The Margin of Safety Quarterly Summer 2015

 In Client Bulletins

Second Quarter 2015
Key Takeaways

  • Greece is back in the headlines resulting in Eurozone and “Greek exit” concerns. A deal was reached after quarter end. China and Puerto Rico also added to the news headlines.
  • Global equity prices were generally flat during the quarter but positive year to date. Year to date, smaller cap US companies did better than large, Europe returns were mid single digit and emerging markets generally outperformed the US equity markets.
  • US bonds declined during the quarter for the first time in over a year and are flat through quarter end. High yield and floating rate bonds returned just under 3%.
  • We initiated a “fat pitch” European equity position during the quarter.

Second Quarter 2015 Investment Commentary
As the quarter ended, Greece was making headlines for its June 30 default on a debt payment to the International Monetary Fund amidst increasingly fraught negotiations with its eurozone creditors, China was in the news for its very sharp short-term stock market decline and surprise interest rate cut, and Puerto Rico announced it would be unable to fully repay its municipal debts. Notwithstanding a dramatic last couple of days, though, the second quarter was generally positive for global equity markets.

While U.S. stocks were barely positive for the quarter, overall they are broadly positive for the first six months of the year with larger caps rising 1.2% and smaller caps increasing 4.7%. On the economic front, first quarter U.S. GDP growth was revised higher in June though it remained in slightly negative territory after a harsh winter depressed economic activity. Job growth remained strong and the housing market appeared in decent shape as average home prices hit levels not seen since 2006.

Developed international stocks were roughly even with U.S. stocks in the second quarter and maintain a lead for the year so far. We added a tactical fat pitch to European stocks across our balanced portfolios in the second quarter, funded from our U.S. large cap core stock allocations. As we discuss in the commentary that follows, our view of potential returns rests on the assessment that European stock market valuations are attractive and European earnings are depressed relative to their long term normalized potential. The recent turmoil in Greece has not changed our longer term view of the potential of this asset class.

Emerging markets stocks rose during the quarter and are also outpacing U.S. stocks for the year despite a mixed bag of economic outlooks as well as concerns that higher U.S. interest rates could be harmful to countries with heavier amounts of U.S. dollar denominated debt. This is a risk we monitor closely and it is our view that overall emerging markets are less vulnerable to negative downstream effects from U.S. rate rises than in the past. Among larger emerging markets, China was a strong positive contributor for the quarter, despite its June decline.

After five consecutive quarters of gains, core bonds declined 1.8% over the last three months as yields on 10 year Treasury bonds rose 40 basis points. Our estimate of core bond returns remains low over the next five years. Consequently, we continue to favor a variety of credit strategies that we believe will outperform our core bond benchmark in flat and rising interest rate scenarios. These flexible credit strategies have broad mandates, which we believe will allow them to benefit from rising interest rates. That said, we retain a partial allocation to high quality core bonds as we view them as a source of portfolio protection in the event of a stock market decline.

We also own positions in diversified, high quality floating rate loan fund in our most conservative accounts in order to benefit from attractive yields as well as protect against rising short term rates and unexpected inflation. Below investment grade bonds (a market segment that includes high yield bonds and floating rate loans, among others) performed well relative to core bonds in the second quarter, and floating rate loans outperformed core bonds by nearly three percentage points.

What the Macro is Going On?
We are regularly asked for our take on the broad macroeconomic topics of the day. The answer is we do not know and we do not think anyone else does either. However, news flow being what it is, clients and prospects do bring up the Greek debt crisis.

We note that Greece has defaulted on its debts previously, required bailouts and has been the topic of debate about whether or not it will stay in the eurozone. This quarter was a little different than in the past, with the snap referendum and closing of Greek banks. However, as we write this, it appears a deal has been reached for now.

This latest Greek crisis provides us with an opportunity to highlight how we think about these types of overarching, large scale, and often complex events in the context of our investment process and portfolio management approach. (Other examples include the potential impacts and outcomes from national elections, central bank actions, and geopolitical conflicts). These situations fall into the category of important but unknowable. As such, we want to stay “macro aware” but we do not make asset allocation decisions based on these events. So as the events currently play out they have not led us to change our asset allocation positioning, although we expect some of our active bond and stock fund managers are responding more tactically to the recent events and attendant market volatility.

