2014 marked the completion of my second decade as a stock portfolio manager. I embarked on this journey with capital markets in January of 1995. We were coming out of a challenging 1994, scarred from the severe sell-off in the bond market. The market rocketed higher in 1995 after recognizing that higher interest rates would slow the economy, but not cause earnings to fall. At the end of 1995, the earnings yield of the S&P 500 was 6.7%. The average corporate bond yield was 7.5%. The Dow was around 4,000.
Since that time, the market has experienced a range of valuations. During the euphoric late nineties, stocks were valued about 80% higher than in 1995. During the despair of 2009, stocks were valued 35% lower than 1995. As we head into 2015, stocks are trading at very similar valuations to 1995. The earnings yield on the S&P 500 is about 6.5%.
Bonds, however, are trading at far higher prices than in 1995. The yield on the average corporate bond only pays 4.5%. Government bonds pay near record low yields, which is another way of saying that government bonds trade for near record high prices. Bonds are almost 70% more expensive relative to 1995.
Strategy for Safe Money
Inflation is the process by which a dollar buys less in the future than it does today. Someone who stashes all of their savings in the mattress will have the same number of dollars ten years from now, but if inflation is 2% a year, today’s dollars will only be worth $.78 in 2025.
Historically, savings accounts and CDs paid more in interest than the rate of inflation. Today, with interest rates so low, savings accounts and money markets are paying less than the rate of inflation. The banks are charging you rent when you lend them your money.
If your objective is growing your savings as fast as today’s rate of inflation, you could lend the money to the government by buying Treasury bonds. Unfortunately, you’d have to lend the money for ten years to get an interest rate that exceeds inflation. If you don’t want to wait ten years to get your money back, you could buy corporate bonds and lend to GE or Chevron for five years and make about 2% a year.
For people who don’t need a lot of growth to ensure their retirement security, lending to investment grade corporations is probably the investment strategy with the most predictable outcome. GE and Chevron will still be operating many years from now. The risk of default for high quality companies is lower than it is for many governments. This low risk approach would produce results similar to what an annuity would generate – a very low return with a high degree of certainty.
One drawback to an annuity purchase is that it locks up your assets for an extended period. The benefit to our clients of owning bonds directly rather than through an annuity is that you have the option to adjust your strategy at any time, or cash out at any time.
The Rewards of Risk
Very few investors can afford to settle for 2% long-term returns without putting their retirement security at risk. Most of our clients are looking for a higher return in order to accumulate enough wealth to ensure their long-term security. There is no such thing as a free lunch. In economics, unpredictability is the price we pay for achieving a higher return.
In modern times, the corporation has been the best vehicle to grow your wealth. This has never been more true than today. Profit margins for publicly traded companies are at all-time highs. The benefits of economic growth are accruing more to the owners of companies than to the employees.
Most people lack the resources to buy their own company, and even if they did, investing your entire nest egg in one private enterprise is a very high risk strategy. The Romans discovered the idea of selling shares of a corporation to multiple owners when they recognized the need to spread the risk of a commercial enterprise throughout society. In modern times, European trading companies issued shares to finance exploration and colonization. Owning shares in different ventures allowed investors the benefit of high returns, while decreasing their risk of a total loss.
Historically, stocks have returned about 7% more than inflation. This means that if you have $100,000 in today’s dollars, you can protect that purchasing power by investing in high quality bonds for the next 30 years. If stocks match their relative performance over the last 100 years, you’ll continue to return 7% more than inflation. Today’s $100,000 will be worth approximately $760,000 in 30 years.
Don’t Put All Your Eggs in One Basket
Diversification is the key to risk management. Not only can we diversify through different companies, we also diversify through different industries and sectors in the global economy. Different industries operate on independent cycles. Owning a variety of industries hedges the uncertainty in our portfolio, creating a more consistent pattern of returns than if we concentrated the portfolio in fewer industries. We also diversify the portfolio by balancing sectors that are sensitive to the economy, like energy and industrials, against sectors like health care and electric utilities that are less sensitive to the overall economy.
Much of the time, stock prices seem to move in unison. In moments of peak uncertainty, investors tend to reduce their risk and sell stocks regardless of the industry or country in which they operate. But, eventually, stock prices reflect the intrinsic value of the company, which reflects the performance of the company.
The big surprise over the last few months is how quickly the price of oil has fallen. From a high of $145 a barrel, oil is now trading for less than $50 a barrel. This is catastrophic for highly leveraged exploration and production companies. The value of many of these companies has fallen by 80-90%. The entire energy sector sold-off when oil prices collapsed, and our portfolios’ companies were not immune.
