Tag Archives: management

Smead Capital Q3 Shareholder Letter

Summary David Dreman’s Red Room and Green Room provides a useful framework for thinking about investments. We argue that a new “Beige” room representing passive investments should be added to the construct. We conclude that the Green Room still offers the best approach for the long-duration investors. The inevitability of market fluctuations caught up with the U.S. stock market and the Smead Value Fund (MUTF: SMVLX ) in the third quarter of 2015. The fund fell 5.93%, while the S&P 500 Index fell 6.44% and the Russell 1000 Value Index fell 8.39%. We were pleased with how our portfolio held up in the decline, but are realistic with our investors about the likelihood that there are periods when our fund will either decline in value and/or underperform the indexes we measure ourselves against. We used the declining prices in the quarter to reduce the number of companies we own and to raise the quality and cheapness of our holdings. Our stocks that contributed the most alpha in the quarter were H&R Block (NYSE: HRB ), NVR (NYSE: NVR ) and Chubb (NYSE: CB ). H&R Block announced a massive stock-buyback totaling 35% of outstanding shares and a Dutch-auction tender offer for $1.5 billion of its shares. NVR has continued to have the wind behind them as home building recovers from a population-adjusted depression in household formation and home buying from 2007-12. Chubb was taken over by Ace LTD at a sizable premium and was sold during the quarter. Among the worst drags on performance was Tegna (NYSE: TGNA ), which fell sharply after splitting from Gannett. Tegna’s ownership of network-affiliated TV stations got caught in cord-cutting and advertising revenue competition fears. We find this ironic. As the value of cellular spectrum increases and a blowout political advertising season looms in 2016, we get very excited about their future. Even today, 55% of adults in America use local TV news as their prime form of news. PayPal (NASDAQ: PYPL ) suffered from its popularity prior to the split with eBay (NASDAQ: EBAY ). Many major companies covet their 75% share of the secure online payments market and it has corrected along with other stocks with above-average P/E ratios. Navient (NASDAQ: NAVI ) disappointed investors during the quarter. They have experienced unusual loan losses in their portfolio and we sold the stock during the quarter. The Red, Green, and Beige Room One of the great investing books of the last 40 years was David Dreman’s, Contrarian Investment Strategy . He started it by telling of a hypothetical gaming casino with two separate, but adjoining, rooms: the red room and the green room. The red room was packed with people and excitement and almost every day someone hit a huge jackpot setting the building on fire with electricity. Every seat was packed, others waited their turn to play and the anticipation was palpable. Yet most of the players left the casino each night without their money, because the odds were stacked heavily in the house’s favor. The green room was relatively quiet and included many empty seats. Players sat patiently and most of them had amassed large chip stacks. Virtually nobody hit it big each day, but through patience and odds stacked heavily in their favor, most the participants in the green room created wealth. In the last 20 years, we think a new room should be added to Dreman’s imaginary casino. We call it the “beige” room. This room is filled with investors who had the natural reaction to bad experiences in the red room, but lacked the patience to succeed in the green room. In this room, you will find participants in passive indexes. Additionally, we think stock market difficulties since 2000 triggered former green room participants to lose their patience, thus contributing to the popularity of being average. Dreman was trying to explain the difference between investing in common stocks based on excitement about future prospects versus buying stocks based on value or intrinsic value. This has been over-simplified by using monikers such as growth stock and value stock. For the sake of our discussion, let’s say that a value stock is one priced below the average stock and a growth stock is one priced above the average. The most common averages used are the price-to-earnings ratio (P/E) and the price-to-book ratio (P/B). Every academic study we’ve seen shows that over one, three, five and seven-year time periods, the cheapest stocks outperform the average and most expensive stocks. The most famous of these studies are the ones in Dreman’s book (see below), Fama and French’s P/B study and Francis Nicholson’s study from 1937-1962. Dreman used P/E quintiles, while Fama and French used P/B ratios