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Stock Market Control

Summary History shows there is a one in three chance that stocks will drop each year regardless of whatever happened the prior year. We think there are certain things we can’t control in the stock market. We try to control what we own, how cheap it is, how often we make changes to our portfolio and quality from the companies we own. We saw the chart below in a recent Marketwatch.com column from Mark Hulbert. It shows the likelihood of the stock market going up or down in the next year, based on how it did the prior year: This got us thinking about what you can and can’t control in the U.S. stock market. After all, the reason that stocks outperform other liquid asset classes over long stretches of time is the uncertainty and variability of returns. Here is a short list of things, which can’t be controlled in the U.S. stock market: 1. Stock market results The chart shows that there is a one in three chance that stocks will drop each year regardless of whatever happened the prior year. We don’t think investors should buy or own common stocks if they feel emotionally ill-equipped to withstand a losing year. 2. Stock Market Volatility Even in good years, stocks can swing wildly from week to week and month to month. The average year sees a peak to trough decline of 10%, and we have seen a 20% or greater decline about once every five years on average. Twice in the last 16 years, we saw the S&P 500 Index decline by more than 30%. Granted, that is an unusual occurrence, since there have been only five such declines since 1940. We remember telling common stock investors near the bottom of the stock market in March of 2009 that it would likely take about four years to get their portfolio value back to where it was before the decline in 2008-09. Those courageous and patient investors have been well rewarded by the bull market since then. An owner of common stocks should expect gyrations as part of the price of admission and use holding periods, which allow for recovery and success. The wise investor seeks to use wide, sharp and emotional price swings in their favor. 3. Stock Market Unpredictability I am approaching my 36th year participating in the U.S. stock market and can say that nobody has proven any consistent ability to predict price moves in the indexes. I’ve read the prognostications of Joe Granville, Stan Weinstein, Marty Zweig, Comstock Partners, Robert Prechter, George Gilder, Nouriel Roubini, Meredith Whitney and numerous other very smart people in my career. The one thing they have in common is they attracted a large following after being very right on a major stock market prediction. However, doing so consistently is a bit like trying to find the pot of gold at the end of the rainbow. We recently read the musings of a highly respected asset allocation firm about their seven-year predictions of asset class returns. Their prediction for the U.S. stock market is extremely negative, which would scare a normal observer and could very well end up being valid. However, we have been reading their predictions for the last ten years and have seen their consistent pessimism for U.S. stocks. We also remember their optimism about emerging markets and commodities. Surely, these predictions from the last five years must have cost someone who followed their advice some serious money. 4. Relative Performance A study of the best stock picking disciplines of the last 60 years (Buffett, Neff, Templeton, Lynch and Carret) showed that they underperformed the S&P 500 Index 35% of the calendar years during their long and illustrious track records. We expect to be subject to those statistics at best and have very little control over which years we get beat by the index. Our goal is to beat the stock market over ten and twenty-year time periods and we believe those results would be unattainable if you try and smooth that truth. Things We Seek to Control We’re not about being glum or dour. We certainly believe there are things that investors can control. We’ve outlined three key tenets to consider when investing in common stocks. 1. Valuation Matters Dearly You can control which stocks you own, and you are free to emphasize stocks, which are cheap in relation to profits, free cash flow, dividends or book value. Studies show that results are improved over both short and long term holdings periods by constantly reemphasizing cheaper common stocks. This requires a contrarian nature, because when these common stocks are cheap their warts show easily. Therefore, you need to be lonely and courageous. 2. Activity Eats into Returns A wise financial advisor told us in early 2012 that a stock portfolio is like a bar of soap: the more you rub it, the smaller it gets. A 2013 study in the Financial Analysts Journal showed that the average turnover among U.S. large-cap equity funds has been 62% and it costs the average equity mutual fund in the database 0.81% (81 basis points) per year in returns. We seek to own securities for an average of over seven years and attempt to save significantly on trading costs by doing so. If you can control yourself and be very patient, we think you can improve long-term results. 3. Quality Adds Alpha and Promotes Patience Studies have shown that qualitative characteristics like a strong balance sheet, consistently high profitability and low earnings variability add to returns over long time periods. These qualities give owners more ability to stay put in bad stock market environments and/or when a company temporarily stumbles. Riding through thick and thin can be controlled and is augmented if there is no threat of one of your companies going out of business. Again, if you can control yourself, you can use long-durations to let quality help you overcome the forces you can’t control. Conclusion We make no effort to have any control over stock market results, volatility, unpredictability and relative performance. We haven’t got any special ability to know what stocks will do next year or how we will fare on a relative basis. What we do try to control is what we own, how cheap it is, how often we make changes to our portfolio (we subscribe to “lethargy bordering on sloth” – Warren Buffett) and what kind of quality we demand from the companies we buy and own. We do this based on our eight criteria for stock selection. In practicing our discipline, we seek high quality companies, purchased at bargain prices and have a desire to hold them for long time periods. In other words, we try to control ourselves, our portfolio and apply long-durational and favorable probabilities. The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Bill Smead, CIO and CEO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve-month period is available upon request.

