Flipping a coin is a truly random event. A coin will land on either heads or tails, and guessing right is a 50-50 proposition. The performance of actively-managed mutual funds is not as predictable. Funds that perform in the top half of their peer group during a five-year period had a less than 50% chance of staying in the top half during the next five-year period, according to a recent S&P Dow Jones study. Investors have better odds flipping a coin than using past performance to pick winning managers.
The famous (perhaps infamous to some folks) John Maynard Keynes has a great quote related to technological unemployment from his essay, “Economic Possibilities for our Grandchildren:” [Technological unemployment] means unemployment due to our discovery of means of economising the use of labour outrunning the pace at which we can find new uses for labour. Source: http://www.aspeninstitute.org/sites/default/files/content/upload/Intro_Session1.pdf see pg. 4 For those …
The defensive value investing model portfolio and its investment strategy did what they were supposed to do in 2013, by producing a high and growing dividend income with high capital growth and little volatility.
A market beating year (more income, more growth, less risk)
At the end of 2013 the portfolio stands some 25.8% higher than it did at the start of the year. In comparison, the benchmark FTSE All Share tracker trust gained 19.5%. These figures should be compared to the average annual gains that you should expect from the stock market, which is closer to 7 or 8% (or 5% after inflation).
Total gains for the portfolio have been 41% since its inception in March 2011. That’s a 9.6% out-performance of the All-Share tracker trust. In cash terms the portfolio is ahead by £4,764 in less than 3 years, with a starting value of £50,000.
Put another way, the annualised returns have been 12.9% for the model portfolio and 10.1% for the benchmark, which is a 2.8% annualised performance gain, or 28% higher returns in relative terms. You can see the results to date below:
Note that the ‘average’ investor underperforms the market by 3% a year (an estimate from various studies on investor performance) and the ‘bad’ investor underperforms by 6% a year (an estimate from the book ‘Monkey with a pin’). Outperformance relative to the ‘bad’ investor is around £15,000.
Beating the market is one thing, but this is a defensive and income focused strategy, so a high dividend yield and low risk are also required:
- High yield – Throughout the year the portfolio’s yield averaged 4.2% while the All-Share’s averaged 3%. The portfolio’s forward yield (the income produced during the year relative to its capital value at the start of the year) was 4.8%.
- Low risk – The defensive value portfolio has also been less volatile during 2013 than the All-Share tracker trust, with Beta (a measure of volatility) hovering around 0.6, which means the portfolio has been just 60% as volatile as the wider market.
1% more from dividend yield, 1% more from growth and 1% more from effective buying and selling
A 2.8% annualised improvement over passive investing is close to what I’d expect from a good defensive value strategy. I believe it’s possible to get an extra 1% each year from a high dividend yield, 1% from owning fast growing companies, and 1% from repeatedly buying low and selling high.
Of course these are estimates, but I think they are realistic, and a 3% absolute improvement is actually a 60% relative improvement compared to the 5% real return the UK stock market has historically provided.
So what did 2013 actually look like in terms of actively managing a portfolio of shares? How much effort was required, and how much stress did it involve?
The answer is, surprisingly little of either. The portfolio is managed using a steady, plodding approach to buying and selling. Each month just one company is bought or sold, and in 2013 8 companies were bought and 4 were sold.
The first sale came in January with N Brown, the catalogue and multi-channel retailer, leaving the portfolio. The holding period was just 8 months but in that time returns were almost 60%, primarily from a dramatically increasing share price.
This wasn’t anything that I had seen coming; the portfolio was just in the right place at the right time, although it helps to have a robust means of discerning a low price from a high price.
The proceeds were recycled into two companies that offered a better combination of value, quality and defensiveness.
The second sale was Reckitt Benckiser, the monotonously successful consumer goods company, sold in April. RB is exactly the sort of defensive, high quality company that I would expect to see in the model portfolio, but only at the right price.
As with N Brown, gains of more than 50% over a 2 year period meant there was perhaps better value to be found elsewhere, despite the company’s intrinsic qualities. The profits were again recycled back into two more attractively valued companies.