We also own companies like United Airlines whose fortunes improved dramatically with lower fuel prices. Perhaps you’ve noticed that airline tickets are just as expensive as they were three months ago. The airline industry is not very competitive. Rather than pass through savings onto their customers, they are keeping prices high as an industry in order to boost profitability. The savings are effectively being passed through to shareholders instead of customers.
The Dangers of Following the Herd
In stocks and perhaps finance in general, the riskiest strategies follow the crowd. At the beginning of 2014, 65 out of 65 economists polled expected interest rates to move sharply higher. They moved sharply lower. In 2009, I could only convince a few clients that the valuations of stocks presented a once in a generation opportunity. In 2000, very few recognized the distortion of the tech stock boom until it went bust.
During the late nineties, investors were obsessed with technology stocks. Tech and internet companies were thought to be the architects of the future, while the old economy companies in industrial manufacturing, basic materials, and energy were considered obsolete. During the dotcom boom, the S&P 500 peaked at thirty times average earnings. The median valuation was only 15 times earnings.
In the late nineties, much of the market’s overvaluation resulted from only a few very large companies. Companies such as Amazon, Ebay, Yahoo, Qualcomm, and Priceline traded at hugely inflated prices relative to their net worth. These overvalued stocks obscured a huge number of undervalued companies. Over the next ten years, all you had to do to trump the performance of the S&P 500 was to avoid the overpriced tech stocks and invest in boring, undervalued, profitable businesses. Fifteen years later, investors who bought the NASDAQ in early 2000 are still down on their investment.
Today, U.S. Companies Are the Most Popular Investments
The U.S. economy has led the global recovery for the last three years. Today, the median U.S. stock trades at the highest valuation since World War II. Unlike the nineties, the appreciation has occurred in most every segment of the U.S. market. In the U.S. today there are very few companies that are substantially undervalued. It seems probable that U.S. stocks will lag the performance of stocks outside the U.S. as the rest of the world has more room to recover from the downturn of 2008-9.
Today, the overwhelming consensus is that the U.S. economy has “decoupled” from the rest of the world. Investors have priced U.S. companies historically high relative to companies outside of the U.S. The performance of the most widely followed benchmark for international stocks (EAFE which stands for Europe, Australasia and Far East) is now at its worst level in its 45 year history against the S&P 500. Over the last thirty years, the S&P 500 and EAFE have each won the year 15 times, but the S&P 500 has won four out of the last five, outperforming by a total of 66% over the last five years.
International versus domestic performance tends to run in cycles. The average period of EAFE underperformance lasts an average of five years, during which EAFE lags the S&P 500 by 67% on average. It has then made up for this underperformance by beating the S&P 500 by an average of 78% over the next four years.
As oil investors are experiencing today, when the consensus is surprised and reverses direction, the sell-off in the most popular strategies can be very significant. We have to be careful that our portfolio is not concentrated in the comfortable consensus of conventional wisdom. The most effective way to do this is to diversify the portfolio into contrarian possibilities.
Last year, the contrarian bet was that interest rates would decline. Today, contrarian investment possibilities include the following: U.S. underperformance, a European recovery, underperformance of passive versus active managers, and higher than expected inflation. The market does not yet anticipate these developments. Markets move when reality unfolds differently than what the consensus expects. Reality being what it is, all we can say with confidence is that 2015 will present its share of surprises.
Looking forward to a great year,
Eric Barden, CFA
Near-Term Strategy
Europe: Focus on European based companies that sell to the rest of the world. Though the European economy is weak, the falling value of the Euro will boost the competitiveness of European multinational exporters. The valuation disparity between high quality U.S. companies versus high quality European based multinationals greatly increases the likelihood that European companies will outperform U.S. companies over the next five years.
U.S: Valuations have recovered to their historic levels. We’re becoming increasingly selective in the U.S. as the margin of safety is more limited in the U.S. than anywhere else in the world.
Japan: Rapid drops in the price of oil and the relative value of the Yen is very beneficial to Japanese manufacturers. We anticipate increasing our allocation to Japanese exporters.
China: China is proceeding through a monumental restructuring that will diversify its economy away from export led growth towards consumer led growth. The commodity boom is over. Over the next twenty years, China’s middle class will grow. We are focused on owning companies that focus on serving the emerging Chinese middle class.
Emerging Markets: We’re being very selective here. Individual companies and countries will follow their own path. Brazil and Russia face major challenges. But other countries in Latin America and Asia present unique opportunities.
Bonds: U.S. government bonds still seem overvalued. We’ve increased our allocation to mortgage backed securities which are less vulnerable to rising interest rates. Default rates are low. As long as we avoid energy companies, high yield bonds appear very attractive.
Return Outlook: A long term return of 8-9% allows you to double the size of your portfolio every 8-9 years. That’s the number I’m looking for. If we achieve that, your portfolio will be five times its present size in five years. We are much more concerned about the long term return than how we track against a benchmark in the short term.
