The Margin of Safety Quarterly Fall 2020
Third Quarter 2020
- Despite some choppiness in September, the S&P 500 Index rose 8.9% in the quarter and has recovered all its losses for the year
- Developed international stocks gained 6.0% this quarter
- Emerging market stocks outperformed U.S. stocks with a return of 10.2%
- U.S. core bonds were essentially flat for the quarter, up 0.6% while floating rate and high yield bonds were up about 4%
- Our diversified alternative strategies return 2.23% for the quarter, out performing core bonds and our international bond position was flat for the quarter
- We see reasons to be optimistic and reasons to be cautious as discussed in the newsletter
Despite some choppiness in September, equity investors were treated to solid gains during the third quarter. The S&P 500 Index rose 8.9% in the quarter and has recovered all its losses for the year. Underneath the surface, mega cap growth names continue to lead the U.S. market. Without the astonishing 42.5% year to date price return of the “fantastic six”, the so called FANMAG stocks (Facebook, Amazon.com, Netflix, Microsoft, Apple, and Google/Alphabet), the S&P 500 would still be down for the year.
The outperformance of these top names means they now dominate the index. Market concentration is not unusual, but with the top 10 stocks in the S&P 500 making up 28% of the index, it’s extreme today. The dominance of a small group of stocks is also apparent globally. One of our respected stock managers shared with us a September 1 Bloomberg article that included a number of insights. As noted by Bloomberg, there are 9,000 companies in indexes that track the broad global market, but just 30 of them produced more than 70% of the total gain over the past five years, more than half of those U.S. companies. Ten stocks – Amazon, Apple, Microsoft, Nvidia and Advanced Micro Devices in the U.S., Alibaba, Tencent Holding and Kweichow Moutai in China, Shopify (Canada) and Magazine Luiza (Brazil) were responsible for more than 50% of gain. And if these statistics were not amazing enough, just three stocks – Amazon, Apple and Microsoft – contributed 25% of the gain.
The important investment takeaway is to not be lured into chasing the returns of what has worked well in the recent past. The “fantastic six” outsized past returns have come from their ascension to the top, not from owning them once they were already there. Owning the largest stocks has badly lagged owning the diversified index over time.
Nevertheless, this U.S. mega cap growth effect is driving the outperformance of U.S. stocks versus foreign stocks this year. Developed international stocks gained 6.0% this quarter, almost three percentage points behind U.S. stocks, though, emerging market stocks outperformed U.S. stocks with a return of 10.2%. Both groups still trail U.S. stocks year to date.
Some of this relative performance is deserved. Unlike in the dot com era, today’s large U.S. growth firms have created real economic value. This has come at a time when growth has been scarce and interest rates low, so investors have been willing to pay up for their growth. That said, a durable economic recovery taking hold could be the catalyst for investors to turn away from these highflyers and favor undervalued stocks in out-of-favor industries and overseas markets.
Bond markets were calm throughout the summer, thanks in large part to the Federal Reserve’s extremely accommodative monetary policy. Treasury yields were unchanged, and core investment grade bonds gained 0.6% in the third quarter. Fed officials say they are now targeting “average inflation” of 2% and have signaled that they do not expect to raise rates at least through the end of 2023. Since inflation has not topped the Fed’s target in a decade, many market participants expect low rates and supportive policy to continue for a long time. In riskier segments of the bond market, high yield bonds and floating rate loans were each up over 4% but remain slightly negative for the year.
Going into the final quarter of 2020, multiple crosscurrents and uncertainties are presenting both investment opportunities and risks, over the near term and medium to longer term. A unique U.S. election approaches in November. The market doesn’t like uncertainty, so the weeks leading up to the election and afterward may be volatile. But history shows any election year declines are usually short lived and the political party in power is not a significant driver of investment returns. Because of the short term nature, political views have no place in our investment process, and we don’t attempt to predict the short term market reaction to elections (or any short term event). There are simply too many other factors that impact markets over time. Instead, we stick to our longer-term analytical framework in which we consider and weigh multiple macro scenarios and assess the potential risks and returns for numerous asset classes and investments in each scenario. The fundamentals are what really drive long term market performance.
Looking through the election, there are reasons to be cautiously optimistic about the investment prospects for global equities and corporate bonds. And there are reasons for caution.
Reasons for Optimism
An economic recovery is underway. Economic data and forecasts are improving (see the growth projections from the Organization for Economic Cooperation and Development, or OECD, in the chart above). All else equal, rebounding economic growth here and abroad should support equity and corporate bond markets.
