Billionaire Says High Beta Stocks Are The Cheapest In The Market

Longleaf Partners Funds, the suite of funds managed by billionaire Mason Hawkins‘ Southeastern Asset Management, recently released its shareholder letter for the third quarter of 2016. In it, Longleaf revealed its sterling third quarter performance, as three of its four U.S. funds greatly outdid their associated benchmarks, while all four have outdone their benchmarks by at least 8.62 percentage points over the last year.

Longleaf discussed the impact that the sustained low interest rate environment and the fear of a severe stock market pullback has had on stock pickers, opining that investors have increasingly driven up the valuations on “safe” stocks with low volatility and predictable earnings. Stocks with high dividend yields have also become sought after according to Longleaf, as investors look for any kind of yield in the face of miniscule bond yields.

Longleaf points to a couple of “safe” sectors which are now trading well above their 10-year average valuations, which are the consumer staples and utilities sectors. In the case of the former, consumer staples stocks in the S&P 500 have been pushed up to a P/E of 20-times, compared to their 10-year average of 16.8-times, while utilities stocks in the same index are now sporting a P/E of 22.2-times, 40% higher than their 10-year average.

Longleaf noted that it has few investments in these “safe” sectors, as the valuations of those stocks rarely meet the standards of the firm, with little margin of safety. Instead, the Longleaf funds are heavily invested in high beta stocks, which are being discounted in the current environment. It should be noted that Longleaf does not perceive beta as anything but volatility (which can work for or against you), rather than through the negative lens of risk of loss with which the measure is often equated.

Below, we’ll take a look at Longleaf’s comparison of several stocks and see how other funds have been trading them lately.

Through extensive research that covered the portfolios of several hundred large investors between 1999 and 2012, we determined that following the small-cap stocks that large money managers are collectively bullish on, can generate monthly returns nearly 1.0 percentage points above the market (see the details).

FedEx Corporation (NYSE:FDX) Far Cheaper Than Rival United Parcel Service, Inc. (NYSE:UPS)

Let’s start with FedEx Corporation (NYSE:FDX), which Southeastern Asset Management owned 6.37 million shares of as of June 30, making it the fund’s third-most valuable position. Despite FedEx having what Longleaf described as lower labor costs and better growth potential compared to United Parcel Service, Inc. (NYSE:UPS), it trades at just a 13.9-times forward P/E, while UPS is trading at 18-times (UPS is cheaper in terms of trailing P/E). As Longleaf points out, UPS appears to be earning a more favorable forward multiple from the market because of its more lucrative dividend yield (2.90% compared to FedEx’s 0.90%) and lower beta (0.7 to FedEx’s 1.2).

FedEx showed off some of its growth capability earlier this month when it announced a $1.5 billion investment in France, which will double its capacity at Charles de Gaulle International Airport in Paris. Longleaf believes that the market is undervaluing companies which reinvest their money in such ways, rather than paying as much of it as possible out to shareholders.

Other hedge funds tracked by Insider Monkey generally agree with Mason Hawkins and his team, as 46 of those funds were long FedEx at the end of June, while just 33 were shareholders of the much larger United Parcel Service, Inc. (NYSE:UPS). Peter Algert and Kevin Coldiron’s Algert Coldiron Investors sold out of its small FedEx position of 7,423 shares during the third quarter.

On the next page we’ll run through Longleaf’s analysis of three stocks from the utilities sector.

Southeastern Asset Management is extremely bullish on Level 3 Communications Inc. (NYSE:LVLT), as it ranked as the fund’s top stock pick at the end of June, and by a wide margin. Southeastern held 28.39 million Level 3 shares valued at $1.46 billion, while its Wynn Resorts Limited (NASDAQ:WYNN) position, its second-most valuable, was worth $1.05 billion.

Longleaf points out that Level 3 Communications Inc. (NYSE:LVLT) is another case of a stock being overlooked in comparison to rivals like AT&T Inc. (NYSE:T) and Verizon Communications Inc. (NYSE:VZ), as it does not pay out a dividend, preferring to reinvest its cash into expanding its high-margin segments, while AT&T Inc. (NYSE:T) and Verizon Communications Inc. (NYSE:VZ) both pay out dividends that yield about 5% annually. Level 3’s beta is also high at about 1.5, while AT&T and Verizon sport betas beneath 0.6.

Thus, despite Level 3 Communications Inc. (NYSE:LVLT) having expected free cash flow growth in the teens compared to AT&T and Verizon’s mid-single digit marks, it currently trades at just 8-times EBITDA, while the latter two are trading for 7-times EBITDA.

Level 3 Communications hit a 52-week high just before its second quarter financial results, but it’s shed over 17% of its value since then after missing revenue expectations with those earnings results. In mid-September, it was reported that Akamai Technologies, Inc. (NASDAQ:AKAM) was beginning to undercut Level 3 and Verizon’s CDN prices by as much as 15% as it tries to fill excess capacity in the wake of its two largest customers turning to in-house CDN solutions.

In terms of the smart money tracked by Insider Monkey, 55 hedge funds owned shares of AT&T Inc. (NYSE:T) at the end of June, while 52 were long Verizon, down from 61 a quarter earlier. Those hedge funds owned less than 1.5% of each company’s shares. In contrast, 48 hedge funds owned over 17% of Level 3’s shares.

Disclosure: None