The Margin Of Safety Quarterly Fall 2016
Third Quarter 2016 Key Takeaways
- Despite numerous uncertainties, including a U.S. presidential campaign that continues to unfold, the S&P 500 rose by nearly 4% in the third quarter
- European stocks outperformed the S&P 500 after the Brexit low. They still trail U.S. stocks for the year (both in dollar hedged and unhedged currency terms)
- Emerging-market stocks finished the quarter up 17% YTD, building upon their sharp rebound and outperformance versus other markets that began in late January
- Yields on U.S. 10-year Treasury bonds rose to as high as 1.75% during the quarter on worries over central bank policies, but the Federal Reserve’s decision not to raise interest rates in September soothed the markets
Third Quarter 2016 Investment Commentary
The S&P 500 Index rose by nearly 4% during a quarter that witnessed populism gain ground in Europe, the installation of a new government in the United Kingdom after the Brexit vote, an unsuccessful coup attempt in Turkey, and a U.S. presidential campaign that continues to unfold as the most unconventional in recent memory. Stock market volatility remained at extremely low levels through July and August but has picked up since then, which provides buying opportunities for our disciplined managers.
Yields on U.S. 10-year Treasury bonds ended the quarter at 1.56%, up from 1.44% as of July 1, as investors braced for an interest rate hike by the Federal Reserve that didn’t come (bond prices fall as rates rise). However, those looking only at starting and ending levels would have missed the big mid-September move. Yields briefly backed up to 1.75% on worries over central bank policies. The Fed’s decision not to raise interest rates in September soothed markets. But a December rise is potentially still on the table.
Core US bonds gained just 0.4% for the quarter, smaller US stocks gained 4-9% depending on the index, Europe and developed international stocks gained 5-6%, emerging market stocks were up 8% (17% for the year), our emerging market bond manager was up about 3% (about 17% for the year) and our alternatives manager was up about 3% as well.
Rising rates pose a significant risk to core bond returns, which is one of the justifications behind our tactical positions in flexible fixed income funds and floating rate loans (for our more conservative portfolios). Our portfolios benefited last quarter from both positions, as they contributed strong absolute and relative performance compared to core bonds.
In this quarter’s investment commentary, we briefly review portfolio performance and recap our current asset class views, before discussing the importance of actual versus perceived diversification and why we choose not to run with the herd, especially during times of elevated market risk. In our view, making investment decisions based on short term market forecasts (guesses) is a losing game. We have no confidence that this approach can be executed successfully over time.
River Capital Advisors (“RCA”) was started in 1998 and in the subsequent two decades, we have been through various market cycles, including the S&P run during the later part of the 1990’s that ended with the “tech wreck” in 2000, the 2007-2009 housing and financial crisis that preceded the global financial crisis, to name a few. We believe in value investing – that the intrinsic value of a security is based on the cash flows generated (whereas the stock price at any given time may not) and over our almost two decades, value investing has been in and out of favor. We have written in past newsletters that value investing (at least until this year) has had an unusual run of underperforming growth investing. However, history has shown that over the long term, value clearly outperforms growth.
Low interest rates today have impacted market valuations a number of ways: 1) investors stretching for yield have bid up prices of higher dividend paying stocks; 2) investors have flocked to stocks with lower price volatility, more predictable earning stocks that appear “bond like” and 3) looking at the rear view mirror, investors have added to securities (stocks, ETFs, etc.) that performed well during the global/Europe debt crisis of 2009-2011, thinking history will repeat.
Below are our thoughts on current asset class values and why we have positioned client portfolios the way we have.
U.S. Stocks: The S&P 500’s gain occurred in the context of a market that saw sharp intraday drops followed by swift reversals, as well as strong rotation into and out of sectors perceived to be “safe,” such as utilities, telecoms, and consumer staples. Financials remained pressured by low interest rates, a challenging regulatory environment, and poor investor sentiment—negative headlines surrounding Deutsche Bank and Wells Fargo have not helped. We continue to view U.S. stocks as overvalued and unattractive relative to the risks over the next five years. We remain underweight.
Developed International Stocks: European stocks outperformed the S&P 500 after the Brexit low and for the third quarter. They still trail U.S. stocks for the year (both in dollar hedged and unhedged currency terms). We continue to believe they are cheap relative to U.S. stocks, based on normalized earnings power, and offer attractive relative returns in our base case scenario.
There are any number of known and unknown events that could result in an earnings recovery. One may be the European Central Bank’s continued efforts to keep borrowing costs down to stimulate lending and investment spending. The ECB recently started buying investment grade corporate bonds as part of its quantitative easing program. That may spur investment and lead to better economic growth. Or, it may spur financial engineering, with companies using the proceeds from issuing debt to buy back stock and boost earnings per share. Either outcome would bode well for future profits and stock prices.