and both studies rebalanced at the end of each year. They argued that excess return could be had by simply starting the year with the cheapest stocks in the S&P 500 Index and replacing the ones which found favor during the year with the latest ones to find the doghouse. These studies led to the “Dog’s of the Dow” strategy, where an investor purchases the 10 cheapest stocks in the index based on dividend yield (another measurement of cheapness). We found Nicholson’s study (see below) even more fascinating because his portfolio was static. It showed that cheap stocks at the beginning not only outperform in the next 12 months, but that their outperformance continues on for seven years. We like to say that cheap stocks are the gifts which keep on giving. Warren Buffett, the number one disciple of the father of value investing, Benjamin Graham, started out being a green room common stock investor and continues to do so in the private equity realm as well. In the 1960s, he ran into his investing partner, Charlie Munger. Mr. Munger advocated for a qualitative addition to these quantitative strategies. He and Buffett believe that the long duration investor, with great patience, can benefit from owning very high quality businesses purchased at a time of distress. They believe that the primary responsibility of the wise long duration investor is to wait until a splendid business gets in the doghouse due to a bear market in stocks or a temporary corporate stumble. Then they pounce on that opportunity by “backing up the truck” and loading up on shares. Munger’s theory was proven correct in a seminal study done by Ben Inker at Grantham, Mayo and Van Otterloo (see below). His study showed that certain qualitative characteristics like low leverage, high and sustainable profitability, low earnings volatility and low volatility in stock trading have proven to add alpha over long durations. We at Smead Capital Management start our research by leaning toward Dreman’s study, because “valuation matters dearly.” We love Nicholson’s study because the seven-year holding period shows that you can own businesses for a long time and keep your portfolio turnover down. Turnover is a huge annual tax on large-cap equity portfolios and the cost averages 81 basis points or 0.81% annually among large-cap U.S. equity funds. However, we at Smead Capital are risk averse and recognize that human nature gets in the way of holding businesses for a long time, especially in the low-quality arena. This is where Munger and Inker, with their focus on high-quality, come into play and how we seek to reduce portfolio risk proactively. In late 2008, after getting clobbered all year, we received many calls to the effect of “Bill, we know you want to own stocks for a long time and we believe in what you are doing. But shouldn’t we get out of the way of this decline in case we have a total economic meltdown like in the 1930s?” Our answer was simple. The only “safe” alternative was investing in Treasury bills/bonds or government-insured certificates of deposit. We pointed out that the merit of those “safe” investments was the backing of the U.S. government. Our government’s guarantee is no better than its ability to collect income taxes. Those taxes are paid by the largest companies in the U.S. and their employees. Therefore, the safety of Certificates of Deposits and T-bonds came from the safety provided by the qualitative characteristics of the stocks in our portfolio. Selling quality stocks at a time of distress was an especially bad idea, in our opinion. What does the red room look like today? It is filled with investors seeking above-average returns by paying extremely high P/E and P/B ratios for companies with perceived “bright” futures in an attempt to hit the jackpot. Red room regulars are excited about social media, internet-based information/advertising, online shopping, fast food, cloud computing and the “sharing” economy. It is enough to make you want to open a bureau in Silicon Valley. What is going on in the beige room lately? The beige room (index investing) has a tendency to work great in an uninterrupted bull market like the one we enjoyed from March of 2009 to the peak in the summer of 2015. There is historical evidence of the index becoming overloaded with shares of the previous era’s most successful companies, ala tech stocks in 1999. In effect, valuation works against the index when it has been particularly effective in the prior five to ten years. The S&P 500 Index has enjoyed the tailwinds of its overweight position in multinational companies, who drafted on emerging market growth in staple products, heavy industrial infrastructure investments in China and technology purchases everywhere. Since we are of the