We do remind those that we talk with that it is important to keep Greece’s economic impact in perspective. We cannot think of many things that people own that come from Greece (no cars, no computers, maybe olive oil). Greece is just not an economic powerhouse and the recent events were market events, not econcomic events. As economist David Rosenberg wrote in his June 16, 2015, “Breakfast with Dave” column, “Remember that we are talking about a $240 billion economy here or 2% of the eurozone GDP [0.3% of global GDP].” Moreover, more than 80% of the total €315 billion Greek debt is held by government related/taxpayer supported entities, such as the ECB, IMF, and the European Financial Stability Facility, according to data from Capital Economics. From a financial standpoint, these entities could handle a default although there would be political ramifications. Only 18% of Greek debt is held by the private sector and private bank.

Asset Class Views and Portfolio Positioning
U.S. Stocks—Another source of uncertainty and potential market volatility is Fed monetary policy. While we acknowledge that central bank actions (as well as Fed governors’ speeches) obviously do impact financial markets on a day to day basis, we also firmly believe it’s foolhardy for long term investors to base investment decisions or portfolio allocations on short term predictions of central bank behavior. The recent reduction in US large cap stocks to fund our European “fat pitch” position (more discussion on this later) has reduced our overweight to the US. Across our portfolios, however, we do have about half of our equity allocation to US equities, predominately with our value managers. We do believe that US stocks are fully valued.

image1We focus our research on the attractiveness of stocks by considering the five year outlook for company earnings relative to stock prices across a variety of economic scenario. Our prior newsletters have discussed our concern about corporate profit margins at historically high levels and the potential for earnings to disappoint the market’s expectations (as reflected in higher p/e multiples). Future US stock returns will not be what they have been since the market low of March 2009 and we have been advising clients that return expectations need to be tempered. We also advise clients and those that we talk with that we have not seen a US market correction (10% or more) in a long time – we are overdue. Counter intuitively, it might even be improving economic growth that is a negative catalyst for stocks to the extent that a strengthening labor market leads to accelerating wage growth, which in turn puts downward pressure on profit margins and earnings. Looking back at what we’ve seen so far this year, S&P 500 profit margins, while still high, have turned down over the past two quarters. Further, S&P 500 earnings growth expectations have been steadily coming down since last year.

We know U.S. stocks may continue to deliver attractive returns over short or intermediate term periods (supportive monetary policy can be a powerful influence, as we’ve seen), and we expect the actively managed stock funds we own to outperform the broad market over multiyear periods. So we own U.S. stock funds in all of our portfolios but at a lower allocation than if return potential were higher. We continue to believe there are better opportunities for our clients outside the U.S. market.

European Stocks—Our assessment remains that expected returns for European stocks are very attractive relative to U.S. stocks looking out over the next five years. Despite a rebound earlier this year, European stock market valuations and corporate earnings (which are well below their long term trend) still have room to improve, both on absolute terms and relative to the United States. For example, the chart below shows the wide gap in net profit margins of non-financial companies in the eurozone compared to the United States. We don’t believe this wide a disparity is sustainable and believe it will adjust in favor of Europe over the next several years.

image2The recent increase in European stocks has resulted in us being overweight developed international markets relative to our neutral weighting.

Emerging-Markets Stocks—We continue to like emerging markets stocks on a longer term strategic basis but we are slightly underweight emerging markets relative to our neutral weighting. Emerging markets stock valuations look attractive and earnings appear to be depressed relative to our longer term expectations.

Investment Grade Bonds—On the fixed income side of the portfolios, given that interest rates will rise, which would be a negative environment for investment grade bonds, we are maintaining a significant underweight to core bonds and interest rate risk, in favor of flexible core bond funds, absolute return oriented bond funds, alternatives and floating rate loan funds that we believe can generate higher returns and better manage their interest rate sensitivity. We continue to own positions in diversified, high quality floating rate loan funds in order to benefit from attractive yields as well as protect against rising short term rates and unexpected inflation. Below investment-grade bonds (a market segment that includes high yield bonds and floating rate loans, among others) performed well relative to core bonds in the second quarter, and floating rate loans outperformed core bonds by nearly three percentage points.

We continue to hold a passive core position in the US bond market, which was funded from our sale of PIMCO Total Return. We are close to finalizing our research for a new, active US core bond manager and at that time, we will remove the passive core bond position.

Risk Revisited
We are big fans of Howard Marks and urge our readers to buy his book, The Most Important Thing. Recent market volatility, given Greece, China, Puerto Rico, etc. made us think about risk as it relates to investing. Mr. Marks also released a recent memo, Risk Revisited Again, which we recommend you read completely (memo is available on the Oak Tree website). We thought we would share some thoughts that resonate with us from his recent memo.