Brexit, along with the rise of many rightwing political parties, may serve as a wakeup call that authorities need to generate better growth in the economic bloc soon. As a result, they may become more open to loosening the fiscal purse strings to assist the ECB’s reflation efforts.
The exact timing is highly uncertain. It’s possible nothing much happens with fiscal stimulus until major elections are completed over the next year, meaning the ECB continues to do what it can and Europe muddles along. Our analysis assumes normalization will take place in roughly five years.
Emerging Market Stocks: Returns have been particularly striking, building upon their sharp rebound and outperformance that began in late January. They are now up 17% for the year (versus almost 8% for the S&P 500) and up 32% from their January low (versus 17% for the S&P 500). Returns have been driven primarily by expanding P/E multiples rather than a strong upturn in earnings growth, which is not (yet) apparent in the market level data we follow. However, we don’t have a strong view about a near term earnings rebound. The political and economic risks, including the very rapid growth of debt in China in particular, are well known. These risks carry meaningful weight in our analysis and overall assessment of emerging market stocks, which has tempered our enthusiasm. We are using a low cost, well diversified, value oriented fund manager for our emerging market allocation, which has returned 20% year to date.
Flexible Fixed Income Funds: Our portfolios also benefited from our flexible fixed income managers, which had good returns compared to core bonds. Our “defensive” manager earned just .75% for the quarter and our “offensive” manager returned over 4.50% for the quarter while the core bond index was basically flat (up 0.4%). Our offensive manager was up around 9% year to date, meaningfully ahead of the 7.7% return of the S&P 500.
Our non-core bond holdings do have more risk than core bonds in certain macroeconomic scenarios. However, we believe the added credit risk is more than offset by our meaningful underweight to U.S. stocks (in our balanced portfolios where we hold fixed income). From a longer-term return perspective, these positions should meaningfully outperform core bonds in either a flat or rising rate environment.
Floating Rate Loan Fund: Our tactical allocation to floating rate bonds, which we own in place of core bonds for our most conservative portfolios, was additive to performance in the third quarter, generating gains of roughly 2.6%. The year to date return is over 6%. We believe floating rate bonds continue to offer attractive mid to upper single digit return potential across a range of scenarios, while also providing a valuable inflation hedge.
Emerging Market Debt Fund: Our emerging market debt fund had similarly striking returns to our emerging market stock fund. For the year to date period it is up over 17%, while still having a 30 day yield of 5.24% as of September 30th. We continue to believe that this asset class is attractive from this point forward, as it is still cheap relative to other bond markets. The rise in price has taken some of the easy money off the table though.
Liquid Alternative Strategies: Our alternative strategies position, which uses a strong group of well regarded individual managers, generated solid positive returns in the third quarter, and outperformed core bonds by a wide margin. The position returned 3% for the quarter, which rivaled the S&P 500 (up 3.8%) with much less risk. Our goal with alternatives is to earn returns in excess of bonds but with much less risk than stocks, as well as to provide portfolio diversification. Our thesis for the position remains intact.
We are pleased many of our tactical positions and active managers added value in the third quarter, but reiterate our exposure is based on our longer-term time horizon and assessment of their potential returns and risks. This is particularly true for emerging markets, European stocks, and other higher risk/higher volatility positions. Over the shorter term, we never know precisely when we will get paid for our investments. But we are confident that over a full market cycle we will be compensated for the risks in owning them. Therefore, we need to remain patient and disciplined to ride out any shorter term volatility or negative performance in the interim.
Perception Versus Reality: Managing Risk
While we spend time analyzing each of our individual positions and holdings, in portfolio management the whole is much more than simply the sum of its parts. By definition, a well diversified portfolio (i.e., one with investments that do not all move together in the same direction) will contain some laggards during any given measurement period, particularly over shorter term periods. But it’s at least as important to focus on the overall portfolio, how the pieces fit together and perform relative to each other, and whether that performance is consistent with the original rationale for owning them.
Successfully managing portfolios also requires the discipline to resist trading based on emotion, rather than on long term return drivers such as valuations, yield, and earnings growth. Even in an advanced economy such as the United States, the stock market has fallen by at least 10% every 16 months on average since 1950. Bear markets (20% or greater declines) in the United States have happened about every seven years on average. In most cases you can’t predict what the exact cause of the volatility will be or exactly when it will hit. Even if you could successfully call it, you’d need to also successfully time your re-entry so as not to miss out on the subsequent gains—and do so consistently and repeatedly over an investment lifetime. That is not realistic, which is why our tactical investment approach is based on a range of potential outcomes and a longer term time frame.
To take just one example of why making investment decisions based on short term market forecasts (guesses) is a losing game, we turn to the U.S. presidential election. We are being asked about the election even more than usual this year. While the specific circumstances of any given election are always unique, our approach remains the same. To the extent a particular result is widely expected, current asset prices will reflect the market consensus. There is too much uncertainty and too many variables that impact investment outcomes for us to likely see any value in positioning our portfolio for a particular result. Instead, we stick to our longer term analytical framework and assess the potential risks and returns for investments we have or are thinking about buying.