On the virus front, the speed of progress in vaccine development is promising. An effective and widely distributed vaccine would allow economic activity to return to its full pre pandemic potential.
And this year’s extraordinarily supportive monetary policy (asset purchases and lower interest rates) and huge fiscal stimulus, both here and abroad, were key drivers of the speedy recovery in markets and the global economy. Central bank actions and government spending don’t guarantee the absence of volatility, another bear market, or recession. But there are programs now in place, especially in the United States, that could step in to help the functioning of markets and the economy in case volatility returns or setbacks occur. The Fed actions to drive down interest rates do result in U.S. stocks looking cheap relative to bonds, however stocks do not provide the portfolio protection that bonds do (even at the current lower interest rates).
Reasons for Caution
It remains to be seen how strong the actual economic recovery is and how much of it is already discounted in current prices. In our view, there is as much room for disappointments as there is for positive surprises. U.S. stocks are expensive (again) relative to history on a number of valuation benchmarks.
Election uncertainty could cause financial market volatility and a disputed result or ballot counting could mean greater volatility than usual.
While vaccine development steams ahead, the potential remains for a large resurgence of COVID-19 in the fall and winter months. We are seeing this already in Europe, and the infection rate has popped up slightly here in the United States recently. This raises the risk of renewed shutdowns and another economic downturn.
Monetary policy is supportive, but more fiscal support from Congress is likely needed to further protect citizens, help businesses survive, and shore up state finances. If it doesn’t happen, it will be a hit to fourth quarter economic growth, which could in turn impact markets.
Finally, there is always the potential for a negative geopolitical shock. The U.S.-China conflict and Brexit come to mind, but a new development could emerge that no one is considering (like the pandemic did earlier this year).
We are very comfortable with how our portfolios are constructed, as detailed below. The watchwords of our current positioning remain balance and resilience. Our portfolios are balanced across multiple dimensions: domestic versus international stock exposure, growth versus value strategies, interest rate risk versus credit risk, and traditional versus alternative investments. And we’ve designed our portfolios with the goal of generating potentially strong returns in more optimistic economic scenarios (especially a more fully open economy), while maintaining resilience in a more challenging scenario.
On the equity side of our portfolios, as a reminder, we were underweight to U.S. stocks and stocks in general for our balanced portfolios going into the pandemic due to unattractive valuations. In March after an initial large decline, we added to U.S. equity exposure at more attractive prices. Since that time, U.S. stocks have appreciated strongly, outperforming most other investments. They have soared more than 50% from the March low and again look historically overvalued. Forward price-to-earnings (P/E) and median P/E ratios are approaching dot-com-bubble highs. Nothing prevents valuations from rising even further near term, but we know high starting point valuations have a strong inverse relationship with future long term returns. Overvaluation tends to not matter until it does. One thing that we don’t want to do is chase performance of things that are working well right now. We know that a diversified portfolio will always underperform what is doing the best. Right now what is doing the best is U.S. large stocks as mentioned earlier. This will not always be the case.
But while U.S. stock valuations look expensive relative to history, they look cheap relative to bonds. Bond yields are extremely low, which forces investors to allocate more to stocks, pushing stock valuations even higher or keeping them higher for longer. Our balanced portfolios are now at our neutral weighting for stocks.
The third broad component of our balanced portfolios comprises multi strategy alternatives. We reduced the weighting to add to U.S. stocks in March but maintain a meaningful allocation for our balanced portfolios. These investments further diversify equity and bond market risk and are intended to generate returns over time that are better than core bonds and with less volatility than stocks.
History shows markets are consistently unpredictable. Just look at the results from the earlier part of this year as no one predicted the pandemic, the subsequent market reaction and related recovery, all occurring in record time. We continue to deal with the uncertainty in the unprecedented circumstances, as well as the related challenges, and structural changes the global economy is currently facing.
Having a high degree of conviction in any single outcome strikes us as imprudent. Instead of trying to continuously predict the future, we are focused on building resilient portfolios across multiple plausible scenarios, accounting for a range of shorter-term risks but keeping our primary focus on the medium- to longer-term fundamentals that ultimately drive investment returns.
Investing this way requires discipline, patience, and a willingness to stand away from the herd at times. It can feel uncomfortable to stay the course, put capital at risk when markets are plunging, or refrain from chasing overvalued markets higher when they are soaring. But in the end, this is the best approach we’ve found to achieve long-term investment goals.
