The following commentary represents the views of the Multi-Cap Value Strategy Team.
Since hitting bottom in March 2009, stocks have enjoyed an historic advance. The S&P 500 has surged more than 180%, capped off by last year’s 32+% gain. Yet even as the average stock now trades at an all-time high, many have called this the most hated equity bull market ever. Investor sentiment has remained remarkably subdued over most of this period. For example, U.S. equity mutual funds continued to experience net outflows from 2009 through 2012, even as share prices kept rising; net inflows into domestic equity funds finally turned positive last year, but not dramatically so. The reason for this cautious behavior is simple: Investors are still nursing their wounds from two horrendous bear markets (2000-02 and 2007-09) in the past 15 years.
While we don’t see a repeat of the financial crisis on the horizon, we are also skeptical of claims that stocks are in the midst a new long-term bull market, much like that which prevailed during the 1980s and 1990s. Historically, secular bull markets begin during periods of high inflation and high interest rates combined with low equity valuations; as inflation and interest rates decline, stock P/E ratios expand to produce above-average returns. These conditions simply don’t exist today. Share prices are trading near the upper end of their historical multiples, and interest rates and inflation remain near all-time lows, with nowhere to go but up (though the timing of a move higher is uncertain). The picture looks worse when you consider the ongoing headwinds of global deleveraging and below-trend economic growth. For these (and other) reasons, we believe that stocks are likely to deliver more modest gains in the future than in the recent past; moreover, this could include sizable periods where share prices remain trapped within a trading range.
Yet this is not to suggest that all is somehow lost, or that equity investors must necessarily resign themselves to a long stretch of poor performance. Even a low-return stock market regularly offers up attractive places to invest. But it does mean, in our view, that a more opportunistic investment approach greatly increases the chances of achieving superior returns.This is what we seek to accomplish in constructing the Model Portfolio within our Multi-Cap Value investment strategy. The main tenets of our approach are summarized below. While our focus at present is on outperforming in a low-return or range-bound market, we believe these principles have broad application to all types of market environments.
- Construct an uncorrelated portfolio – It stands to reason that if the major stock market averages are priced to generate subpar returns in the future, then a portfolio resembling the stock market will perform in essentially the same way – or more likely even worse, after subtracting for fees. To avoid this trap, the holdings in the Model Portfolio are typically diversified by, among other things: market capitalization (large, mid, and small); primary driver of expected return (e.g., P/E expansion, sustained earnings growth, or some combination thereof); implied volatility (below-average versus above-average beta); expected holding period (e.g., long-term sustainable growth versus shorter-term restructuring); and geographic location (domestic versus foreign).
- Avoid a dogmatic buy and hold strategy – It doesn’t pay to be greedy in a range-bound market. Since few stocks can break free of the thrashing and churning action of the broader market indices, it often pays to realize meaningful gains whenever the opportunity arises. This requires a stricter sell discipline. Sometimes it means pruning back a position that has outperformed, while a full sale may be more appropriate in other cases. Failure to act means there’s a decent chance that much or all of the capital appreciation achieved during good times will be given back later during subsequent market corrections. The good news is that wide trading ranges in share prices mean investors will typically over time have several opportunities to profit from buying and selling the same high-quality stocks.
- Prevent small losses from becoming large losses – Recouping losses in a low-return environment, where opportunities for sustainable price appreciation are fewer, is, by definition, more difficult and time-consuming than during a bull market. Remember that range-bound markets, unlike bull markets, won’t bail you out of your mistakes. Because valuations typically compress over time in these market conditions, the downside potential in most company shares is greater than the upside, even when earnings rise. Stocks are routinely punished far more for delivering bad news than they are rewarded for good news. This means that avoidance of large losses, which is essential to superior long-term performance in the best of times, takes on even greater importance now. This is another reason for adopting a stricter sell discipline.
- Increase your margin of safety – Typically, value investors seek to buy stocks that are significantly mispriced relative to their normalized earnings power and where the market’s expectations for the future are excessively depressed. This approach can be particularly effective in avoiding the effects of P/E compression in low-return markets. Since these stocks are already “washed out,” there is usually little additional downside as all the bad news and negative expectations for the future have been baked into the share price. Another profitable tactic is to buy shares of companies that pay, and can easily sustain and grow, attractive dividends. These companies may not have much sex appeal, but investors will find it much easier to generate a 10+% return from a stock, where a substantial part of it comes guaranteed in the form of cash dividends. Then, so long as the equity valuation stays the same, the company needs only to generate mid-to-high single digit earnings growth to satisfy the second half of the return equation.
- Prudently increase risk exposure when market conditions are favorable – The number of truly attractive opportunities in low-return markets are fewer than normal, so you must take advantage of them when they arise. Large selloffs in the market and/or in individual stocks may produce the kind of conditions – cheap valuations and depressed sentiment – that shift the odds of a favorable outcome strongly in investors’ favor. In that case, we seek to gradually build up more concentrated positions in those holdings that we believe possess the most favorable profile of excess return versus below-average risk of loss. Sometimes this requires us to buy more of a position on the way down, thereby lowering our average cost. We subsequently expect to pare back these larger positions at a meaningful gain as our investment thesis plays out over time.
- Don’t ignore the global economic environment – In the past, investors could, if they chose, safely ignore much of the financial news flow coming from outside the U.S. While U.S equity markets were occasionally roiled by overseas economic events, such as the Asian currency crisis in the late-1990s and Latin American debt crisis in the early-1980s, this was the exception and not the rule. But this is no longer true today. Investing now takes place on a global playing field, with large gains or losses in one country’s financial markets often sparking a chain reaction in markets across the globe. While company-specific considerations should always be paramount in security selection, investors who choose to bury their heads in the sand rather than pay attention to “faraway” economic/political events do so at their peril.
- Use cash as a risk-management tool – In a range-bound market, cash is most certainly not trash. Even with money-market rates currently near zero, we believe it’s far better to hold cash than to unnecessarily put it at risk when attractive investment opportunities are scarce. Cash helps cushion the Model Portfolio against loss and allows us to take advantage of periodic corrections in the stock market and in individual stocks. The size of the cash reserve in our Model Portfolio naturally adjusts itself according to market conditions, falling when stock prices are cheap and rising when they are dear.
The information herein has been obtained from sources we believe to be reliable but is not guaranteed and does not purport to be a complete statement of all material facts. This report is for informational purposes only. The views expressed represent the opinions of the Multi-Cap Value Strategy Team and are not intended as a forecast or guarantee of future results. All securities trading, whether in stocks, options or other investment vehicles, is speculative in nature and involves substantial risk of loss.