Can South Africa ETF Sustain Its Recent Rally?

The South African equity market has been on a roller coaster ride this month recording big, wild moves both ways. The market took a deep plunge after South Africa’s president Jacob Zuma replaced finance minister Nhlanhla Nene, after less than two years of his appointment, with law maker David Van Rooyen (who is relatively unfamiliar and unproven) on December 9. Per reports, Nene’s efforts to cut back spending was not agreed upon in the parliament. This political upheaval dragged down the South African currency to an all-time low and punished the stocks and bonds. Following the removal of Nene, Zuma faced a series of outrages and protests and cries for Zuma’s resignation were widespread. To contain the slide in the market and soothe political uproar, South Africa’s president Jacob Zuma immediately intervened and named well-regarded Pravin Gordhan as the new finance minister who has vowed to restrain the budget deficit and total public debt, Reuters . Market Impact Given the constructive changes in the finance ministry, the South Africa ETF – the iShares MSCI South Africa ETF (NYSEARCA: EZA ) – added about 8.9% on December 14. The ETF lost over 5.8% in the last five days and is off 28.4% in the year-to-date time frame (as of the same date). The ETF also hit a 52-week low on December 11 when shares of EZA were down roughly 42% from their 52-week high price of $73.08/share. Can the Uptrend Last? The fund has been massively beaten down this year by a flurry of issues. The looming Fed lift-off has already soured investors’ mood towards this emerging market. Moreover, South Africa is a commodity-rich nation. Since the greenback is soaring on an impending rate hike, commodity prices are falling fast as most of these are priced in U.S. dollars since one can buy the same quantity of any commodity by a few dollars now. Credit agency Fitch already cut South Africa’s rating on December 4 to barely one mark above the junk status and also added that the firing of Nene “raised more negative than positive questions.” Charts Give Bearish Cues EZA has a Zacks ETF Rank #4 (Sell) with a High risk outlook. For a technical look, the short-term moving average (9-day SMA) for EZA is well below the long-term averages (both 50-Day SMA and 200-Day SMA) signaling further downward movement. Also, EZA is currently trading way below the parabolic SAR indicating a bearish trend for the product. However, the only ray of hope is that the Relative Strength Index (RSI) is around 33.67, suggesting that the ETF is on the verge of entering the oversold territory and is thus due for a trend reversal. Still, for investors who believe that the recent rise in EZA will likely continue for quite some time, we have detailed the ETF below. After all investors should note that much of the Fed-induced blows are currently priced in the present EM valuations. Though emerging market investments will be edgy in 2016, repeated comments made by the Fed on a slow hike trajectory might not hit the EM bloc as badly as is being feared. Also, the fund (EZA) has just 5.3% exposure in materials and 6.7% in the energy sector, and should not be deeply affected by the slumping commodity market. EZA in Focus This ETF looks to track the MSCI South Africa Index. It has a major focus on large and mid-cap equities. The ETF invests about $283.2 million assets in 56 holdings. EZA carries high company-specific concentration risk, with Naspers Limited N Ltd ( OTCPK:NPSNY ) (23.87%), Sasol Ltd (NYSE: SSL ) (6.51%) and MTN Group Ltd ( OTCPK:MTNOY ) (6.28%) taking the top three spots of the basket. From a sector point of view, the fund is tilted towards consumer discretionary (35.7%) and financials (28.9%). The fund charges 62 bps as fees. Original Post

