Performance in the real estate sector generally tracks the economic cycle. During periods of high growth and inflation, real estate investments usually post strong returns. However, during an economic bust, these investments tend to underperform. These factors drive the profitability and cash flows of real estate companies,
Strange Markets of 2014
2014 Equity Markets Year-to-Date, Active Manager Performance,
- § Active Equity Managers have mostly underperformed their benchmarks in 2014, especially Large Cap Funds.
- § The peer group ranking of Large Cap Value Funds is closely clustered, with the best and worst performing funds separated by relatively small percentages.
- § The opportunity set for stock selection – intra-market dispersion among stocks – is at or near all-time lows in 2014.
- § As a result, “Benchmark-Hugging” has been rewarded at the expense of truly active “Stock-Picking” – This trend will not continue forever.
Investment Management Market Commentary: A Challenging First Half of 2014
With more than half of 2014 in the rearview mirror, it is a good time to review the investment management landscape. As broad equity markets have continued to rally, stock pickers have been trounced by their passive benchmarks.
As of midyear, 73% of large-cap fund managers failed to beat the index, says Morningstar, with the average manager’s 5.8% return undershooting the plain-vanilla SPDR S&P 500 ETF’s of 7.1%. If this continues, it will be their worst showing in the last decade versus the index, except for 2011. As it turns out, market conditions not only failed to improve, but worsened by the most important measure: the variety of individual stock returns.
For an active manager to succeed in outperforming, a fund’s portfolio must look different than it’s index and peers. Opportunity for stock selection requires a menu of stocks whose returns vary significantly from one another.
Divergent returns among stocks have been at or near all time lows in 2014, i.e. intra-market correlations have been near all time highs. The most recent data available from Ned Davis Research notes that a mere 50% of stocks in the S&P 500 are either outperforming the S&P by 5% or underperforming the market by 5%. For comparison, the historical average for this dispersion percentage is 66%. Many fewer stocks are performing differently from the broad market than has historically been true, hindering stock-pickers and non- benchmark-huggers.
The trend of active Large Cap management underperforming in recent years does not seem sustainable. In fact recent studies on the concept of Active Share – which measures fraction of a fund’s portfolio that is different from the benchmark index – indicate that Fund managers with the greatest differences vs. their benchmark are the most likely to be long-term outperformers.1
The S&P Persistence Scorecard, released in July 2014, further illustrates the difficult environment for active management in recent years. The scorecard tracks the consistency of the top-performing actively managed funds over yearly consecutive periods. This isn’t about beating a benchmark; it’s about whether a top-performing fund – in this case, one beating 75% of its peers – can continue to outperform.
The S&P Persistence Scorecard demonstrates just how difficult it has been for active managers to do that.
• Out of the 687 funds in the top quartile of their category as of March 2012, only 3.8% managed to stay there by the end of March 2014. In other words, 96% of the top-ranked funds failed to maintain their position in the leading 25% over three consecutive 12-month periods. Large- company funds fared particularly poorly, with just 1.9% maintaining their top-quartile position.
1 As an Active Share illustration, a fund manager benchmarked to the S&P 500 starts by investing $100 million in the index, thus having a pure index fund with five hundred stocks. If the manager only likes half of the stocks, sells half and invests $50 million in those stocks he likes, this produces an Active Share of 50% (i.e., 50% overlap with the index). If he instead invests in only fifty stocks out of five hundred (assuming no size bias), his Active Share will be 90% (i.e., 10% overlap with the index). According to this measure, it is equally active to pick fifty stocks out of a relevant investment universe of five hundred or ten stocks out of hundred—in either case you choose to exclude 90% of the candidate stocks from your portfolio.
Over five years, less than 0.5% of funds maintained their top position. The only category of funds with any persistence over five years was small-company funds, 1.3% of which maintained their spot in the top quartile.
These results echo the S&P Indices Versus Active Funds U.S. Scorecard, better known as the Spiva, which measures mutual funds against their benchmarks.
• The latest Spiva Scorecard, released in March found that in 2013, 56% of large-company mutual funds and 68% of small-company funds failed to outpace their benchmarks. The two bright spots: 61% of actively managed mid-cap funds and 51% of international small-company funds beat their benchmarks last year.
Very few funds have been consistently outstanding performers.
The S&P Dow Jones team looked at 2,862 mutual funds that had been operating for at least 12 months as of March 2010. Those funds were all broad, actively managed domestic stock funds. (The study excluded narrowly focused sector funds and leveraged funds.)
The team selected the 25 percent of funds with the best performance over the 12 months through March 2010. Then the analysts asked how many of those funds — those in the top quarter for the original 12- month period — actually remained in the top quarter for the four succeeding 12-month periods through March 2014.
• The answer was a vanishingly small number: Just 0.07 percent of the initial 2,862 funds managed to achieve top-quartile performance for those five successive years. If you do the math, that works out to just two funds. Put another way, 99.93 percent, or 2,860 of the 2,862 funds, failed the test.