We recently became aware of a local Jacksonville firm who believed that they could time the markets and they got the timing exactly wrong. They exited the markets in early April after prices had already come down and they started entering the market again in August, after markets had already come up. The temptation is always there to try to do this and we hear from clients on a regular basis about wanting to sell when markets are down, when it is “scary” or buy more of what is doing well when those prices are up. We believe that a large part of the extra returns earned by our clients is in developing a game plan that they can stick with and advising them against these type of moves.
Summary Of Themes From Calls with Our Stock And Bond Managers
We conduct a lot of calls and meetings with the managers we utilize for our portfolios throughout the year. We typically increase these when volatility is at its highest. This provides us insight into how the managers are reacting and we can then evaluate their decisions after the smoke has cleared. We conducted a large number of these calls in the late June and early July time period. In this section of the newsletter we wanted to provide some broad themes that we are hearing.
Many of our managers were finding lots of opportunities on the stock side back in the early days of the pandemic. This allowed them to upgrade their portfolios and deploy cash that was on the sideline. The consensus was that the pandemic may lead to a downturn but that downturns bring opportunity. There are companies that will not be as impacted as others. By July most of these opportunities were gone, particularly in the U.S. as the market increased in value. Managers started looking at international stocks, if they could add them under their mandate. On the bond side similar events occurred where managers were finding some bargains in March. For many they had only a limited time to act as the Federal Reserve backstopped bonds by making unprecedented moves to buy ETFs and individual corporate issues.
We have also discussed the price gap between value and growth stocks with many of our managers. These gaps are now some of the widest in history. One of the hardest things to know is when this will reverse itself and what will cause it. We spend a lot of time talking about stocks that are doing well vs. those that are doing badly and questioning our managers’ thesis around why this is. Many point to stocks like Shopify as an example of excess in current valuations. The company has no current earnings and is worth $129 billion dollars because of the promise of cloud based strategies for mid sized businesses. Meanwhile a company like BNY Mellon, which is one of the largest custodial banks in the world, trades for only 8 times earnings and is worth $33 billion dollars. Our managers believe that when things don’t make sense you don’t try to change how you evaluate companies to reflect the new reality. Instead you keep your conviction that at some point the world will make sense again. This is how these managers have made money through previous crises like 1999-2003 and 2007-2009 and we think it will work again.
River Capital Advisors News
Tax filing season finally ended October 15. Due to the pandemic and IRS filing date changes, we have been working with clients and their returns since March. We identified tax planning opportunities during the year as well – we took tax advantage of the early year sell off to harvest tax losses and as noted earlier, added to U.S. stocks. This resulted in many of our clients having tax losses on hand to offset current and future year capital gains. The positions subsequently recovered as stock markets gained. We also worked with clients to undo required minimum distributions they took early in the year, as the CARES act included provisions to eliminate the need for distributions for the year. This helped clients avoid taxes they would have otherwise been paid. We are now talking with clients that have not taken IRA distributions about their options. There are a few different ways that clients can take advantage of the new law depending on their need for distributions and their tax sensitivity. Ideally, if a client doesn’t need withdrawals from their IRA they can leave the dollars invested which will defer taxes to future years and increase growth.
We believe that proper tax planning is an important part of portfolio returns, although the incremental return is not seen directly on statements. We have incorporated many tax planning concepts into our asset allocations and portfolio process since our founding in 1998.
We are talking to more clients about the benefits of donor advised funds (DAFs), especially with the current higher standard deduction amounts. DAFs can be used in lieu of “bunching” charitable donations, as one benefit from the client and charity perspective is the ability to give each calendar year. Bunching results in a year where a client does not give to charity. DAFs can also be used to smooth out the process of giving appreciated securities to several different charities as the DAF can accept the securities and the charities will receive cash.
Giving away appreciated securities continues to make sense for clients as they avoid the gain on sale, if they are charitably inclined. With a DAF any IRS recognized charity can be given to. Giving cash to a charity is the least tax efficient way you can give. Let us know if you would like to discuss these or any other tax strategies.
We are also keeping a close eye on the elections and the prospect of significant changes to the income and estate tax law. During recent client meetings, we have shared insights on what a Biden presidency might mean from an income and estate tax perspective, while also educating clients that their investment plan should not try to anticipate the result of the presidential election – we believe individuals spend way too much time with a focus on what a change in President means from an investment perspective. This happens every four years and we have educated clients that historically, going back to the early 1900’s, what is most impactful to market prices is growing cash flows and profits, which drive equity prices. Equity prices are generally up more than they are down and over time, stocks are one of the best ways to grow net worth.
We have used the following Ben Graham quote before but think it is useful to share again:
“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.”