I would not be surprised to find RB back in the portfolio once again, if the shares can be bought at an acceptably low level.
The third company to leave the portfolio was Interserve, sold in July and producing gains of more than 110% over 2 years.
Interserve showed the value of patience; after a virtually flat first year the shares shot up by around 70% in their second year. At that point they began to look expensive relative to the rest of the portfolio and so profits were taken in order to be recycled in to some better value-for-money shares.
The last sale of the year came in October and was of Go-Ahead Group, the leading UK public transport company (over Christmas I travelled on HS1 – which they operate – and very impressive it was too).
Despite being in an apparently ‘dull’ and defensive industry, Go-Ahead’s shares produced total returns of more than 30% in just over a year and a half. Again, a rapidly increasing share price was the main driver, although the starting yield of 6% gave a real boost.
Profits from Go-Ahead have been recycled into yet another two value-for-money, high quality companies.
Slow and steady wins the race
All in all it has been a steady year, with this slow, methodical, plodding approach to buying and selling proving itself worthwhile. I think it’s a good pace to work at, which allows the portfolio to be improved and profits to be taken, but without having to rush around keeping an eye on the market at all hours of the day.
For 2014 I expect to sell 5 or 6 companies, and to maintain the number of holdings at around 30 with the addition of 5 or 6 new holdings.
I also expect the combination of high quality, relatively defensive companies – mixed with high yield shares and prudent profit taking – to continue to provide above average income and growth, at below average risk.
2013 was a great year for stocks, but less so for earnings. As a result, equity valuations rose sharply. Given higher multiples and the magnitude of last year’s rally, many investors are wondering whether the gains can continue, and just how high stocks can go this year.
I foresee U.S. equities posting more muted gains in 2014. Why? The interaction of two factors that defined the market last year – significant multiple expansion and higher interest rates – represents a headwind for stocks this year.
Most of last year’s stellar advance was powered by higher multiples. In other words, investors were willing to pay increasingly more for a $1 of earnings. Over the course of 2013 the trailing price-to-earnings (P/E) ratio on the S&P 500 rose from 14.2 to 17.50, a 22% increase. Based on P/E measurements, stocks are commanding the highest valuation since early 2010, when multiples were still high due to depressed earnings. Using a different metric, price-to-book, the S&P 500 is now trading at the highest multiple since before the financial crisis.
While I don’t believe that stocks are in a bubble, last year’s multiple expansion does matter for future returns. Historically, markets have done slightly worse in years following multiple expansion. Since 1954, the return, net of dividends, on the S&P 500 has averaged 5.85% following years in which stocks got more expensive. In contrast, the average return following multiple contraction was more than 10%. Admittedly, the results seem to be disproportionately impacted by a few bad years, such as 2000 and 2002. If instead of using average returns, you focus on the median – which is less impacted by outliers – the difference is smaller: 9% in years following multiple expansion and 12.5% in years following multiple contraction.
However, investors should still be a bit nervous for another reason. Not only did multiples rise last year, but interest rates increased as well. In the past, higher multiples and higher rates have represented a challenging combination. In those instances when multiples rose but rates were lower, the average return for the market was more than 9%, in-line with the historic average. In other words, to the extent that rates are dropping, rising multiples don’t represent the same degree of headwind as when rates are rising. However, in the 14 instances between 1954 and 2013 when multiples rose and interest rates rose, the average return on the S&P 500 in the following year was a relatively paltry 2.3%.
That said, I don’t believe that the U.S. market is necessarily condemned to a year of near zero returns. I expect U.S. stocks will finish 2014 with a mid- to high-single digit gain. First, rates are rising from unusually low levels. The yield on the 10-year note is still barely 3%, well below its 20-year average of 4.5%. At these levels, bonds still represent little competition for stocks. Second, a stronger economy this year should translate into faster earnings, which means stocks can advance without a further jump in valuations. Still, last years’ multiple expansion and higher rates arguably constitute a yellow flag for U.S. stocks. Given this, I continue to advocate that investors raise their exposure to international markets and focus on cheaper parts of the U.S. market, such as large and mega cap stocks and the technology and energy sectors.