The study sliced and diced the mutual fund universe in a number of other ways, too, each time finding the same core truth: Very few funds achieved consistent and persistent outperformance.
In fact, the Russell 1000 Value itself is solidly in the top quartile of Large Cap Value managers, indicating how few managers were able to beat it.
- § The rapid growth of passive management has driven high correlations among individual stocks, spurred low inter-stock volatility, and created a significant gap between “price and value” – that gap cannot persist, and company fundamentals will ultimately drive returns.
Peer Group Dispersion and the Rise of Indexation: More than a Competitive Consideration
In recent years, peer group comparisons such as those from Morningstar have shown a narrow dispersion between the best and the worst active managers. A Fund’s’s 200 basis points lag to the Large Value median through June 2014 is not quite as difficult a performance period as a percentile ranking in the 80-90% range seems to imply. What is perhaps more interesting is that nearly all active managers – and even the highest-performers – trail their benchmarks handily, as is the case with Funds benchmarked to the Russell 1000 Value. Market dynamics are surely an important contributor to this phenomenon, with the growing popularity of exchange- traded funds (ETFs): both broad market ETFs as well as sector-specific ETFs. The ETF phenomenon has resulted in stretched valuations for many stocks, simply by virtue of their inclusion in passively managed indices.
When including index mutual funds and private accounts, the value of passively indexed assets may now exceed several trillions of dollars. As a result, the importance of individual security valuation has become
de-emphasized, with investors choosing instead to look to a particular asset class or theme.
Like all financial market innovations, there are unintended consequences that result from the rise of indexation and the type of momentum investing that results from index buying. In fact, we believe that the increased use of ETFs and passive vehicles has led to a large disconnect between price and value in equity markets.
This circumstance has aspects in common with 1999- 2000 bubble period, when blue-chip companies were discarded in favor of technology, dot-com, and telecommunications stocks….until they weren’t. In today’s ETF version of that phenomenon, companies that were already constituents of major indices persistently receive their proportionate share of dollar purchases, even if the businesses have poor fundamentals or are strategically challenged. Unlike the tech bubble – when investors may have been irrational in overpaying for companies but were buying specific stocks, nonetheless – it may be the first time in history that the mode of investing in equities is done with complete disregard for the evaluation of the individual companies whose shares are being purchased.
As a consequence, the liquidity and daily trading volume of some of the largest ETFs now exceed the liquidity of the underlying stocks in the index. With that in mind, the indexation phenomenon may have reached a critical point: indices, which are meant to replicate the performance of, and provide exposure to, groups of stocks, have come to distort the prices of the stocks they are meant to measure – one of the great ironies that emerged from the trauma of the financial crisis, which instigated a surge by investors into ETFs as a tool to diversify their holdings and reduce overall portfolio volatility has, by the incredible magnitude of index investing, actually contributed to the lockstep movements among indices. It has driven both correlations and volatility to levels last witnessed in 1929. For value investors like us, stocks that are bid
So far, in 2014, several of the top-performing sectors in market benchmarks have been driven by factors other than company fundamentals or the operating environment for their businesses. Instead, the surprising decline in interest rates has fueled an exuberant quest for high-yielding stocks, including Real Estate and Utilities, with little regard for valuation. Historically, this behavior sets the stage for valuation sensitive investors (like us) to exceed the indices going forward. This is accomplished by avoiding investments in the most extremely overvalued stocks, instead preferring to invest in those stocks that had been previously overlooked.
Through the first half of the year, we had not found Utility stocks attractively priced, with dividend-seeking investors having bid the prices up well beyond their fair
Our process is going to generally steer away from highly interest rate sensitive sectors and companies: interest rates are the primary determinant of fixed-income returns, and we cannot add value by replicating the risks that investors already take in their bond portfolios. These companies, in particular, have a difficult time earning the kinds of return on capital we look for from a good business, making valuation all the more critical in assessing Utility stocks. Too often, investors evaluate stocks with a focus on dividend yield rather than looking at the underlying fundamentals first. This habit causes them to miss potential red flags. If the stock is overvalued, it will likely underperform, even with the dividend.up without support from underlying business fundamentals are worth avoiding.
Applying Our Management Approach Today
With that in mind, our management philosophy has always centered on purchasing good businesses at value prices, and to identify catalysts that will drive appreciation. Often times, bad news provides the entry point for buying a good business, and the catalyst may come when headwinds abate, or tailwinds begin to take hold for the operating businesses we are purchasing. In 2013, a number of companies (including Goodyear, Navistar, VOYA) that met our value criteria were also businesses operating in economically cyclical sectors – we were aggressive in purchasing those stocks and the results were very positive contributors to portfolio performance.
We have always taken a “dividend agnostic” approach to buying stocks. To paraphrase legendary investor John Neff, dividends are a nice snack, but we are more interested in the main course: price appreciation.
