RECENT HAPPENINGS AND THE MARKETS YEAR TO DATE
The last few weeks have definitely been volatile and full of market moving news. Greece defaulted on its loan to the International Monetary Fund and may be exiting the Euro zone. China has seen its stock market drop by over 20%. Puerto Rico tried to find a way to get a bailout of sorts from Washington for its debt issues. We will touch on each of these briefly in this letter but first let's look at the markets and what has happened year to date.
We have been writing for some time about how the markets outside the U.S. are much more attractive from a valuation perspective than local companies (Something we can learn from the French). Last year, non-U.S. investments largely lost value while the U.S. large company valuations continued to expand. As Ben Graham is fond of saying, "In the short run the market is a voting machine, but in the long run it is a weighing machine." Last year was one where the market rewarded momentum. This year it seems the undervalued areas are starting to more life. Non-U.S. investments have done best so far, especially the smaller companies, even with what has been happening in Greece and China. Gold, REITs, energy, commodities and bonds are all underwater year to date. And lastly U.S. equities through the first half of the year have been treading water.
Our more aggressive models with exposure to a greater percentage of smaller companies are doing relatively well. Through the end of the year our global long term stock model is up approximately 5.4% with the other more conservative stock models trailing alongside the M.F. models. Currently all models whether they be stock or M.F. models are positive for the year.
The last few years have rewarded non-diversified portfolios. Diversified portfolios will tend to show more consistent returns over the long run although many can make a case for investing in a focused portfolio of best ideas and how this can do well over time (Should Investors Abandon Diversified Portfolios). Our M.F. models are more attuned to diversified portfolios that will benefit when the blue bars (above chart) are prevalent. Our stock models are more focused and have definitely outperformed during the years when diversified portfolios are penalized. Generally speaking, more conservative investors are better served by making sure they are diversified and may not be able to handle the swings associated with more concentrated investing.
As we noted in our Greek Default article earlier this month, we do not feel that the actions taken by the Greek government will have near the impact on other European nations as many investors fear and have even less impact upon our markets here in the United States. China on the other hand is a much larger country and seems to be undergoing many speculative excesses that we saw on our shores in the late 1990s. When companies are rampantly re-branding themselves as high-tech companies and pet food companies, fan makers and sauna companies are trading at multiples over 200 times earnings, it is wise to be wary. This said, it is hard to tell how big you can blow up the balloon until it bursts.
Here in the U.S. even though some indices are slightly up for the year we are currently seeing a lower percentage of stocks advancing and making new highs and a greater percentage declining and making new lows. This is a sign of a somewhat worn out market.
The length of this bull market (starting in March of 2009) has now lasted longer than all but two bull markets since World War II. We are now a few months away from passing up the 1960s expansion but not too close to catching the 1990s expansion. It has also been almost four years since we had a correction of greater than 10%. The last time this happened was toward the end of 2007. With the average investor more optimistic than they have been since 2004 it may be that the market thinks we are not going to have any more corrections or larger pullbacks. Every time I can remember people saying that this time things are different, they had a rude awakening.
In our experience we have found that company CEOs, CFOs and other insiders are best at weighing the value of the companies they manage, usually followed by a select number of money managers and institutions. We prefer to look at the buy - sell ratio in that CEOs are typically best knowing when their company stock should be bought and is undervalued versus sold and is overvalued. The CEO buy-sell ratio has not been as low as it is currently since mid 2007. It is interesting to note however that we have been seeing strong CEO buy - sell activity in Energy companies and Financials recently. Corporate share repurchases (buybacks) and merger - acquisition activity is also down from 2014 year to date.
Conversely, the market in general usually over-reacts to news and lets things go to extremes of over-valuation and under-valuation. At the extremes, we also typically see rampant borrowing to buy stock at higher and higher multiples. I did not think we would see margin debt levels grow to levels higher than what we were seeing in February of last year, but the April 2015 numbers were even higher. This definitely gives us concerns.
As we noted a few months ago, we also have to go back over 30 years to find a time when U.S. companies were more overvalued when compared to their European counterparts. The European Union is pumping hundreds of billions of stimulus Euros into their economy every quarter currently whereas here in the U.S. we are looking at the possibility of raising rates. For these reasons we feel that many foreign investments look more attractive than what we can find locally.
PLAYING DEFENSE (EVOLVING STRATEGIES)
Our models moved into defensive mode in early to mid May this year. We reduced our stock exposure, but not quite as much as we have in years past. With interest rates at historical lows and the potential for rate increases later this year, we have taken a slightly different approach recently. In our M.F. models we reduced exposure to U.S. stocks but we also reduced exposure to global bonds, choosing instead to reallocate to balanced portfolios. Especially in non-U.S. markets, earnings yields and in many cases dividend yields are a bit higher than bond yields. U.S. earnings yields are currently almost 4% more than treasuries and many other countries have even higher spreads. This is a somewhat rare occurrence over the last 40 to 50 years.
We have talked and written at length about bond alternatives over the last year (Bond, James Bond) and wrote on what sectors and alternative investments hold their value during turbulent market conditions (Not Selling in May? Best and Worst Sectors). To this end we have reduced our exposure in our Stock models to transports, technology, defense, and entertainment and increased our exposure to consumer staples, health care, low volatility foreign stocks and tax free bonds. We are still holding many financial and energy companies (especially MLPs) because we see a good bit of value there and company CEOs are currently buying shares in these companies on balance.
A NOTE ABOUT RESEARCH
In our recent article (What Works on Wall Street - In Reality) we wrote on the three fundamental factors to look at when researching stock investments. Quality is most important when considering a buy and hold philosophy. Momentum is most important if you want to see gains immediately. Value is most important when we are focused on "Margin of Safety" and protecting the downside. When I can find all three wrapped in one, I get excited. But where do we get our ideas?
One of our favorite places to find investment ideas is just what we encounter in everyday life. If a company wows us, offers a truly unique service or seems to have everything going for it in a new, under the radar industry without any apparent real competition, we may have found a real gem. Other opportunities are found by running screens or through investment services and newsletters. We regularly scour reports and screens through Valueline, Zacks, S&P, Thomson Reuters and other services for new or improving opportunities. Spinoffs and re-organizations are many times under-followed and offer hidden value. Having many contacts at previous firms, we are also able to access research reports from many brokerage houses although we are more suspect of many of these reports, especially if they have investment banking relationships (See Wall Street's Pigs and Wolves).
Many of these "wirehouses" and increasingly money management companies are displaying more preference toward proprietary products (Do you Really Know What You Own?). With the advent of "robo-advice" it is interesting to see how often a "robo-advisor" or even some of these more inexperienced human advisors who are cutting their teeth at these companies are creating portfolios where a majority of the investments and sometimes all of the investments are proprietary products. When meeting with new clients, we many times can see these showing up in the portfolios. Why limit yourself to just Vanguard, Fidelity, Russell or Wells Fargo funds when you can select the best from each bunch. That is what we feel is best for clients.
Where do we most like to find investment ideas? We look at when the company CEOs are buying more stock in their own company. I can think of no good reason why a CEO would want to make a significant additional investment in their own company unless they thought it was a great value or wanted more voting power. Significant company share buyback plans come in closely behind CEO purchases and the reports to access this information is readily available, if you know where to look.
Data as of July 13th, 2015