Sources: BlackRock research, Bloomberg
David M. Blitzer is managing director and chairman of the S&P Dow Jones Index Committee. He has the overall responsibility for index security selection as well as index analysis and management. A graduate of Cornell University with a B.S. in engineering, Dr. Blitzer received his M.A. in economics from the George Washington University and his Ph.D. in economics from Columbia University.
Emerging markets are going through a recalibration phase in growth trajectories, governance and asset return expectations.
As we approach the end of the year, it’s scorecard time once again – time to see how our predictions and projections for 2013 worked out. In my first blog post of the year, I explained what I thought the macro environment would look like and identified 3 strategies that I thought investors should consider as a result.
So how did I do? Interestingly, the year shaped up very much like I had expected, but the markets moved in an unexpected way. Economic growth was modest, so that turned out to be the right call. And the Fed did maintain their quantitative easing program, continuing to purchase both US Treasuries and mortgage-backed securities each month.
I had expected that the Fed’s decisions would keep interest rates relatively low. However, the tone and guidance provided by the Fed changed, and that resulted in an increase in interest rates. After trading below 2% for most of the year, Bernanke’s comments on tapering in May caused the 10 year Treasury to shoot up to 2.7% by early July, a rise of 100 basis points in just 2 months. That sudden increase in rates has led to negative returns for many fixed income portfolios, especially those with more interest rate risk.
Given that backdrop, let’s look back at the three strategies I outlined for investors at the beginning of the year and see how I fared:
- Focus on municipals and credit. Of the two, credit performed better, and actually outperformed US Treasuries during the year. But both asset classes were hit hard by the increase in interest rates and subsequent investor withdrawals. This was especially true in municipal bonds, where we saw outflows in both mutual funds and ETFs over the year (driven not only by the rise in interest rates but also by heightened credit concerns on the back of the City of Detroit filing for bankruptcy and fiscal concerns in Puerto Rico). Investors in less interest rate sensitive funds did better, with funds like the iShares Short-Term National AMT-Free Muni Bond ETF (SUB) and the iShares Floating Rate Bond ETF (FLOT) experiencing positive returns. Lower credit quality also fared well, like the iShares iBoxx $ High Yield Corporate Bond ETF (HYG). Because high yield has exhibited some equity-like properties, this served it well in 2013 as it was pulled up by the strong equity market and outperformed all other fixed income sectors.
- Look outside the US. This ended up being a mixed call as developed markets performed better than most U.S. markets, with funds like the iShares International Treasury Bond ETF (IGOV) down slightly. But emerging markets fell sharply, as evidenced by the negative returns of the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB). A combination of rising interest rates and a shift in EM sentiment hit the market hard in May and June and it never recovered.
- Rethink the role of Treasuries. Here I stressed the importance of diversification and the value that Treasuries can play in balancing portfolio risk and potentially evening out returns. This turned out to be true, but not necessarily in the way you might have imagined. The S+P 500 is up an amazing 29.11% for the year (as of 12/11/13). The Treasury market has done its job as a diversifier, returning -1.97% during that same timeframe. It’s a hard pill to swallow in such a strong equity year, but remember that diversification is a long term value proposition. If the equity markets were down and Treasuries up, investors would feel very differently.
So what can we take away from the year? Three important lessons for investors really stand out:
- The most important decision for any fixed income investor is how much interest rate risk they take on. You can make a lot of smart decisions, but if you get the rate call wrong it can undo everything else. If you are uncomfortable with that risk then don’t make any extreme interest rate bets with your portfolio.
- Forecasting the market environment is not just about market levels; sentiment also plays a huge role. With the Fed still very active with QE, what they say is in many ways just as important as what they do. Pay close attention to Fed messaging and how it evolves in 2014, because that could drive investor behavior and interest rate movements.
- Diversification is a two-way street. Yes, a diversifying asset can help moderate portfolio returns through time. However, by definition the diversifying asset should perform differently than other assets in your portfolio – meaning sometimes it will provide relatively positive returns, and sometimes it can drag portfolio performance. The latter was certainly the case for Treasuries in 2013. But over long periods, diversification can help produce higher risk-adjusted returns than a less diversified approach.
