The Margin of Safety Quarterly Fall 2019
Third Quarter 2019
- The third quarter of 2019 was a choppy one for financial markets as investors continued to weigh the overall health of the global economy against a host of uncertain macro factors.
- On the economic front, the Federal Reserve followed its 25 basis point interest rate cut in late July with another 25 basis point cut in mid-September.
- Amidst this backdrop, equity markets rose in July, fell in August, then rallied in September.
- Despite a rebound in September, foreign stocks posted negative returns for the quarter.
- Bond yields around the world continued to move lower in the third quarter as deflation concerns took hold.
- U.S. core investment grade bonds were flat in July, rallied sharply in August, then dropped in September as interest rates rebounded from historic lows.
- Corporate bonds gained for the quarter.
- The economic environment continues to feel like a game of tug of war between the contractionary effects from U.S. trade policy and accommodative/expansionary global monetary policy.
Third Quarter 2019 Investment Commentary
The third quarter of 2019 was another choppy one for financial markets as investors continued to weigh the overall health of the global economy against a host of uncertain macro factors. Uncertainties included the ongoing trade war with China, a drone attack on Saudi Arabia’s oil fields, the seemingly never ending Brexit negotiations, and—as September wrapped up—an official presidential impeachment investigation in Washington, D.C.
On the economic front, the Federal Reserve followed its 25 basis point interest rate cut in late July with another 25 basis point cut in mid September. These actions were in response to the weak global economic environment and the impact of trade policy on U.S. business sentiment and capital expenditure. The European Central Bank also cut its policy rate and announced it would launch a new open ended asset purchase plan (i.e., quantitative easing) starting in November.
The divergent outcomes we see as possible from here (recession vs. cyclical rebound) explain our balanced portfolio approach and focus on diversification. Our tilt toward international and value stocks on the equity side should benefit portfolios if a cyclical rebound takes hold. Our alternatives and fixed income positions provide some ballast and dry powder for portfolios. Together with the broader diversification across asset classes and investment strategies, client portfolios should be resilient across a range of economic and market scenarios.
Amidst this backdrop, equity markets rose in July, fell in August, then rallied in September. Larger cap U.S. stocks gained 2% for the quarter and have netted over 20% year to date. Smaller cap U.S. stocks suffered more acutely during the market drops and ended the quarter down 2.3%. For the year to date, they are still up a healthy 14.1%.
Foreign stocks likewise rode a roller coaster quarter; however, their rebound in September wasn’t quite enough to see them keep pace with U.S. stocks. In the third quarter, developed international stocks fell 0.9%, European stocks fell about 1.8%, and emerging market stocks fell 4.1%. Returns are still robust for the year so far, with developed international and European markets posting double digit gains (13.2% and 13.6%, respectively) and emerging market (EM) stocks rising close to 8%.
Bond yields around the world continued to move lower in the third quarter as deflation concerns took hold. The benchmark 10 year Treasury yield ended the quarter at 1.68%, down from a 2% yield at the end of the second quarter. Core investment grade bonds gained 2.4%, while floating-rate loans returned 1.0% and high-yield bonds gained 1.2%.
Our alternatives position continue to have good returns, up just under 6.50% year to date and our emerging markets bond manager has returned just under 10% year to date.
The global tilt of our balanced portfolios was a damper on our overall performance for the quarter. However, our portfolio positioning added value in September when interest rates moved higher, catalyzed by an apparent détente (at least for the time being) in the U.S. China trade war. Rising interest rates brought losses to core bonds, while our flexible fixed income and floating rate loan funds had gains. September’s more optimistic news on the trade front also boosted more cyclically sensitive international and EM stock markets as well as U.S. value stocks, all of which have lagged the S&P 500 market index the past several years.
Market and Portfolio Outlook
“Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves”—Peter Lynch
The financial environment continues to feel like a game of tug of war. On one side, we have a still solid U.S. economy that has grown for a record number of consecutive years. While measures of manufacturing activity are slowing, global services activity, which represents upward of 70% plus of the global economy (and more than 80% of U.S. GDP) still looks solid. Household balance sheets and consumer spending also remain healthy, supported by low unemployment and solid wage growth.