opinion that the U.S. economy will do better in the next ten years as compared to the last ten years, we contend that the index is at a disadvantage because nearly half of its revenue comes from abroad. Lastly, there are some pretty persuasive arguments which surround the idea that index returns will be in the 6% area going forward. These theories take into account dividends that are lower than historical averages and interest rate increases over time which would reduce historically high profit margins. Our opinion is that the beige room is appropriate for those who are incapable of investing in the green room or unable to figure out whom is. Owning U.S. large-cap equity for a long time is preferable to most other liquid investments and you can get average performance from an attractive asset class in the beige room. Where are folks congregating in the green room? They are rummaging around in financial service companies like banks and insurance, which have low P/E and P/B ratios. The death of traditional media and advertising is a foregone investor conclusion and the lowest P/E and P/B ratios lists are sprinkled with TV content and broadcasting companies, network-affiliate station owners and newspaper/magazine publishers. We are always on the lookout for companies on the cheapest list which meet our eight criteria for stock selection because valuation matters dearly, we want to own companies for a long time and to do that we must own very high quality companies. Thank you for your ongoing confidence in our methodology. The information contained herein represents the opinion of Smead Capital Management and is not intended to be a forecast of future events, a guarantee of future results, nor investment advice. The Smead Value Fund’s investment objectives, risks, charges and expenses must be considered carefully before investing. The statutory and summary prospectuses contain this and other important information about the investment company, and it may be obtained by calling 877-807-4122, or visiting smeadfunds.com . Read it carefully before investing. Mutual fund investing involves risk. Principal loss is possible. As of 09/30/2015 the fund held, 6.02% of NVR Inc., 5.61% of Amgen Inc., 5.17% of Tegna Inc., 5.04% of Berkshire Hathaway Inc. Class B, 5.01% of American Express Co., 4.81% of JPMorgan Chase & Co., 4.42% of Bank of America Corp., 4.34% of H&R Block Inc, 4.33% of Aflac Inc., and 4.29% of Wells Fargo & Co. Fund holdings are subject to change at any time and should not be considered recommendations to buy or sell any security. Current and future portfolio holdings are subject to risk. The S&P 500 Index is a market-value weighted index consisting of 500 stocks chosen for market size, liquidity, and industry group representation. The Russell 1000 Value Index is an index of approximately 1,000 of the largest companies in the U.S. equity markets; the Russell 1000 is a subset of the Russell 3000 Index. The Russell 1000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000 companies with lower price-to-book ratios and lower expected growth values. Price/Earnings (P/E) is the ratio of a firm’s closing stock price and its trailing 12 months’ earnings/ share. Price / Book (P/B) is the current price divided by the most recent book value per share. Alpha is the excess return of a fund relative to the return of its benchmark. Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns. A Dutch auction tender for public offer is a structure in which the price of the offering is set after taking in all bids and determining the highest price at which the total offering can be sold. In this type of auction, investors place a bid for the amount they are willing to buy in terms of quantity and price. Small- and Medium-capitalization companies tend to have limited liquidity and greater price volatility than large-capitalization companies. Active investing generally has higher management fees because of the manager’s increased level of involvement while passive investing generally has lower management and operating fees. Investing in both actively and passively managed funds involves risk, and principal loss is possible. Both actively and passively managed funds generally have daily liquidity. There are no guarantees regarding the performance of actively and passively managed funds. Actively managed mutual funds may have higher portfolio turnover than passively managed funds. Excessive turnover can limit returns and can incur capital gains. Frank Russell Company is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell ® is a trademark of Russell Investment Group. The Smead Value Fund is distributed by ALPS Distributors, Inc. ALPS Distributors, Inc. and Smead Capital Management are not affiliated.