So what’s on tap for fixed income in 2014 and, perhaps more importantly, can I do a better job of predicting investment opportunities next year? I will cover this in my next post.
Past performance does not guarantee future results. For standardized performance for HYG, click on the ticker above. Index returns are for illustrative purposes only. Indexes are unmanaged and one cannot invest in an index. Diversification may not protect against market risk or loss of principal.
Wall Street is always coming up with cunning new marketing techniques to attract tourist investors. These are less-sophisticated individual investors and advisers who are easily wowed by glitzy industry trends, only to abandon them when the strategy falls short of expectations. The latest spin to attract tourist money is “smart beta.” The phrase didn’t exist one year ago, yet a Google search today shows 190,000 results. The inference that investing this way is smart has ignited a strong interest among less-sophisticated investors while those who truly understand what’s behind these strategies find the phrase distasteful at best.
In the aftermath of the financial crisis, the term “bubble” has come into wide use in the financial press. The stock market bubble: The leveraged loan bubble: The Bitcoin bubble: Although everyone seems to use the term, bitter fights have erupted across academia about what a “bubble” actually is. We took an informal web survey of conversations on the …
Market Economics – Stephen Koukoulas Blog
A year ago, I outlined my top 10 economic and policy issues for 2013 in my Business Spectator column, which can be seen here.
With 2013 all but over, the bank manager and key clients are well satisfied.
Those Top 10 calls for 2013 from Business Spectator are reproduced in full below and I have a short comment following each one.
In the next day or so, I will outline a similar top 10 for 2014. If it is as successful as this year, it may well be a bath in Billecart Salmon this time next year.
From Business Spectator:
The top 10 big issues for 2013
1. GDP growth
GDP growth is likely to muddle near 2.5 per cent early in 2013 before easier monetary policy and a more positive tone from the global economy boosts activity through the course of the year. A solid pick up in housing construction and a lift in household consumption will be significant contributors to the growth pick up, and will take up some of the slack from a less robust mining sector. With accommodative monetary policy in place, the cash flow for the household sector and business will be growth positive. Government demand will continue to act as a dampening influence on economic activity, moderated in part by the decision of the government to allow the automatic stabilisers to support activity. By end 2013, GDP growth is likely to be around 3.5 per cent.
[Comment: GDP growth was 2.3% in the year to the September quarter and looks like holding 2.75% when the December quarter data are released next year. I may have been a quarter premature with my call for stronger GDP growth. Components panning out as expected.]
Inflation (RBA underlying) will be skewed towards the bottom of the RBA’s 2 to 3 per cent target as the lagged effect of softer growth through 2012 impacts on prices. The persistently high Australian dollar will further dampen import price pressures, at least for the first half of 2013. Another dampening influence on inflation is the moderate wage increases and solid growth in productivity. By end 2013, the moderation in inflation may be dissipating and the market and RBA may legitimately be factoring in inflation risks in 2014.
[Pretty much spot on. Inflation is locked in the lower portion of the 2 to 3% band, but the September quarter was high. With the December quarter CPI next month, the annualised run rate for the second half of 2013 is likely to be near 3%.]
The unemployment rate will be five-point something every month during 2013. And while it might edge up in the first half of the year as the economic expansion unfolds a little below trend, it should end 2013 near where it is now, that is 5.2 per cent. The forward indicators for jobs point to the unemployment rate moving higher in the near term and it would be no surprise to see an off month with unemployment hitting 5.7 or 5.8 per cent. But as economic growth picks up through the year, the unemployment will fall back lower to around 5.2 per cent.
[See comment on GDP but the unemployment rate has basically been in a 5 ¼ to 5 ¾% range all year. It just has not started to tick down yet but it probably will as growth accelerates.]
4. House prices
House prices have been weak for two years. Stretched affordability has finally been catching up to house prices and to the extent there ever was a bubble, it has been deflating in an orderly manner. The fundamental drivers of house prices are increasingly positive. Strong population growth is underpinning long run demand, while low interest rates, low unemployment and rising real wages are likely to underscore housing demand and therefore prices. After the weakness of the last two years, it would be no surprise to see house prices rise 10 per cent this year.
