Tag Archives: asset-allocation

The Dead Model

Click to enlarge How Lucky Do You Feel? Nine years ago, I wrote about the so-called “Fed Model.” The insights there are still true, though the model has yielded no useful signals over that time. It would have told you to remain in stocks, which given the way many panic, would not have been a bad decision. I’m here to write about a related issue this evening. To a first approximation, most investment judgments are a comparison between two figures, whether most people want to admit it or not. Take the “Fed Model” as an example . You decide to invest in stocks or not based on the difference between Treasury yields and the earnings yield of stocks as a whole. Now with interest rates so low, belief in the Fed Model is tantamount to saying “there is no alternative to stocks.” [TINA] That should make everyone take a step back and say, “Wait. You mean that stocks can’t do badly when Treasury yields are low, even if it is due to deflationary conditions?” Well, if there were only two assets to choose from, a S&P 500 index fund and 10-year Treasuries, and that might be the case, especially if the government were borrowing on behalf of the corporations. Here’s why: in my prior piece on the Fed Model, I showed how the Fed Model was basically an implication of the Dividend Discount Model. With a few simplifying assumptions, the model collapses to the differences between the earnings yield of the corporation/index and its cost of capital. Now that’s a basic idea that makes sense, particularly when consider how corporations work. If a corporation can issue cheap debt capital to retire stock with a higher yield on earnings, in the short-run it is a plus for the stock. After all, if the markets have priced the debt so richly, the trade of expensive debt for cheap equity makes sense in foresight, even if a bad scenario comes along afterwards. If true for corporations, it should be true for the market as a whole. The means the “Fed Model” is a good concept, but not as commonly practiced, using Treasuries – rather, the firm’s cost of capital is the tradeoff. My proxy for the cost of capital for the market as a whole is the long-term Moody’s Baa bond index, for which we have about 100 years of yield data. It’s not perfect, but here are some reasons why it is a reasonable proxy: Like equity, which is a long duration asset, these bonds in the index are noncallable with 25-30 years of maturity. The Baa bonds are on the cusp of investment grade. The equity of the S&P 500 is not investment grade in the same sense as a bond, but its cash flows are very reliable on average. You could tranche off a pseudo-debt interest in a way akin to the old Americus Trusts , and the cash flows would price out much like corporate debt or a preferred stock interest. The debt ratings of most of the S&P 500 would be strong investment grade. Mixing in equity and extending to a bond of 25-30 years throws on enough yield that it is going to be comparable to the cost of capital, with perhaps a spread to compensate for the difference. As such, I think a better comparison is the earnings yield on the S&P 500 vs the yield on the Moody’s BAA index if you’re going to do something like the Fed Model. That’s a better pair to compare against one another. Click to enlarge A new take on the Equity Premium! That brings up another bad binary comparison that is common – the equity premium. What do stock returns have to with the returns on T-bills? Directly, they have nothing to do with one another. Indirectly, as in the above slide from a recent presentation that I gave, the spread between the two of them can be broken into the sum of three spreads that are more commonly analyzed – those of maturity risk, credit risk and business risk. (And the last of those should be split into an economic earnings factor and a valuation change factor.) This is why I’m not a fan of the concept of the equity premium . The concept relies on the idea that equities and T-bills are a binary choice within the beta calculation, as if only the risky returns trade against one another. The returns of equities can be explained in a simpler non-binary way, one that a businessman or bond manager could appreciate. At certain points lending long is attractive, or taking credit risk, or raising capital to start a business. Together these form an explanation for equity returns more robust than the non-informative academic view of the equity premium, which mysteriously appears out of nowhere. Summary When looking at investment analyses, ask “What’s the comparison here?” By doing that, you will make more intelligent investment decisions. Even a simple purchase or sale of stock makes a statement about the relative desirability of cash versus the stock. ( That’s why I prefer swap transactions .) People aren’t always good at knowing what they are comparing, so pay attention, and you may find that the comparison doesn’t make much sense, leading you to ask different questions as a result. Disclosure: None