On the other side, global economic growth remains weak and consensus expectations are for further slowing. In particular, the longer a China U.S. trade agreement remains elusive, the weaker the economy will get as corporations further delay capital expenditures and hiring decisions, not to mention the direct impact already felt by the manufacturing sector.
Given the conflicting financial environment today, the financial “news” media does not help investor success. We have written many times about the impact on investor psychology due to the constant 24/7 news flow. By the time the financial news media broadcasts a headline (any of the items above as an example) that might actually have a market impact, the investment professionals have already obtained that information from other sources. You might ask, if CNBC does not help in the short term, what about over the long term, by obtaining market insights from the broadcasts? We suggest that individuals test this thesis by watching market reactions – if the content was useful, markets would react.
The reality is that markets don’t care about what is said on financial news channels. Most talking points are about events that have already happened – old news. Opinions shared are, honestly, a dime a dozen. If professionals do not rely on financial news media, why should individuals?
We have written in the past that financial news media is entertainment – with the goal of bringing eye balls to the show, to lure in advertisers and make money for the show, not to help someone be a better investor. Watch closely who advertises on these shows – most of the advertising dollars come from firms that make money via trading and commissions – the goal of the show is to motivate you to trade more, with your “information”.
The financial news media does not really care what is in the best interest of the individual. They want to maximize their profits via higher readership, website clicks and viewers. To accomplish this, they put on the shows content that sells rather than information that can help increase the odds of investment success. We know that what does NOT sell is boring pieces on asset allocation, the benefits of having a long term investment plan in place, one that is consistent with the individual’s goals and objectives, that market timing is not possible, etc. What does “sell” is content related to short term speculation (where is the market going), security picking and of course, market timing.
Here are some past market comments/predictions that we feel highlight how (un)valuable media predictions are:
- “The World Economy: Be Afraid,” Economist Magazine, October 1, 2011.
- “No one sees a growth rate fast enough for the American economy to return to full employment any time soon.” Joseph Stiglitz, Nobel laureate 2001.
- “The American Labour Market Remains a Shambles.” Financial Times, March 13, 2012.
- “Bill Gross, co-founder and co-chief investment officer of Pacific Investment Management Co., says stock investors should rethink the age-old investing mantra of buying and holding stocks for the long run. Stocks, he says, operate much like a Ponzi scheme, showing returns that have no real bearing on reality.” as quoted by Steven Russolillo and Kirsten Grind from article “Bill Gross: Stocks Are Dead and Operate Like a Ponzi Scheme,” Wall Street Journal, August 1, 2012.
- The Dow will hit 30,000 by 2008 – Book “Why Its Different This Time” – Robert Zucccaro, CFA®
- Paul Krugman noted economist in 1988 “As the rate of technological change in computing slows, the number of jobs for IT specialists will decelerate, then actually turn down; ten years from now, the phrase information economy will sound silly.”
- “I Love Netflix (but not the stock)” Paul La Monica CNN/Money Senior Writer, Netflix was trading at $11 a share, now $280
- “The Great Crash Ahead” predicted in 2011 stock market crash to 3,000 on Dow in 2013 – Harry Dent CEO of economic Research company HS Dent
- “I believe that it is virtually certain that Google’s stock will be highly disappointing to investors foolish enough to participate in its overhyped offering — you can hold me to that.” – Whitney Tilson, noted Wall Street Analyst, Motley Fool 2016
- “NO! NO! NO! Bear Sterns is fine. Don’t move your money from Bear, that’s just being silly.” Jim Cramer, Mad Money, CNBC March 11, 2008 five days before stock fell by 93%.
We have a piece that we run from time to time about the differences between investing and speculation. Speculation is like gambling – the promise of a quick, short term investment profit. In a capitalistic society, there is nothing wrong with the financial media/entertainment entities making profits but our goal is to educate our clients and others that the financial media is entertainment, they have a conflict of interest in their content and marketing.