Dumb Alpha: The Ignoramus’s Guide To Asset Allocation

By Joachim Klement, CFA Modern finance constantly busies itself with the development of new, more sophisticated ways to manage risk and generate returns. These efforts, however, generate their own risks – for example, overspecifying a model or falling prey to data mining. On the opposite end of the spectrum are simple ways to invest that have a proven track record of providing superior investment outcomes. This article focuses on investment techniques that are so simple it is surprising how well they work, a phenomenon that Brett Arends of MarketWatch has called “dumb alpha.” The Dumb-Smart Way to Think about the Future Assume you are a middle-aged man with a receding hairline and an expanding waistline. In short, you don’t look like George Clooney – you look like me. Moreover, you need to finance your retirement with your savings. Creating a portfolio to build retirement wealth is no easy feat given the fact that retirement may be 20 to 40 years in the future. A lot can happen in that time: 30 years ago, Japan was on its way to overtaking the United States, China was a closed-up Communist country, Europe and North America had broken the spell of runaway inflation, and Brazil was a basket case. Who can say what the next 30 years will bring? Luckily, you are well aware that it is nigh impossible to predict which investments will do well during the next three decades. And assuming this is true, there are only two logical ways to invest. One possibility is to hold all your savings in cash or the safest short-term bills and bonds. The problem with this approach is that you will have a hard time keeping pace with inflation once taxes and other expenses are taken into account. And in some countries, like Germany and Switzerland, you even face what my colleague Will Ortel calls ” unterest rates .” The other possibility is to invest the same amount of your money in every asset class. This makes sense because you don’t know how stocks will do compared with bonds or real estate investments, or how Apple stock will do compared with Barry Callebaut. The simplest example of this naive equal-weighted approach would be a portfolio split 50/50 between stocks and bonds. Another approach would be to invest one-quarter of your assets in cash, one-quarter in bonds, one-quarter in equities, and one-quarter in precious metals. Similarly, instead of investing in a common stock index such as the cap-weighted S&P 500 Index, you could evenly spread your precious funds across all 500 stocks of the index. The Advantages of a Naive Asset Allocation As it turns out, this way of investing tends to work extremely well in practice. In their 2009 article ” Optimal versus Naive Diversification: How Inefficient Is the 1/N Portfolio Strategy? ,” Victor DeMiguel, Lorenzo Garappi, and Raman Uppal tested this naive asset allocation technique in 14 different cases across seven different asset classes and found that it consistently outperformed the traditional mean-variance optimization technique. None of the more sophisticated asset allocation techniques they used, including minimum-variance portfolios and Bayesian estimators, could systematically outperform naive diversification in terms of returns, risk-adjusted returns, or drawdown risks. Unfortunately, naive asset allocation does not work all the time. Over the last several years, only one asset class generated high returns: stocks. So, a naive asset allocation will not keep up with the more equity-concentrated portfolios during such periods. But it is interesting to note how well a naive approach works over an entire business cycle. Practitioners should compare their portfolios with a naive asset allocation to check whether they really have a portfolio that delivers more than an equal-weighted portfolio. You can create a better (“more sophisticated”) portfolio than the equal-weighted (“dumb”) one, but it is surprisingly hard to do. As a check, you can create an equal-weighted portfolio from the assets or asset classes used in your current portfolio. Then test whether the current portfolio is superior to this equal-weighted benchmark over time in terms of returns, risks, and risk-adjusted returns. If that is the case, congratulations: You have a good portfolio. If not, you should think of ways to improve the performance of your existing portfolio. It is also pretty clear why this dumb alpha works. Within stock markets, putting the same amount of money in every stock systematically prefers value and small-cap stocks over growth and large-cap stocks. These two effects conspire to create outperformance. There is a second effect at play, however. After all, the value and small-cap effect cannot explain why a naive asset allocation also works in a multi-asset-class portfolio. The key reason for its strong showing is its robustness to forecasting errors. Most asset allocation models, like mean-variance optimization, are very sensitive to prediction errors. Unfortunately, even financial experts are terrible at forecasting, and one follows forecasts at one’s peril. By explicitly assuming that you cannot predict future returns at all, an equal-weighted asset allocation is well suited for unexpected surprises in asset class returns – both positive and negative. Since unexpected events happen time and again in financial markets, in the long run an equal-weighted asset allocation tends to catch up with more “sophisticated” asset allocation models whenever an event happens that the latter are unable to reflect. In other words, if the naive asset allocation outperforms a more sophisticated portfolio, it might provide a hint as to why this is the case. Are there too many risky assets in the sophisticated portfolio that directly or indirectly create increased stock market exposure? What are the implicit or explicit assumptions that led to the more sophisticated portfolio that have not materialized and have led to an underperformance relative to a less sophisticated naive asset allocation? In this sense, the naive asset allocation can act as a check to an existing sophisticated portfolio and as a risk management tool. Disclaimer: All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Does This New Consumer Discretionary ETF Look Promising?

