The Margin Of Safety Quarterly Winter 2017
Fourth Quarter 2016 Key Takeaways
- Global stocks performed well both in absolute terms and relative to core bonds this year, with U.S. stocks again taking the lead.
- Emerging market stocks were also strong performers, gaining 12.2% for the year. Developed international stocks were the big laggards. They returned just 2.7% in U.S. dollar terms.
- For the year, core bonds produced a 2.5% gain and investment-grade municipal bond returns were slightly negative on the year.
- While 2016 wound up being a poor year for Treasuries and core bonds, it was a good year for riskier fixed income sectors.
- Alternative strategies turned in mixed performance overall. Our multi-manager alternatives strategy performed very well, returning about 7% for 2016, in line with our expectations.
Fourth Quarter 2016 Investment Commentary
In 2016, the US market reached new highs and stocks in a majority of developed and emerging market countries delivered positive returns. The year began with anxiety over China’s stock market and economy, falling oil prices, a potential US recession, and negative interest rates in Japan. US equity markets were in steep decline and had the worst start of any year on record. The markets began improving in mid February through midyear. Investors also faced uncertainty from the Brexit vote in June and the US election in November.
Many investors may not have expected global stocks and bonds to deliver positive returns in such a tumultuous year. This turnaround story highlights the importance of diversifying across asset groups and regional markets, as well as staying disciplined despite uncertainty.
Large cap stocks gained 11.8% and small cap stocks surged 21.6%. This marked the eighth straight year the large cap S&P 500 Index had a positive return. While streaks of this length have occurred twice before, the market has never had a nine year winning streak. Most of our large and small cap value managers outperformed these benchmarks, especially the S&P 500.
European stocks did worse, falling 0.4% in dollar terms, although they gained 7.2% in local currency terms. For the third straight year, dollar appreciation was a drag on European stock returns. The major currency decliner was the British pound. It plunged 16% versus the U.S. dollar, triggered by June’s Brexit vote. The euro fell 3% on the year. Overall, the U.S. dollar index rose around 4% against a basket of developed market currencies. Emerging market equities performed well in 2016, returning about 12%. Our diversified, emerging markets value manager outperformed this benchmark, returning about 20%.
Though core bond prices got off to a strong start with the 10-year Treasury yield dropping to an all time low of 1.37% in early July, yields then reversed course, rising to 2.5% by year end. In the fourth quarter, the core bond index fell 3.2%—its worst quarterly performance in 35 years—due to rising interest rates.
Fixed income sectors with more credit risk (and less interest rate risk), such as high yield bonds and floating rate loans, performed very strongly, gaining 17.5% and 10.2%, respectively.
In this quarter’s investment commentary, we look back at 2016 as well as ahead to 2017. Several trend reversals occurred in 2016 that leave us hopeful the portfolios we manage will outperform in the coming years. Our analysis leads us to stay the course, maintaining a focus on our investment discipline, as opposed to trying to forecast economic or political outcomes, which we believe are inherently unpredictable.
Portfolio Positioning and Asset Class Comments
Fixed-Income: In our balanced portfolios, roughly half of our fixed income exposure is in non core bond funds, including actively managed unconstrained/absolute return oriented, flexible multisector, emerging market debt and floating rate loan funds. These positions benefited greatly from rising interest rates and added significant value compared to core bonds. Gains were in the 8% to 11% range for a number of our managers versus 2.5% for the core bond index. Looking ahead to 2017, floating rate loan funds should again meaningfully outperform core bonds, although 2016’s double digit returns will not repeat.
Larger Cap U.S. Stocks: Our slight underweight to U.S. stocks in favor of non U.S. stocks and alternative strategies was a headwind to performance this year. However, our portfolios have a value focus and a number of our value managers performed well in 2016, adding to performance.
Smaller Cap U.S. Stocks: Smaller cap US stocks have not performed as well as larger US stocks but 2016 was different. The Russell 2000 was up 21.6% versus our value managers, which earned anywhere from 20.5% to over 29%.
Developed International Stocks: Given our modest tactical overweight to Europe, we were hurt by U.S. stocks’ continued outperformance versus other regions. This marked the fourth straight calendar year and the sixth in the past seven that the S&P 500 beat the global ex-U.S. index. Since 2008, this is one of the longest stretches of U.S. outperformance on record. U.S. stocks also meaningfully outperformed European stocks.
Emerging-Market Stocks: We were pleased to see emerging market stocks rebound in 2016, with the index up about 12% while our value manager returned 20%. Through the end of October, emerging market stocks were up 18% on the year (versus larger cap U.S. stocks’ 6% rise), though they did give back some gains following the presidential election.
Alternative Strategies: Our lower risk alternative, multi-manager strategy exceeded its performance objective this year, returning about 7%. Our goal for the strategy is to earn returns in excess of fixed income but with lower volatility than stocks.
Why Not Put All Your Eggs In One Basket?
Over the last few years, some investors are asking why bother owning assets outside of the US.
Since the end of 2009, the S&P 500 has returned a cumulative 131%. In contrast, developed international stocks have gained 32% and emerging market stocks a measly 1.3% in dollar terms. It is natural, we think, given the unpredictable and scary world we live in, to want to stay with what is familiar. People do this all the time, in life, sports, etc. and it is called familiarity bias. People tend to have faith in or root for what is most familiar. From an investment perspective, we would call it “home country” bias – invest only here in the US. However, with the US representing roughly half of the globe, we do not believe we want to ignore the other half. The old adage of not putting all your eggs in one basket applies to investing in our opinion. In a previous newsletter, we talked about a Japanese investor who, in the 80’s, might have questioned the benefits of being globally diversified given the great performance of Japanese businesses and markets. The last couple of decades have educated this Japanese investor about the benefits of being globally diversified, as Japan as not performed well.
