The Margin Of Safety Quarterly Spring 2017
First Quarter 2017 Key Takeaways
- Global equities greeted the new year like they ended 2016, with good returns for the quarter
- In Europe, stock gains also seemed to reflect a combination of bullish investor sentiment and positive economic data, including rising corporate earnings
- Investors took the Federal Reserve’s widely anticipated rate hike on March 15 in stride, treating it as another indicator of the U.S. economy’s return to form
- Defensive assets turned in a solid performance, with core investment grade bonds making up some ground along with Treasuries in the latter half of March after the Fed’s announcement
- It’s too soon to know what the second quarter holds in store, but we remain alert to potentially policy driven political risk in the United States
First Quarter 2017 Investment Commentary
Global equities greeted 2017 like they ended 2016, with good returns for the quarter. Emerging market stocks led the way with a double-digit return, followed closely by developed international and U.S. stocks (Vanguard FTSE Emerging Markets ETF up 11.2%, Vanguard FTSE Developed International ETF up 8%, and Vanguard 500 Index up 6%). Our portfolios benefited from their overweight to emerging market stocks (and bonds), as emerging market equities outpaced U.S. stocks by over five percentage points for the quarter. Upward revisions to corporate earnings forecasts, GDP growth that far outstrips that of developed economies, and valuations that are still cheap compared with developed market stocks all helped drive the strong gains. The rise of European stocks of over 8% in dollar terms, seemed to reflect a combination of bullish investor sentiment and positive economic data, including rising corporate earnings.
Investors took the Federal Reserve’s widely anticipated 0.25% increase in the federal funds rate in stride, treating it as another indicator of the U.S. economy’s return to form. As Fed Chair Janet Yellen stated, “The simple message is the economy is doing well.” The Bureau of Economic Analysis recently released a revised GDP figure of 2.1% for the fourth quarter of 2016 versus an earlier estimate of 1.9%.
Defensive assets turned in a solid performance during the first quarter as well. Treasuries rallied after the Fed’s March 15 announcement and the core bond index made up some ground in the latter half of March. Our flexible bond manager, Carl Kaufman, returned over 1.50% for the quarter vs 0.9% return for the US bond market (Vanguard Total Bond Market Index). Our core bond managers outperformed US bond returns as well. Floating rate bonds performed in line with the index and our emerging market bond manager continued to have good performance, up over 7.50% for the quarter. Our alternatives manager picked up 1.25% through March 31 as well.
It’s too soon to know how the second quarter will play out, but we remain alert to potentially policy driven political risk in the United States. In Europe, the outcome of upcoming elections, and related developments in France (May) and Germany (September), may have unexpected impacts on markets. To date investors have shown a remarkable degree of staying power, that does not mean they will continue to do so.
Global economic growth is in sync and improving. A quick survey of the economic landscape suggests the environment should remain supportive of stocks and other risk assets, at least over the next six to 12 months or so. We continue to believe high current valuations will be a major headwind to U.S. stock market returns looking out over the next five years. We also remain concerned about the unresolved risks stemming from the global debt build-up and unprecedented central bank policies. But for the time being, the global macroeconomic backdrop offers reason for optimism, many of the reflationary trends that have benefited our portfolios in recent quarters can continue. As always, our focus remains on prudently managing each of our client’s portfolios to achieve long-term, risk adjusted returns consistent with their investment objectives.
Across a wide range of measures, the global economy is in its best shape in many years. Economic growth in most countries and industries is in sync and has been accelerating, albeit modestly. Leading economic indicators suggest this trend can continue, and many of the respected economic research firms we follow agree. Global Manufacturing Purchasing Managers Indexes, which have been correlated with global equity returns over time, recently made new multiyear highs in the United States, the Eurozone, and China. While unexpected macro shocks can occur at any time, causing at least a short term flight from risk assets, the likelihood of an incipient U.S. or global economic recession appears low. Without a recession, history suggests a bear market in stocks is unlikely.
Macroeconomic fundamentals appear reasonably solid and are improving from cyclically depressed levels in many regions outside the United States.
But financial markets respond to new data, information, and events that differ from consensus expectations already discounted in prices. The Citi Economic Surprise Indexes are meant to capture whether, and to what extent, new economic data points are exceeding or disappointing consensus expectations. These indexes have rebounded sharply over the past year. In fact, the Surprise indexes for Europe and emerging markets both recently hit seven year highs.
Where Do We Go From Here?
Readers of our newsletters know that our opinion is that trying to predict short term market moves is a losers game (and anyone who says otherwise is not being honest). For US stocks, our managers continue to see few stocks that are cheap and rising US interest rates, if the trend continues, this could also impact US stock prices.
In order to set an appropriate asset allocation plan for our clients, we think about the ability of global central banks to wean markets off of cheap credit, the length of the weaning off process, and what the actions taken will do to interest rates and inflation. We cannot predict but we can prepare.
For fixed income positions, we are keeping duration (the amount of price sensitivity of bonds to raising interest rates) low (giving up some yield for capital protection) and credit quality is generally high for our core position. We also have flexible fixed income managers, whose investment mandate does not tie them to only one sector of the bond market. We believe that flexibility is important since the interest rate landscape is changing here in the US. Lastly, we have a meaningful allocation to alternatives, with a goal of returning more than bonds but put with less price volatility than stocks.
What about Stock Market Valuation or Current Trading Levels?
A question we are getting fairly frequently today, especially from those holding significant amounts of cash, is that stock prices are high and so should I really invest now? We think this is an important question and as our readers know, valuation is a key investment tenet here at River Capital Advisors.
