It's been very well. But-- I think there's a possibility you get some margin expansion, the market cap's only about a billion five, so it's not well-known. But I think there's a distinct possibility you get some expansion here because the earnings are accelerating. MIKE SANTOLI: It would seem the kinds of companies that you focus on with relatively low valuations and good businesses and maybe smaller size would often be candidates to be acquired. I mean, is that something that's just a perennial for your portfolio that they can take-- SCOTT BLACK: We do have takeovers, but we never buy on that basis. You make mistakes doing that. We buy it as an ongoing concern. If it happens to get taken out, so much the better. MIKE SANTOLI: Uh-huh. Got you. Now, you also, maybe not in the day-to-day of putting together the portfolio, but you focus a lot on politics, on what policy might mean. A lot of people now at this point I think are getting accustomed to the idea of what the polls are saying in terms of result of the presidential election. Markets may be even trying to focus on what it might mean if we had a swing in Congress to be a Democratic-controlled House and/or Senate. First off, do you think that's a likelihood, and what might it mean in terms of policy and the economy? SCOTT BLACK: Well, for the record, I've been a lifelong Democrat, but it's too bad Joe Biden isn't on the ballot this year. I've met him. He's a nice gentleman. 100% integrity which I like and he hasn't lost the common touch with ordinary people. But assuming Hillary gets elected, which I think she will, obviously, I think you'll see a boost in infrastructure spending. But a lot of the companies in that area have already had good runs. The multiples have are high. MIKE SANTOLI: And these would be, like, the companies that are very directly benefit from construction-- SCOTT BLACK: Construction, energy. But even companies like an InSteel. Most people don't know they went triple IN. They do the reinforced steel bar that goes into concrete for roadways and guardrails type of thing-- MIKE SANTOLI: Oh, the rebar. Yeah. SCOTT BLACK: The other area where you have to be cautious would be the pharmaceutical companies, obviously. I mean, Mylan, all right, they have bad public relations, but just in general, because of the days of taking prices up and getting reimbursed by Medicare and Medicaid may be over, and you may have to rescind some of the prices, they're not going to allow Gilead to charge $85,000 a year for Hep C even though it's a great drugs, Harvoni, and that cures people. So they're going to have to be very cautious. I don't think the Democrats win the House, honestly. I think they have a very good chance of winning the Senate. And you senator, who has come to visit me in Boston, Chuck Schumer, probably will be the Senate majority leader, and he's very intellectually intelligent. MIKE SANTOLI: Just when it comes to pharma, I mean, Mylan aside, a lot of people will look at that rest of the kind of specialty and generic pharmaceuticals and say that they look very cheap on the surface. I mean, is that an area that you can say, "Well, the policy risk is already there--" SCOTT BLACK: No, not really. I mean, the other big player in there is Teva, and that's a cheap multiple as well. And then, of course, you had Allergan, which unloaded its generic business, the old Watson Pharmaceutical. But the stocks have been hit hard. It's a very well-run company. Don't get me wrong. These are terrific companies. I mean, one we bought here on a dip, the stock got hit hard, was Shia PLC. It's selling at roughly 12 times earnings. It's got legitimate growth. The franchise they brought from back salt that has growth eight percent in real terms and their own Shia business is growing at about a 15-16% clip. They have some new drugs. They have one for angioedema. They have another one called Xidra that came out. It's a competitor for Restasis. There's a billion dollar potential, and it's only a 12 and a half multiple. But the reason it's a 12 and a half multiple is because people are fearful what's going to happen in the health care sector. MIKE SANTOLI: One thing we always like to ask if over your years of investing, what are some of the main lessons or the main principles or the things that you feel like you have to go back to or remind other people of that are common pitfalls that the average investor makes, let's say? SCOTT BLACK: Well, don't chase momentum. That's a big, big thing, you know. Let's be frank. A lot of the networks, they like excitement. MIKE SANTOLI: I don't know what you mean. SCOTT BLACK: No, you're going to cover Netflix and Amazon. But truthfully, you know, Amazon's got a great cloud business, but if you took out the stock-based comp at Amazon, they earn close to zero. And a lot of these other companies have, you know, almost infinite multiples. You see some of the genetics companies, and with the exception of a handful, like BioGen or AmGen, which earn real money, most of them. We have a building I can see from my own building called Vertex Pharmaceuticals with a little over ten billion market cap. They've yet to earn a dime in the history of the company, even though they have their own building. So I'd be careful chasing, you know, fads and fashion. It's better to buy the business, as Warren Buffet said, and not to pay up for it. Then the other thing is sometimes things don't turn out the way you expect when you buy a company. Don't get wed to the idea you're going to wait for it to come back to get even. If you make a mistake, and you're rational about it, sometimes you have to take the mistake. (SNEEZE) And I can give you a company we made a mistake on. I saw the management. I visited them here on Park Avenue. Navigator Holdings. You may know. It was an LPG tanker. Wilbur Ross controls the company. He's a shareholder. It was bought out of bankruptcy by Lehman Brothers, and the fellow who runs it, Mister Butt, is a nice gentleman. But day rates and capacity utilization went down. They were supposed to earn two dollars, and now, the estimates are, like, 80 cents, and we weren't wed to the stock. I made a mistake, you know, even though I did the homework, and stock sells below tangible book value. You have to take the error if you make one. MIKE SANTOLI: All right, don't double down on it. Thank you very much, Scott Black. I appreciate it. SCOTT BLACK: Thank you, Michael. MIKE SANTOLI: For CNBC Pro Talks, I'm Mike Santoli. Transcript by Transcript Associates, Inc.

Value investor Scott Black, the founder of Delphi Management, a money management firm he started in 1980, says extended valuations could keep the market at bay.

"Even if you've factored in a 10 percent increase [in earnings] next year to $120 or $121, you're still looking at the high 17s on a multiple basis ... the historical norm is about a 16 P/E, which says that the market is maybe 10 to 15 percent overvalued," Black told CNBC's Mike Santoli during this exclusive interview.

"Now, let's look at the homogeneous classes of small and mid cap. The Russell 2000 right now is 27 times earnings, and the Russell 2500 is 25 times earnings. I mean, these are nosebleed territories. So, again, you have to rely on individual stock selection," the money manager said.

In this wide-ranging conversation, Black, who has over 40 years of financial and investing experience, reveals his top investment ideas, and discusses:

Why his formula for picking stocks hasn't changed.
Areas of the market that remain attractive.
Three of his favorite value picks.
Investment lessons from his multi-decade career.

PRO subscribers can also read the entire transcript of the exclusive interview below.