‘Go For Growth’ Still A Sound Strategy In Today’s Market

Stocks perceived as mitigating the effects of market volatility were popular among investors in the first quarter. Big swings in equity markets drove a flight to quality that benefitted dividend-paying sectors such as Utilities and Telecommunication Services (which were the two best-performing sectors in both ACWI and the Russell 3000). We largely have avoided those sectors due to their elevated valuations and the fact that we don’t believe they offer the growth possibilities that are necessary to generate long-term returns. While some high-profile growth stocks trade at triple-digit P/E valuations today, the reality is that the vast majority of growth stocks do not, and we do not believe it is worthwhile to examine what is happening with the growth story. The case for growth stocks in a low-growth world is relatively straightforward. All else being equal, companies that are capable of delivering above-average growth in a low-growth world should be rewarded by investors over time. However, in investing, all else is rarely equal. A high-growth stock at an unsustainably high valuation can be just as risky as – or even more risky than – a company that is in secular decline. 2015 was the best year since 2009 for major U.S. growth indices (e.g., Russell 1000 Growth, S&P 500 Growth) versus their value counterparts (e.g., Russell 1000 Value, S&P 500 Value), so it makes sense to take a deeper dive. The median growth stock trades at a similar valuation (on both an absolute and relative basis versus non-growth stocks) to where it started 2015. For example, the median P/E of Russell 1000 Growth stocks that have no weight assigned to the Russell 1000 Value traded at a next 12-month P/E of 19.4 at the start of 2015. This group of stocks entered 2016 with a very similar next 12-month P/E of 19.5, and ended the first quarter at 19.7. Absolute valuations for this group as a whole are not cheap, and therefore, risks associated with coming up short of investor expectations can be high. However, the premium for these high-growth businesses versus the rest of the Russell 1000 is well within historical norms (see chart below). Against this backdrop, we continue to seek opportunities to own well-positioned, growth-oriented businesses with valuations that offer attractive compensation for the risks taken. The number of such opportunities might be fewer than earlier in the current market cycle, but we believe a selective and active approach to investing can maximize the likelihood of finding such companies today. Click to enlarge Investing in companies that can grow their earnings at rates above the trend in broad economic growth is particularly important in today’s slow-growth economy. As an illustration, we’ve taken returns in the U.S. equity market on a rolling 10-year basis and broken them down into how much came from earnings growth and how much came from changes in the P/E multiple (i.e., multiple expansion or contraction). Beginning in 1970, it has been earnings growth that has been more consistent and stable most of the time (see chart below). Historically, earnings growth has been a more reliable contributor to the returns we get as investors than multiple expansion. Click to enlarge While there certainly are periods in which multiple expansion drove or provided a boost to returns, changes in multiples have been quite volatile. In the 1980s and 1990s – when multiple growth helped returns – the market was coming off some attractive starting valuations and had a backdrop that was favorable for rising valuations. As a result, there was solid multiple expansion. But before that – and, more importantly, recently – not only could investors not rely on multiple expansion, they also had to deal with multiple contraction. This is one illustration of why we believe it is particularly important right now to focus on companies that are capable of growing their earnings on an individual basis, which, in our view, puts investors in a much better position to generate positive returns. Past performance does not guarantee future results.

What Makes A Stock Go Up (Or Down)?