[Again, spot on, with house prices surprising just about everyone else with gains of 10% locked in for the year.]
5. Monetary policy
Monetary policy will remain accommodative through 2013. The RBA is likely to cut interest rates in the first part of the year as it catches up to the slowing growth and low inflation dynamics prevailing at the moment. The official cash rate is likely to bottom out at 2.5 per cent during the June quarter with ongoing low inflation driving the reasons for the easings. Rates are likely to remain on hold over the second half of 2013, but it would be no surprise to see financial markets starting to price in the risk of a monetary policy tightening as the year draws to a close.
[Again, close to perfect, with the only variance a month or two out on the date of the rate cut to a historical low of 2.5%. According to a Bloomberg survey in early January 2013, there were only four other forecasters out of 29 expecting the cash rate to end 2013 at 2.5%.]
6. Australian dollar
The Australian dollar ends 2012 significantly over valued. It is a classic market overshoot based on strong global investor demand for Australia’s triple-A rated assets. Markets can be prone to overshoot but in time they inevitably revert to fair value. If the Australian dollar reverts to fair value during 2013 it is likely to be trading near US90 cents at some stage. That said, a free-fall in the dollar is unlikely because of the global economic improvement through the year and the possibility that commodity prices move higher as China and the US pick up. The trading range for the Australian dollar for 2013 should be US88 to US106 cents.
[Another near perfect forecast – the range for the year (with 2 weeks to go), has been US89 to US106 cents, embarrassingly accurate. Recall that when the forecast was made, the AUD was trading at US105 cents.]
7. Australian stock market
The Australian stock market is likely to continue to move higher aided by a move positive growth and profit outlook. A bearish year coming up for bonds will also likely see an asset allocation move to stocks. At some stage during 2013, the ASX200 will break above 5000 and could well trade at 5250 as the year progresses. A positive lead from global markets will be a positive driver with super stimulatory policy prevailing in the US, Europe, Japan and the UK.
[The ASX was strong, up until a few weeks ago. The ASX200 hit 5,400 and looks like ending around 5,100. I probably was a touch too bullish.]
8. Bond yields
Bond yields will stay low in the early part of 2013 aided by the policy actions of the US Fed, the European Central Bank and the Bank of England. As the economy accelerated and the market started to become a bit more concerned about inflation risks, bond yields should move higher. It is likely the 10-year government bond yield will exceed 4 per cent from the middle of the year.
[Again a good call with the 10 year yield currently around 4.3%, up over 100 basis points for the year. It has been good to be short.]
9. Australian election
The election should be held in October, around the 19th or 26th. While an Abbott-led coalition victory is more likely than not. That said, the fickle nature of the political environment, the unpopularity of Mr Abbott and a positive policy agenda from the Labor Party could easily see the election go either way. With economic management – including interest rates – usually an important influence in election outcomes, the Labor Party could win. It will be that versus the carbon and mining taxes and issues of trust that will be driven by the coalition in forming the election campaign issues. It is not yet clear whether the election would be market moving, other than if there was a coalition victory, but without control of the senate, there may be a year or so of policy stalemate as the senate blocked policies to remove the carbon and mining taxes.
[Election date wrong, winner correct, and issues wrong. The economy was not the focus of the campaign. My error. The election outcome has been market moving, although not in the way some would expect. Markets are increasingly taking a dim view of the economic credentials of the new government.]
10. Federal budget
In terms of policy, Treasury is obviously of the view that the budget will record a small deficit in 2012-13. That outlook is premised on a half year of sub-trend economic growth, ongoing softness in commodity prices and the terms of trade remaining weak. For the 2013-14 budget, the government will be incorporating the financial cost of implementing the Gonski education reforms and the roll out of the National Disability Insurance Scheme. When incorporating these policy changes in the budget on May 14, it will find the money to fund it. Expect to see a scaling back of the generous tax treatment of superannuation and more policies that limit benefit payments to high income earners.
[Nothing much either way here. The budget deficits are small, and aside from the unexpected policy decisions from the new government, a surplus was on track in the next couple of years.]