The first key point and something we have talked about over our history is that volatility is not risk. Volatility is the academic’s choice to define and measure risk, since it can be used for computations as Howard points out. We agree with Howard that most investors don’t fear volatility – what they fear is the possibility of permanent loss of capital. Permanent loss of capital is very different from volatility or price fluctuation. A price fluctuation is temporary and is not a big problem if the investor is able to hold on and come through the other side. A permanent loss of capital is something the investor cannot rebound from and occurs for either of two reasons: a) the investor locks in the temporary price fluctuation by selling (because of fear, loss conviction, cash crunch, as examples) or b) the investment itself is unable to recover for fundamental reasons. With a proper plan (adequate cash reserves, proper investment mix, appropriate time horizon, as examples), we can help the client (and have helped clients) ride out volatility. However, once sold, we never get a chance to undo a permanent loss of capital.

The second key point for us is that the future is unknowable. People in the prediction business think the future is knowable, and all they need to do is be among those who know it. We agree with Howard that the future isn’t knowable and reasons for the inability to predict include: a) we are aware of factors that can influence the future, such as governmental action, changes in commodity prices. But, these things are hard to predict and we doubt anyone is capable of taking all variables into account at one time; b) the future can be influenced by events that aren’t on anyone’s radar screen today (think 9/11, natural or manmade calamities, in short the unknown unknowns); c) there is far too much randomness at work in the world for future events to be predictable and lastly d) the connections between contributing influences and future outcomes are far too imprecise and variable for the results to be dependable. For this last item, Howard gives a great example: Physics is science, so an electrical engineer can guarantee that when you flip a switch over here, the light goes on over there, every time. But, for the dismal science of economics, the relationships are not the same because of human behavior and the role it plays in economics and investments.

So, what is the investor to do when trying to decide on a portfolio for future developments that are not knowable? We like to say, we cannot predict but we can prepare. We can focus on the knowable and controllable – spending needs are key for our clients. How much is needed and when. We can work with a client to revise spending, which is a big determinant of them achieving their financial goals. We work with clients to have an adequate cash reserve, to keep from a permanent loss of capital. We develop a strategy, a game plan, to try and keep emotions from driving decisions – we want analysis, facts, etc. to drive decisions. We understand that game plans need to change when the financial situation changes – our plans are not ones to set and forget. We construct globally diversified portfolios, using a combination of active and passive strategies. Diversification is one of those things, though, that when prices are increasing, the investor believes they have too much of and when prices are declining, they believe they do not have enough of it! Lastly, we work with our clients to try and get them to “know thy self” – to understand as best as possible their tolerance for volatility and the ability to stay with a game plan. For that reason, when we construct portfolio’s, we do so with the downside in mind. We find that if a client or portfolio declines less in down markets and captures most of the upside, we will protect, preserve and grow our client’s capital.

Financial Fiduciary
We are very passionate about being a financial fiduciary to our clients. We are also disappointed in our industry that there is not a better understanding about who is and who is not a financial fiduciary. The result is confusion for clients and many times someone is sold an inappropriate financial product by a “financial advisor”. Unfortunately in our industry today anyone can call themselves a financial or investment advisor, even if they are a salesperson whose primary loyalty is to their employer rather than to the individual client. We became aware of a grass roots organization known as the Committee for the Fiduciary Standard who believes like we have for our whole history that the fiduciary standard should apply to everyone who provides personalized investment advice. We have adopted their simple, straight forward oath. The RCA team has signed the oath as part of our pledge to put our client’s financial interests where they belong – at the top of the pyramid. As noted in the enclosed memo, we encourage our readers to share the oath with their friends and family. We also recommend that they talk with their other financial advisors and ask that they sign a similar oath. It is a straightforward request and if the “financial advisor” does not or will not, you know that you are not working with a financial fiduciary – why would you trust your financial future to someone who does not put your financial interests first?

River Capital Advisors News
RCA is pleased to announce that Stephen D. Kyle, CFP®, has joined our firm as a Wealth Manager Associate. Stephen has worked in the insurance and financial services industry for five years. He has extensive knowledge in property, casualty and life insurance. Stephen graduated from Florida State University and he and his wife are expecting their first child! Please welcome Stephen, we are pleased to add him to the RCA team.

We wish to thank all of our clients and we really appreciate the continued referrals we receive. It is an honor to work for our clients and it means a lot to us when a client mentions us to others that need independent, objective advice from a financial fiduciary. We will continue to work hard to help our clients achieve their financial goals and objectives.

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