When it comes to the stock market, one thing is for certain: stocks go up and stocks go down. The question is: what makes a stock go up or down? What makes a stock go up or down is determined by the recent operating results of a business and its future expectations. This means stock prices reflect both fundamentals (operating results) and emotions (future expectations). When either one or both of these change for a particular stock, its price will be affected. What Makes A Stock Go Up (Or Down)? It’s impossible to pinpoint exactly what makes a stock go up or down on a daily basis. To borrow a phrase from The Princess Bride , “Anyone who says differently is selling something.” On the other hand, it’s quite simple to see what makes a stock go up or down over time. Stock prices are based on how investors think a company will perform in the future compared to how the company is performing now. In any investment, investors are betting on the future. Because the future is uncertain, stocks cannot be priced based on a business’s current operating results alone. They must be valued by predicting future performance. Price Ratios In order to quantify these predictions, investors use price ratios. Price ratios are simple tools which show how a stock is priced compared to its recent operating results. For example, a Price-to-Earnings (P/E) ratio of 10 says that a stock is valued 10 times higher than its current earnings. This does not mean that investors expect the company’s earning to increase by a multiple of 10 in the near future. It merely means that if the earnings were to stay constant, investors would break even on their initial investment after 10 years. In other words, the earnings yield on the principal is 10% (10/100 = 0.1). Say a stock has a P/E of 50 and investors still expect to receive an earnings yield of 10%. Paying 50 times earnings only makes sense if the company’s earnings are expected to increase substantially over time. Multiple Futures No matter how badly stock analysts pretend to be fortune tellers, no one can accurately forecast a company’s future performance (especially on a consistent basis). Charles Duhigg, in his book Smarter, Faster, Better: The Secrets of Being Productive in Life and Business , summarizes the reality of what the future is. Duhigg says, “The future isn’t one thing. Rather, it is a multitude of possibilities that often contradict one another until one of them comes true.” These multitude of possibilities are what cause price ratios to fluctuate so often for any one stock. Although there are countless numbers of possible futures when considering a stock investment, there are really only three general scenarios. Scenario #1: A company’s operating results will increase. Scenario #2: A company’s operating results will remain constant. Scenario #3: A company’s operating results will decrease. The level of a stock’s price ratios is determined based on which scenario investors anticipate will come true for that particular stock. Scenario #1: High price ratios. Scenario #2: Average price ratios. Scenario #3: Low price ratios. Operating Results Before getting too focused on price ratios, it’s important to remember that change in operating results is the second half to determining what makes a stock go up or down. Say a stock is reporting earnings per share (EPS) of $5 and has a P/E of 10. The stock would be valued at $50 per share ($5 x 10 = $50). Then, the company unexpectedly reports EPS of $5.50. If the P/E stays at 10, the stock is now valued at $55 per share. To summarize, stock prices go up or down depending on changes in operating results and the levels of its price ratios. The interesting thing is that changes in operating results most often trigger changes in price ratios. Because the future is hard to predict, operating results often differ (sometimes greatly) from what investors expect them to be. When a surprise like this happens, future expectations are reconsidered and price ratios are modified. Impact of Surprises In David Dreman’s book, Contrarian Investment Strategies: The Psychological Edge , he notes the impact of such surprises. Here is Dreman discussing the market’s reaction to unexpected results: Several researchers have found that when a company reports an earnings surprise (that is, a figure above or below the consensus of analysts’ forecasts), prices move up when the surprise is positive and down when it is negative.” It makes intuitive sense that stock price adjustments correlate with positive or negative surprises. Not only do the surprises reveal a change in operating results, but the change in operating results affect the future expectations of the company. This explains why value stocks (low price ratios) outperform growth stocks (high price ratios) over time. Value Goes Up, Growth Goes Down Low price ratios anticipate negative futures (decreased profits) and high price ratios anticipate positive futures (increased profits). Therefore, stocks with low price ratios have more upside potential. On the flip side, stocks with high price ratios have nowhere to go but down. In Contrarian Investment Strategies , Dreman references several studies which show that positive surprises impact value stocks greatly but only minimally affect growth stocks. The studies similarly show that negative surprises impact growth stocks greatly but only minimally affect value stocks. Here’s Dreman explaining the impact that both positive and negative surprises have on growth stocks: Growth Stocks: Positive Surprises Since analysts and investors alike believe that they can judge precisely which stocks will be the real winners in the years ahead, a positive surprise does little more than confirm their expectations.” Growth Stocks: Negative Surprises Investors expect only glowingly results for these stocks. After all, they confidently – overconfidently – believe that they can divine the future of a ‘good’ stock with precision. Those stocks are not supposed to disappoint. People pay top dollar for them for exactly this reason. So when a negative surprise arrives, the results are devastating.” And here’s Dreman explaining the impact that both positive and negative surprises have on value stocks: Value Stocks: Positive Surprises Those stock moved into the lowest category precisely because they were expected to continue to be dullards. They are the dogs of the investment world and investors believe they deserve minimal valuations. A positive earnings surprise for a stock in this group is an event. Investors sit up and take notice. Maybe, they think, these stocks are not as bad as analysts and investors believed.” Value Stocks: Negative Surprises Investors have low expectations for what they believe to be lackluster or bad stocks, and when these stocks do disappoint, few eyebrows are raised. The bottom line is that a negative surprise is not much of an event.” Fundamentals Change Expectations These scenarios explain why value stocks have nowhere to go but up, and growth stocks can only go down. If a value stock’s fundamentals unexpectedly increase, not only will its operating results improve, but investors’ future expectations will be raised as a result. Contrarily, a growth stock’s fundamentals are already expected to increase. Any improvement in operating results is already priced into the stock. Decreased operating results are already priced into value stocks but not growth stocks. Unexpected poor performances wreak havoc on growth stocks, but not value stocks. Buy Value Stocks Because human emotion plays a critical role in what makes a stock go up or down during the short term, investors are wise to invest where expectations are low and positive surprises are likely. To paraphrase a line from The Wolf of Wall Street, “It doesn’t matter if you’re Warren Buffett or Jimmy Buffett, no one knows if a stock will go up, down, or sideways.” We can know, however, which stocks are more likely to go up. Buying stocks with low price ratios is a time-tested approach to achieving superior investment returns.