An Unexpected Reason Behind This Strategy’s Outperformance

One of the great anomalies of investing: the historical long-term outperformance of certain smart beta or factor-based strategies relative to the broader equity market (think choosing stocks based on their valuations, momentum, low volatility or quality metrics such as profitability). For example, according to data from MSCI, the MSCI USA Minimum Volatility (USD) index’s Sharpe ratio, a common way to measure risk-adjusted returns, was 0.61 for the last ten years, above the benchmark MSCI USA Index’s 0.44 ratio. The persistence of smart beta strategies’ outperformance relative to the broader market is surprising, because it doesn’t line up with the idea of an efficient market, one in which investors shouldn’t be able to simultaneously buy and sell securities for a profit without taking extra risk (the so-called “no arbitrage” principle ). In other words, in an efficient market, equity portfolios exhibiting low volatility, for instance, shouldn’t be able to earn comparable returns to their higher-risk counterparts. It’s no wonder, then, that numerous academic and financial industry research papers have been written on this topic, and there are various explanations for factor strategies’ outperformance. According to BlackRock’s smart beta experts, including my fellow Blog contributor Sara Shores, this outperformance can generally be attributed to a risk premium, structural impediment or behavioral anomaly. In other words, the outperformance is to compensate investors for taking on what’s actually a higher level of risk, a reflection of market supply-and-demand dynamics or the result of common decision-making biases. Personally, no shocker for my regular readers, I think explanations for this return performance anomaly rooted in behavioral finance add valuable insights to the discussion. In today’s highly connected world, where we can follow each other’s every move via social media, where we’re bombarded by data from every angle – including information on other investors’ positioning and trades – and where it can be hard to tune out the noise, human behavior may be a stronger performance driver than ever. Put another way, I believe investor behavior likely has a lot to do with the strategies’ outperformance. Behavioral explanations focus on investors’ cognitive biases, and the human tendency to use simple rules of thumb to make quick intuitive decisions, with individuals’ collective decision-making mistakes translating into security price distortions. Here’s a look at explanations for the outperformance of four commonly used equity factors. Value: Value stocks are ones that appear cheap in light of their sales, earnings and cash flow trends. Their returns, according to proponents of the efficient market hypothesis, have to do with investors rationally requiring extra compensation for investing in value firms, which tend to be procyclical, have high leverage and have uncertain cash flows. From a behavioral finance perspective, the outperformance of the value factor may have to do with a common decision-making mistake: people’s tendency to look at recent data trends and believe those trends will continue . If investors extrapolate past positive sales or earnings growth data into the future, they may overpay for growth stocks and underpay for value stocks. As a result, the prices of growth stocks may become too high relative to their fundamentals, predicting future reversal and the outperformance of value stocks. Alternatively, some researchers believe people’s tendency to strongly prefer avoiding losses over achieving gains (known as loss aversion) can help explain this anomaly . They hypothesize that loss-averse investors may perceive value stocks as riskier than they truly are, given the stocks’ recent underperformance, and may therefore require a higher future return from these investments. Momentum: This factor focuses on stocks that have strong price momentum , i.e., they have performed well over the past 6-12 months, and strong fundamental momentum, i.e. their earnings have recently been revised upward by security analysts. One explanation for this factor’s outperformance: Investors rationally demanding a higher return for investing in momentum stocks, which tend to be highly correlated and are perceived to perform poorly in times of distress. The behavioral finance explanation for this equity factor’s outperformance, on the other hand, has to do with analysts and investors putting too much weight on their prior beliefs at the expense of new information, leading to slow dissemination of firm-specific information , delayed price reactions to news and price continuation. For example, if investors like a stock and believe it has high earnings growth potential, they tend not to immediately adjust their beliefs sufficiently in light of new negative information – an investing mistake arising in behavioral finance from ” the anchoring-and-adjustment heuristic .” In other words, investors frequently drive price trends by projecting past wins onto future investments, creating a ” herding effect .” Quality: Quality generally describes financially healthy firms with high return on equity, with stable earnings growth and low financial leverage. They can effectively be characterized as having less risk based on their fundamentals . Behaviorally, people may ignore these potentially profitable, yet also perhaps more boring, companies, and instead, veer toward potentially more exciting, yet also less stable, growth and lottery-like stocks (for example, because the more exciting stocks tend to be featured in colorful news stories). As a result, they may end up overpaying for the less-stable stocks, which quality strategies seek to avoid. This predicts future reversal and potential outperformance of quality stocks. Low volatility: The low, or minimum volatility, factor loads up on stocks with low volatility. Low volatility stocks’ excess returns may be rationally explained by leverage constraints. In the absence of access to leverage, investors may overpay for high-volatility stocks in an attempt to increase risk in their portfolios, potentially leading lower-volatility stocks to become more attractively valued and outperform in the future. From a behavioral perspective, these stocks’ outperformance may be due people’s tendency to overestimate small, and underestimate, large probabilities . The idea is that this tendency leads to a preference for lottery-like stocks with a small chance of a very high payoff, and this preference, in turn, drives up the prices of high-volatility stocks disproportionately, suggesting future underperformance. Further, overconfident individuals may veer toward riskier securities in expressing their outsized faith in their own investing and stock-picking abilities, exacerbating the anomaly. To be sure, while focusing on factor and smart beta strategies has historically, over longer periods of time, earned higher risk-adjusted returns relative to the broader market, there have been stretches, even long ones, when factor-based approaches underperformed (think value during the 1990s), according to data accessible via Bloomberg . Finally, while in an efficient market, these anomalies should diminish in size and ultimately disappear, a widespread belief in the factors’ outperformance may also become a self-fulfilling prophecy. This post originally appeared on the BlackRock Blog.