As value investors, we know that “price is what you pay, value is what you get” – in other words, it is important to know the value of a financial asset (whether real estate or stocks), which is typically determined based on the expected cash flows to be received discounted back to today. Once you know the value of an asset, an investor can assess whether the asking price is above or below fair value. Valuation is the anchor that helps make rational investment decisions.
For example, our research indicates that European corporate earnings have barely grown since the 2008–2009 financial crisis. Fiscal and monetary policies have not been stimulative enough to offset this. Meanwhile, U.S. company earnings have grown strongly, exceeding prior cyclical highs due to historically high profit margins, stock buybacks, and low interest expense. This divergence in earnings trends is the key reason we view European stocks as more attractive looking forward.
We estimate that over the next five years, European companies will likely grow earnings at a much faster rate than their U.S. counterparts; this would lead to outperformance by European stocks. We believe European earnings are cyclically depressed, while U.S. earnings are near cyclical highs. Current European stock prices do not yet reflect the better value of the companies but at some point, we believe global investors will start to appreciate the cheapness of European stocks.
So, back to the question. Our stock managers are “bottom up stock pickers”, which means they make individual stock investment decisions based on the value of the individual stock versus the current stock price Mr. Market has for any given day. Since our stock managers build portfolios without regard to any index benchmark, they will not buy a stock that they believe is overpriced.
They will hold cash, not as an investment but as a conscious decision to wait for a good price to buy. Therefore, overall market valuation is not necessarily the most important concern for the individual manager. The ability to find good business at good to fair prices, investing with capable management, is the most important concern.
We think about overall stock and bond market valuation when we build client portfolios. This analytical process is an important part of developing the right mix of assets, keeping the overall portfolio downside in mind. As we have been writing about for some time now, we believe that the US stock market is fairly to slightly overvalued. Therefore, as global investors, we have allocated roughly half of our client stock portfolios to markets that are cheaper than the US – emerging markets and developed international.
Lastly, depending on the specific financial goals of the individual that we are talking with, the best time to start investing is today, the next best day is tomorrow. The specifics of the financial goals of the individual dictate how much of their liquid assets should be in stocks and bonds. Cash needed in the next two years or less should not be invested but kept in cash.
Cash and Inflation
We recently visited one of our managers for an on site due diligence meeting. The lead portfolio manager noted at the meeting that during his lifetime, the value of a dollar has declined about 80%! This is an astonishing statement. Firing up our financial calculator, we know that assuming a 3% inflation factor, in five years, a dollar is worth 14% less, after seven years, 19% less, after ten years, 26% less! Inflation is a “silent killer” of wealth and holding more cash than is necessary for short term needs means that an individual is willing to accept negative returns. Although we never say never, generally is is not possible to achieve a lifetime of financial goals by not taking advantage of compounding capital by making prudent investment choices so that the purchasing power of the financial assets outpace inflation.
Cash is a financial teddy bear and in the short term, it feels good. However, the negative returns brought by holding too much cash can cause individuals to have to make significant changes in their financial life or potentially not be able to reach their goals.
Putting It All Together
Despite a high level of volatility emanating from U.S. politics in recent months, U.S. stock market volatility has remained very low. That is unlikely to last. Our portfolios are prepared for more oscillations, particularly downside risk to U.S. stocks. We remain confident in our positioning and in our investment process, both of which allow us to look past periods of uncertainty and keep our focus where it should be: on prudently managing our diversified portfolios to achieve long-term, risk-adjusted returns.
Wisdom of Great Investors
From time to time, we reach back into our library to share insights that are timeless. Now seems like a good time to do just that and attached is an excellent piece from Chris Davis and his team at Davis Financial. Please take a few minutes to read the insightful quotes from some of the most respected investment minds attached to these newsletter.
River Capital Advisors News
By the time you read this newsletter, the initial phase of the 2016 tax return filing season will have passed. We are being asked by many clients about the prospects for tax reform this year. There is a lot of talk about changes but as planners, we need to wait until we see meaningful legislation in order to help our clients revisit their tax planning. We think the prospect for tax reform is good, however as we saw with the attempt to repeal Obamacare, talk is one thing, getting a law passed is another. We are monitoring Washington closely and will update our clients whenever we get a better sense of income and estate tax law changes.
Prior newsletters have noted basic financial planning concepts that everyone needs to take advantage of, depending on where they are in their financial life. We have recapped our favorites for you:
- Individuals need to save as much as they can, for as long as they can.
- Try to maximize or at least increase annually contributions to your work retirement plan. If you cannot maximize, contribute at least the amount necessary to capture the company match (free money!).
- Take advantage of a Health Savings Account and the triple tax play available for them (tax deduction for contributions, tax deferred growth on the contributions, tax free withdrawals if used for qualifying medical expenses).
- Track your spending – spending is the one area of your financial life that you can control – with the goal of living below your means.
- Buying a financial product is not financial planning.
- Work with a financial fiduciary – why would you trust your money with someone who is not a financial fiduciary to you (if you are interested in more information on this topic, contact us).
- If you do not have the time or skills to manage all aspects of your financial life, hire an independent financial advisor like River Capital Advisors (“RCA”) to help identify your life and family goals, develop a plan to achieve those goals and to help you in all areas of your financial life.
We have updated our ADV and are including in our client quarterly package a Summary of Material Changes. If you would like a complete copy of our ADV, please contact Bradley Miller, Client Service Specialist, here at RCA for a copy.
Enjoy the spring!
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