Oct 08, 2014
Coming off a strong second quarter, stocks turned in a mixed performance for the three months ending September 30. The fundamental backdrop for stocks remained relatively stable, with interest rates drifting slightly lower and generally supportive news flow around corporate earnings, economic growth, inflation and Fed policy. While this familiar combination of factors has been hospitable for stocks, this past quarter reflected a growing unease about the prospects of further upside.
Some of this apprehension can be seen in the divergence of equity results during the quarter. Most Large-Cap indices were flat to slightly positive, with the S&P 500 ahead by 1.1%, while the Russell 2000 Small-Cap index declined 8.0% for the quarter. International stocks continued to underperform with the EAFE index falling 6.2%, and higher-yielding stocks gave back some of their earlier year gains on fears of higher interest rates. From a sector perspective, the strongest performance came from Health Care and Technology, while Energy, Utilities and Industrials all lost ground in the quarter.
Bond returns were generally flat as interest rates moved in a relatively tight range. There was little new information about Fed policy or inflationary trends. Concerns about a weakening European economy have weighed on foreign interest rates, keeping pressure on U.S. Treasury yields in spite of marginally better news on our own economic growth.
For the last several years, we have written this third quarter Investment Update in Q&A style as a way to address a few investment topics more relevant to our management beyond the more general economic commentary.
(1) A year ago you addressed a disconnect between the strong equity returns and a sub-par economic recovery. A year later, this still seems to be the case. Doesn’t this disparity have to eventually come together, one way or the other?
Common sense tells us that basic economic fundamentals have to matter in how stocks are priced. But history has shown that the relationship between economic performance and stock market performance is loose, meaning they can be in disequilibrium for longer than might seem rational. We also know stocks are often a leading indicator for the economy, but when stocks outrun the real economy like we’ve seen the past 5 ½ years, it usually leads to valuations becoming stretched.
Some valuation measures today show stocks have moved to more extreme levels while others show stocks being valued more in the upper-end of normal ranges. Valuation alone does not move markets, but rather serves as a useful measure of the potential upside or downside of an investment. We believe the current disparity we’ve seen between the growth in stocks and the economy makes stocks riskier, simply due to where we’ve come.
That doesn’t mean stocks won’t continue to move higher. There is certainly room for valuations to expand based on history, but it would raise the stakes further that economic growth will have to become meaningfully stronger. Given the existing burden of federal debt and policy issues that have hindered the natural growth of private enterprise, we are less sanguine about this divergence coming together in a positive way.
(2) How does your near-term view of the markets impact the decisions you make in managing portfolios?
Like any investment manager, we are often asked to share our current view of the marketplace. More relevant, however, is how these views actually translate to the way we manage portfolios. On balance, our current thinking about key issues like interest rates, Fed policy, and economic growth do not drive the way we spend most of our time. This is for two reasons: First, we have no real insight into these macro factors and we believe there are too many variables that are simply unknowable to get these big picture bets right with any consistency. Second, even if we did have some inside track on these variables, as discussed in the previous question, getting the economic picture right does not necessarily lead you to the right investment conclusions.
When we look at the type of decisions we make in managing portfolios, most fall into one of three general categories: (1) Investment Policy – setting strategic targets (and ranges) for allocating funds between stocks (growth) and bonds (safety) based on individualized client circumstances, (2) Portfolio Construction – risk management-based decisions dealing with how investments are allocated across different sectors, company size, geography and more specific portfolio characteristics, and (3) Security Selection – identifying the individual companies through our valuation ranking process and qualitative analysis that we choose to own in the portfolios.
A particular viewpoint about the current investment environment would have little impact on establishing a client’s longer-term asset mix targets, although it may impact the pace of getting new funds invested and positioning the equity exposure within the ranges around the longer-term targets. At the portfolio construction stage, we focus more on the bottom-up process of selecting stocks to determine our sector weights, which is different from most investment approaches that are more thematically driven.
Lastly, the security selection stage is designed to be insulated from the conventional top-down market approach by the use of our valuation ranking process. While the qualitative stage of our analysis is designed to be aware of the current environment, we believe the quality of our decisions will consistently be better the less they are exposed to the prevailing views of the day, even if they are ours.
The exception to this thought process would be if the markets were at an extreme point of valuation, either high or low. In these rare times, the odds of being able to add value from top-down thinking becomes more in our favor.
(3) If most everyone agrees that stocks are due for a pullback and likewise, that it is folly to try to time such an occurrence, what is your best advice to mitigate the risk of a correction or bear market decline?
We believe the best way to approach this is to structure a portfolio with the assumption that a correction or bear market can occur anytime. Warren Buffet once said far more money has been lost anticipating corrections than has been lost in the corrections themselves. Leaving aside the premise that these downturns can be avoided, the real risk to an investor is not the likelihood that they will lose money during downturns, but rather that they will not be able to hang in there through the downturn. The inability to do that makes losses permanent and foregoes the opportunity to recover. Hanging in there converts risk into the length of time it takes to become whole. For investors with shorter time frames to recover losses, a more conservative portfolio structure should be in place to keep potential losses in check.
Given that it’s been over two years since the last downturn of 10%, now is a good time to revisit investment guidelines to be sure the asset mix is one you can stick with. In the meantime, we will be reviewing accounts where equity exposure has expanded beyond guideline targets due to the strong equity markets.
(4) When you evaluate potential buy candidates for your respective equity strategies, do you look at the factors in your valuation process differently when stocks, in general, are more fully valued than what we’ve seen in recent years?
Our valuation ranking process is structured to be effective in all market environments. It includes multiple factors that fall into three basic categories – Valuation, Growth and Momentum. After markets have had an extended positive run, it is not unusual to see momentum-based factors showing up strongly. We know momentum, by definition, works well until it doesn’t. In this environment, we are careful to look closely at stocks that rank well to be sure the score is well supported by the valuation and growth components.
There are other factors in our process that we pay a little more attention to with markets at these levels. Strong free cash flow, real revenue growth and limited debt should give a company stronger footing when a downturn does occur.
The reality of a 5 ½ year bull market is that practically every stock we look at has already had a good run of some sort. The days of finding good cheap, undiscovered investment opportunities are few in a mature bull market like this. Our valuation process gives us the discipline to discern good opportunities relative to all opportunities, so we can build the best portfolio in any environment. The intent is not to look for stocks that won’t decline in a negative market, but rather to own companies that you have very good reason to believe are valuable and let the market cycles, with the correct asset allocation in place, take care of themselves. Sometimes easier said than done because of the extreme cycles we’ve seen in the past 15 years, but we believe this is still the best approach to building long-term wealth.