In the end, the answer continues to be that individuals should not act on forecasts and financial media headlines. It is just entertainment and acting on the entertainment will be a negative for your long term financial health.
The current investing environment and its range of conflicting outcomes only highlights why we believe it is important to incorporate a wide range of scenarios in our portfolio management process. The most effective way to do this is through diversification across multiple asset classes and investment strategies that have different risk exposures and different sources of return. Of course, this also means that not every position will perform well in every scenario or macroeconomic environment. That’s the definition of portfolio diversification and the essence of risk management under uncertainty.
Thoughts about US and EM Stocks
At a time when U.S. stocks have continued to outperform, clients sometimes ask us why we don’t have more in U.S. stocks. (Interestingly, we rarely get asked why we don’t have less.) The most important point we relay in those discussions is that a portfolio needs to maintain a balance because each asset in it has a defined role and no one knows how to time market tops or bottoms.
Markets typically don’t stop rising when they reach fair value. History has shown they overshoot both when they go up and when they go down because of investors’ greed (or fear of missing out) or fear (of losses). To justify a higher weighting to U.S. stocks at present, we’d have to assume history is largely irrelevant. We will briefly explain how we arrive at this conclusion.
There are only three drivers of stock returns: dividend yield, earnings growth and valuation (how much investors are willing to pay for each dollar of earnings). Dividend yield is around 2% and we do not see a lot a variance under different return environments. However, earnings growth and valuation are much more variable.
US earnings in the current cycle have grown about 8% per annum, between annual sales growth of about 3% and higher profit margins of around 10%. The impressive performance of profit margins offsets the relatively poor sales growth this cycle. To give some historical context on current profit margins, we recently reviewed a research piece that commented that an investor in 2009 would give 10% margins a less than 3% chance of playing out over the going forward time period! Current profit margins are high.
We believe margins have been lifted higher as several long-acting forces converged more strongly: globalization and free trade, and labor continuing to get a lower share of economic profits relative to corporations. To a lesser degree, lower interest rate costs and lower corporate taxes have helped prop up margins.
We believe it is unlikely that the factors that have led to unusually high profit margins are sustainable. Globalization and free trade seem to be reversing with protectionism, tariffs, etc., on the rise, just to name a few concerns. The key point we want to make on margins is that the collective forces behind their rise have little room to provide further benefit and some key ones are in fact turning negative. So, let’s assume margins retreat a bit to 8%. For a base case in sales growth, we think 6% annual sales growth over five years is optimistic but we will go with that number. We can think of this 6% growth in terms of inflation and real economic growth. Assuming the Fed will meet its 2% inflation target, it means we will need to assume the U.S. economy can grow around 4% in real terms (the consensus economic forecast for trend real GDP growth is roughly 2%). We think this is optimistic because all the monetary and fiscal stimulus we have seen in this cycle could only produce about half that growth. So, adding dividend yield and earnings growth (2%+3%) we get 5%. However, valuation also needs to be considered.
As of June 30, 2019, investors were paying 22x earnings for the S&P 500. An investor in a U.S. stock market index fund or ETF is paying an even higher premium: the weighted P/E ratio for the S&P 500 is close to 30x, according to Fiduciary Management, Inc. Since the 1980’s, the multiple has been 18-19x, post 1920s, 16x, for some context.
We think that due to higher regulation risk, political risks, protectionism and inflation risks, interest rate risk (we do not think interest rates stay low forever) and due to high current valuation levels, we assume valuations revert to 17x over a five year period, or a loss of about 4.6% due to valuation.
To put the above discussion into perspective, because of relatively poor sales growth and high margins in this current cycle, the S&P 500 currently trades at the highest price to sales multiple in its history.
When we aggregate the three return components (dividend yield of 2%, earnings growth of 3%, valuation or P/E compression of 4.6%), future five year expected U.S. stock returns are less than one percent, annualized, and this is despite our relatively generous margin and sales growth assumptions. If we were to stretch on valuation multiples and assume 19x or 20x P/E, returns are a bit above 3%, which is still poor for a risky asset like stocks.