While foreign stocks’ underperformance is trying, we continue to believe, supported by our analysis, in maintaining large strategic allocations to foreign stocks particularly after this prolonged period of underperformance. Our analysis implies that from current price levels, both European and emerging market stocks are likely to generate much higher returns than U.S. stocks over the next five years. In a base case scenario, the potential exists for low double digit returns from European and emerging market stocks, driven largely by improving earnings growth from still very depressed levels. This compares to a base case of low single digit expected returns for the S&P 500.
While our analysis indicates we are being reasonably compensated for equity risk in Europe and emerging markets, U.S. stocks appear overvalued, with a lot of optimism baked into current prices. This accelerated post election and makes them particularly vulnerable to a negative surprise. We expect the market price to earnings multiple to decline in a base case, consistent with U.S. market history, dragging down expected returns. History and investment logic also tell us that high starting point valuations are a strong predictor of low future returns over a five to 10 plus year horizon. It is this horizon upon which we base tactical decisions. So on a relative and absolute basis, we are slightly overweight to non U.S. stocks and underweight to U.S. stocks.
There are risks to both US and non US equities, however for non US equities, current valuations suggest that the risks are at least partially reflected in the current prices. News flow regarding political uncertainties from rising nationalism in Europe and related economic/breakup risks facing the Eurozone, or the negative ramifications for emerging markets of China’s huge public debt build up (to name a few big ones), has contributed to their poor stock market performance in recent years. With investors discounting lots of risks and bad news, the news must only be “less bad” for sentiment and stock prices to improve. That typically happens when the market least expects it.
We believe the key earnings growth and valuation assumptions that underlie our analysis for non U.S. equities are reasonably conservative. We believe the overall risk/reward, the combination of the likelihood of certain scenarios playing out and the magnitude of gains or losses across those scenarios, continues to support a modest tilt to overseas markets for our stock allocations.
As Warren Buffett wonderfully and concisely put it, “A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.” Everyone agrees with this, especially in hindsight, but of course doing this is much easier said than done.
Why Does Portfolio Diversification Work?
As our clients know, we develop portfolios with the downside in mind as our almost twenty years of experience have shown us that investors “feel” losses more than the joy of gains. As planners, we need to have an investment plan that clients will stay with, in good times and bad, in order to reach their financial goals. A diversified portfolio is a risk management tool so that the benefits are gained of top performers (the US of late) without bearing the full effect of bottom performers (non US of late). Our portfolio construction goal is to smooth out the highs and lows and research has clearly shown that a diversified portfolio will outperform a less diversified one over the long term – long term here is over an investors lifetime (not just a couple of years). Eugene Farma has a great quote that encapsulates the need for investors staying the course with an asset allocation that reflects their needs, risk preferences and objectives: “If three or five years of returns are going to change your mind [on an investment], you shouldn’t have been there to begin with.”
The Schwab Center for Financial Research has a great chart (see next column) that illustrates the value of diversification. Having just a S&P 500 portfolio starting with $100,000 returned $230,000 over the analysis period (2001-2016). A 60% stock, 40% bond portfolio actually performed slightly better over the same time period, growing to $233,000. However, a globally diversified portfolio grew to $280,609.
There is no “free lunch” in finance, but as Harry Markowitz famously said, diversification is as close as we can get to a free lunch. Because global assets are not perfectly correlated (they do not react the same way to global events or said differently, do not go up and down at the same time), a diversified portfolio will have less risk. We agree the world is different today than when Markowitz did his study. However, global asset classes do not move in the same direction at the same time. There are times, such as now, when one asset class is more expensive than the others and we want to own cheap assets when can, as lower current prices have the potential for larger future returns. So when others look at the returns we mentioned earlier for the US vs. foreign markets for the last several years and see risk in the foreign market, we see potential.
River Capital News
Our portfolios performed well in 2016, with our value managers generating very good returns, as well as our emerging market stock and bond investments. We think active stock pickers will be rewarded in 2017 and that value oriented investments are poised to build on 2016 returns. We do not think that bonds will have a very good year as we think that interest rates will rise but we believe that they are still needed in portfolios as a risk mitigator. We are cautious on the markets in general and think that a pullback is more likely than not. However, we can’t judge what the magnitude nor the timing may be.
We have been gradually introducing clients to our new financial planning software and the feedback has been very good. We have improved our ability to view, in a more comprehensive way, all areas of our clients financial life. Although we focus mostly on the markets in our newsletters River Capital is a true full service wealth management firm, as we are practicing CPAs and CFP practitioners. There is no area of our clients financial life that we do not get involved in to help them meet their financial goals and objectives. This includes insurance, estate planning, budgeting, retirement planning, education planning, car and home purchases, etc. Using technology and our financial experience as advisors and planners, we are better positioned to help our clients develop a coordinated investment and financial plan.
The 2016 tax filing season is upon us. This is an excellent time to review your financial goals and most importantly, your spending. Spending is the most important variable in accumulating wealth and is especially important once the work years are done. We also recommend that you save as much as you can, for as long as you can. Saving more prior to retirement serves the dual purpose of reducing current consumption, which makes it easier to make needed adjustments once the paychecks stop , and boosting your nestegg.
Here is to a prosperous 2017!
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