Consumer discretionary is one of the sectors that have delivered commendable performance so far this year. The credit goes to the recovering U.S. economy, cheap gas prices, subdued inflation and prolonged ultra-low interest rates. The recent Fed minutes revealing its reluctance to raise interest rates in the near term should bode well for the sector, at least for the rest of the year. Notably, the most popular consumer discretionary ETF, Consumer Discret Sel Sect SPDR ETF (NYSEARCA: XLY ), returned 7.7% in the year-to-date time frame, while S&P 500 Index lost 2.1% in the same period. Manulife Financial Corp’s (NYSE: MFC ) insurance and investment manager John Hancock has forayed into the ETF world with six multi-factor smart beta offerings. One of them is JHancock Multifactor Cnsmr Discret ETF , trading under the symbol JHMC . The launch of this consumer-discretionary-focused ETF looks to be timely. Smart beta ETFs aim to obtain a return that’s higher than the return of the benchmark index, which is the fund’s alpha. Apart from higher returns, the fund seeks to reduce costs and enhance diversification. They follow a passive management strategy with a tweak in the component weightings unlike traditional, market-cap-weighted index funds. JHMC in Details Like other ETFs of John Hancock, JHMC is also based on the index that is developed by Dimensional Fund Advisors, which will also act as the sub-advisor to the fund. Dimensional is one of the first managers to work on multi-factor and rules-based investing. The index comprises securities in the consumer discretionary sector within the U.S. universe whose market capitalizations are larger than that of the 1001st largest U.S. company. The ETF comprises 154 holdings with Comcast Corporation (NASDAQ: CMCSA ) occupying the top position with 3.52% share, followed by Amazon.com, Inc. (NASDAQ: AMZN ) with 3.45% share and Home Depot, Inc. (NYSE: HD ) with 3.22% share. The top 10 holdings constitute around 23.96% of the fund. As far as sector allocation is concerned, media takes the top spot with 22.38% allocation, followed by specialty retail, and hotels, restaurants and leisure with 22.32% and 14.66% shares, respectively. The fund is moderately expensive as it charges 50 bps in fees from investors per year. How Does it Fit in a Portfolio? The upbeat September auto sales data triggered optimism in the consumer discretionary sector. U.S. light-vehicle sales increased 15.7% year over year to 1.44 million units in September. Sales on a seasonally adjusted annualized rate (“SAAR”) basis surged to 18.17 million units in the month from 16.53 million units in September 2014. It was the highest SAAR since July 2005. Further, retail sales spending indicates positive consumer sentiment for the sector. Consumer spending accounts for roughly 70% of the economic activity in the U.S. In August, personal spending edged up 0.4% from the prior month, as per the U.S. consumer department. For September, consumer spending is expected to rise as well given higher auto sales and, with the holiday season around the corner, it would likely remain bullish this year. The National Retail Federation predicted that U.S. holiday sales for the last two months of the year will grow 3.7%, higher than the 10-year average of 2.5%. Finally, rising consumer confidence bodes well for the sector. According to the business research group, Conference Board, the consumer confidence index increased to 103 in September after rising to 101.3 in August. The monthly reading was the highest since this January. The bullish trend in consumer spending is not only a positive for the consumer discretionary sector but also for investors interested in this new ETF. ETF Competition Being a smart-beta ETF, JHMC definitely deserves attention. However, there are a number of popular consumer discretionary ETFs that are already on the investors’ tracking list. Among them, the most popular are above mentioned XLY and First Trust Cnsmr Discret AlphaDEX ETF (NYSEARCA: FXD ). XLY tracks the S&P Consumer Discretionary Select Sector Index focusing on companies defined by the S&P 500 Composite Stock Index. The fund’s top ten holdings comprise nearly the same stocks as that of JHMC. It has an impressive asset base of $10.7 billion. On the other hand, FXD follows the StrataQuant Consumer Discretionary Index selecting stocks from the Russell 1000 Index that may generate positive alpha relative to traditional passive style indices. It manages an asset base of $2.4 billion. Both XLY and FXD stand nearly at the same level in terms of yield, with XLY offering 1.4% and FXD offering 0.86%. However, on the cost front, XLY looks very attractive with only 15 bps in fees compared with a much higher annual fee of 70 bps for FXD. Original Post