Along with the U.S. presidential election, central banks’ policies, particularly the Fed’s, remain a key near term wildcard for financial markets. At its September 21 meeting, the Fed remained on hold but signaled it is on course to raise rates later this year, likely in December. It also lowered its longer term forecast of rate hikes yet again. It now forecasts just two in 2017, down from the three forecasted at the June meeting and the four forecasted at the March meeting. Financial markets responded positively.
Investors are effectively being forced out of low risk, extremely low yielding, core bonds into riskier assets that offer higher current yields (still quite low compared to historical levels). Many investors appear to be “reaching for yield” for some time now, as well as perceived safety in traditionally “defensive” yield oriented sectors of the stock market, such as utilities, telecoms, consumer staples, and REITs. Valuations have soared (see charts). But these trades can unwind quickly and momentum can work in reverse. It certainly seems “defensive” plays are vulnerable to any hint of interest rate increases and are potentially higher risk right now than the broad stock market, not to mention bonds.
To the extent the “buy ‘bond-like’ and dividend yield stocks” theme remains in play, it will likely be a headwind for our actively managed U.S. stock funds overall. When that trend reverses, our managers and portfolios should benefit. We saw that happen in the third quarter, as the yield on the 10-year Treasury bottomed at 1.37% on July 5 and closed at 1.56%.
While ultralow interest rates are supportive of financial asset prices, we continue to view them as unsustainable and inconsistent with longer-term economic growth. Trying to anticipate the markets’ reaction to each Fed governor utterance or Fed policy statement is a short term guessing game that we simply won’t play with our investment portfolios.
Putting It All Together
Our decision making is anchored in our long term fundamental and valuation driven approach. We and our clients need to be psychologically and financially prepared for periods of market stress and able to ride them out on the path to achieving long term investment and financial goals. This is why, for each client, we tailor their investment plan to their specific financial goals, time horizon and work with our clients to make sure they have sufficient cash reserves to avoid selling assets when prices are low. Investors who can’t stomach a given level of volatility or downside risk should reallocate into a portfolio with a lower targeted risk level. The time to do so is before a period of volatility, not during or right after it when they would be selling their riskier assets at lower prices and buying more defensive assets at higher prices.
We structure our balanced portfolios across a well diversified mix of investments, each with a distinct role. We also look at the downside potential for a given portfolio and spend time with our clients in making sure they are comfortable with the downside. Their financial plan can only be successful if they stay with the investment plan, which means the ability to go through periods of market volatility to capture the upside. We expect our portfolio’s to be resilient and to perform at least reasonably well across a wide range of outcomes, balancing our objective of long term compounding above inflation with shorter term downside risk management appropriate for each client’s risk tolerance.
While July and August were unusually calm months for the markets, volatility picked up in early September. We’re prepared for more of it heading into (and potentially coming out of) the November election, as well as on the increased likelihood of a Fed rate hike in December.
River Capital Advisors News
Tax filing season for 2015 has ended and at least for 2016, we do not have any major income tax law changes. This allows for some better tax planning. The big IRS proposed rule change (not yet law) is the valuation changes (Section 2704) for closely held businesses. In short, the IRS wants to do away with lack of control, lack of marketability discounts. Commentary that we have seen from appraisal firms is that even under the proposed changes, discounts would still apply but there is a question of the magnitude. In addition, attorneys and CPAs, along with appraisers, will be providing the IRS with feedback on their proposed regulations. We are monitoring the final outcome of this.
We talk regularly with clients who are not yet retired to save as much as they can, for as long as they can. We recommend when possible to max out company retirement plans and if more can be saved, contribute to an IRA (even if nondeductible) or a ROTH (if you meet the eligibility rules). We are recommending that clients take advantage of Health Savings Accounts (HSA), contributing the maximum possible and when possible, paying for medical costs incurred during the working years from non HSA funds. This allows the account to grow and compound, providing a potential source of funds for health care during retirement. HSA’s provide a triple tax benefit – tax deduction for contributions, tax deferred compounding and if used for qualified medical costs, no income incurred at all.
Lastly, we have upgraded our financial planning software and client feedback has been very positive. The software is web based, allows us to model scenarios and immediately show the impact on the financial plan of a particular planning strategy, real time account values, the ability to track and categorize spending and a client vault for important documents. We can incorporate an estate plan as well, showing how any financial decision impacts the family finances, income and estate taxes.
We thank you for your confidence in us and for the referrals we are receiving. This means a lot to us and we will continue to work hard on our clients behalf.
Our thoughts and prayers go out to those who were impacted by Hurricane Matthew. We have not seen a storm like this in a number of years, while many people were not seriously impacted, many others were. Make sure and count your blessings each and every day.