The analysis above and research we review can be wrong. However, by most metrics, the U.S. stock market is expensive and therefore does not deserve a higher allocation in our client portfolios at present. In the short term, U.S. stocks may continue to outperform as they have for several years. But this would only borrow returns from the future. We also know by stretching our time horizon over 10 years and longer, U.S. equity returns should be decent. So, in our balanced portfolios we continue to allocate approximately half of our stock allocation to the US.
For EM and foreign stocks, another portion of client portfolios that clients will ask about, the thesis is recapped below:
- EM and other foreign stocks in general expand an investor’s opportunity set.
- Emerging markets provide exposure to higher growth regions, such as China.
- Foreign and U.S. stock performance moves in repeated cycles through history. Skeptics are judging asset class returns from a single end point while we are in the midst of an unfinished cycle.
- Our unhedged foreign stock investments help investors diversify away the risk of a declining U.S. dollar and in turn help maintain our clients’ purchasing power.
- The price of an asset matters to the ultimate return an investor should expect. U.S. stocks are not priced to deliver good returns regardless of their quality given their high valuations, we believe EM stocks are.
Using a similar valuation approach for foreign and EM stocks, we think they have much better return possibilities over the next 5-10 years versus the US. EM stocks for example yield 3.2% (more than 1.2% more than U.S. stocks), if earnings growth is only 2.8% (conservative given GDP growth in these markets), and valuations increase by 1.4% from current low levels (about half of this from currency appreciation and half from valuation changes) then we get a gain of about 7.4% vs. the less than 1% gain noted above for the U.S. For developed market stocks the yield is 3.5%, growth could be around 1.6% (lower than the U.S. and EM), and valuations change by 0.2% (prices move down a bit but currency moves up more). Then you would get a 5.4% return on international stocks.
We think that this methodology makes it easier to see why, with realistic assumptions, international and emerging markets appear cheap while U.S. stocks appear overvalued. We have held this viewpoint for a few years and have been asked if, in light of the U.S. markets continuing to outperform, why haven’t we come to the conclusion that we might be wrong.
Sometimes being early can make you look stupid. What we do know is that in investing, valuation matters. We also know that overvaluations can last for a while but that when they do change they change quickly. This is what happened in 2000 and in 2008. So we would rather be early than late.
River Capital News
The 2018 tax filing season ended October 15. However, financial planning is a year round activity. We continue to receive positive feedback from all of our clients that have taken the time to develop their unique financial plan. Our financial planning website has a number of great tools, including the ability to model different planning scenarios, so that we, and the client, can see the potential impact of different financial options and decisions. Spending can be captured and categorized, which empowers the client to see where their money is going and to make spending changes – as we like to say, it is not how much you save but how much you spend that dictates financial success. The planning website also allows the client to see their net worth and financial products, all in one place. Coupled with a sound investment plan, the financial plan allows our clients to make financial decisions, not based on emotions, but based on analysis.
As we enter the last quarter of the year, we will be working with clients on year end tax planning, preparation of tax projections, reviewing portfolios to rebalance and/or to harvest tax losses. For clients who are over 70 ½ and do not need to spend the IRA required minimum distribution, clients can give directly to charity IRA dollars to satisfy their charitable giving goals and also achieve benefits for income tax planning purposes. The last quarter of the year is a busy time!
For client investment plans, we continue to construct diversified, global portfolios that can perform well in rising markets but just as importantly, can also play some defense. We believe that one of the most important financial tenets is to have an investment plan that clients can stick with during periods of market volatility. With this in mind, we strongly consider the potential downside that a portfolio can have in a twelve month period of time – portfolios will go down on their way to going up. However, to experience the upside, the client needs to be able to stay with the plan on the downside. We also work with our clients to ensure that they have an adequate emergency cash reserve, so that when Mr. Market is not in a good mood, we do not need to be selling assets. Keeping our clients on track with their planning is the most important service we provide.
We think the Ben Graham quote below encapsulates how individuals should think about their financial and investment planning:
“The best way to measure your investing success is not by whether you are beating the market, but by whether you’ve put in place a financial plan and a behavioral discipline that are likely to get you where you want to go.”