Dividend distributions are only one of several ways that companies can utilize cash, and we are more interested in intelligent capital allocation and the resulting business strength that drives stock price returns. Corporations’ use of cash to satisfy short- term pressure from analysts and activist investors has been a much-discussed issue in 2014. In fact, BlackRock CEO, Larry Fink, wrote to the leaders of every S&P 500 Company earlier this year, warning them that continued cuts in capital expenditure could be jeopardizing companies’ future prospects.
How do the Factors Influencing YTD Performance differ from those in 2013?
In discussing recent performance, it’s important to note portfolio positioning entering this year. Specifically, 2013 rewarded contrarian purchases in stocks that had previously been among the market’s laggards. Last year, we had a number of winning stocks that were initiated after significant declines.
In 2014, our attention to value entry points has not been rewarded in quite the same way it may have been in 2013. This year, we saw coal as an overly beaten-up sector with the potential for a turnaround and attractive valuations. However, historically low natural gas prices, stagnating demand for electricity and more competition from renewables were a drag on coal producers. We also believed that offshore energy plays would benefit from continued expansion of joint ventures with Russian firms. Here, geopolitics have been a challenge, with offshore energy companies having suffered from the potential impacts of the Western sanctions against Russia. This continues to be a highly unpredictable situation but we believe that offshore energy needs will turn out to provide tail winds to the business with or without the Russian firms’ participation.
Consumer-focused stocks, such as Apple, Best Buy, and Foot Locker have been a theme in the portfolio this year, with attractive valuations and an operating environment characterized by a better economy. While retailers had a difficult Q1 2014, improving earnings and more positive picture for economic growth have given us an opportunity to seek appealing entry points for quality companies.
Consumer stocks with more defensive characteristics such as Whole Foods, McDonalds, Ross Stores, Bed Bath & Beyond and Walgreens have looked attractive to us, as well. With impressive “moats” around their
businesses —barriers to entry in the form of brand, economic scale, or other advantages that make it very hard for newcomers to knock off the market leaders. Warren Buffet, Charlie Munger, and other great investors have often said that a good moat is one of the most important attributes for any company. We share Buffet and Munger’s view, even as consumer companies have underperformed so far in 2014.
Industrial companies have also had a tough YTD, although the global growth that should support the sector continues on an upward trajectory and inflationary pressures remain muted. Still, the improvement in business conditions in the U.S. and abroad has given us an opportunity to enter attractive companies. For example, sales for Deere & Co. have been difficult recently, but we believe that the business is being hit by very low prices in key commodities this year – a reversal from historically high prices in recent years. We like the company’s strong positioning, which has allowed for a combination of Deere’s $0.60 per share quarterly dividend as well as appealing share repurchases. We expect Deere to be a strong performer in the second half of 2014, and like the valuation where we entered the position.
We have often found value in companies that sit below the “Very Large” or “Mega-Cap” segments of the capitalization range. Historically, these “Non-Mega-Cap” stocks have had the added benefit of performing very well during periods of strong economic growth, and are oftentimes involved in the M&A or corporate actions we monitor to help unlock value. These stocks have underperformed this year, consistent with the market’s YTD bias in favor of dividend payers.
In 2014, sometimes we stayed too long in underperforming stocks, sometimes with stocks that had previously been big winners for us (i.e., Valeant, Chicago Bridge & Iron), but also with some stocks that were not good performers out of the gate (Peabody Energy). Our investment thesis does not always play out in a several week or month time period, but while that may not lead us to abandon the thesis, we are always disciplined when entering and exiting positions. We also understand that many people focus on shorter time periods when discussing stock market results and moves, and some investors were disappointed with performance through the first half of 2014.
We remain very committed to our Sell Discipline, and will exit positions when:
- The stock has done extremely well, especially over a short period of time, and such that the stock is no longer as compelling of a valuation. In this case we take some of the profits off the table in order to reduce exposure and capture some of the profit.
- Fundamentals change for the worse. This can be company specific or on a sector basis.
- Other stocks look more favorable for holding within the sector due to one of our stock selection criteria, i.e., better opportunities within the sector.
Going forward, we plan on being consistent in our philosophy, with modifications based on existing and unusual market dynamics. Our fundamental intrinsic value investment philosophy will not and has not changed. We continually try to improve our decision- making and learn from our mistakes through an ex- post analysis and review of our investment decisions. During this process, we challenge our assumptions and analysis of the market environment, which could potentially lead to refining certain aspects of our investment process. We will not change the investment process solely based on a short-term period of underperformance.
Given the market’s continued run and our valuation sensitivity, we are making a concerted effort to strengthen quality in the portfolio while maintaining the portfolio’s value characteristic.We feel that at this stage in the market (5 years from the last major bottom) that this is particularly important. At long last, the “dash to trash” may have run its course.
In addition, we will be more sensitive to relative underperformance. We will be less inclined to tolerate large underperformance of individual stocks to the benchmark and we will evaluate this on a real-time basis, not just from the date of purchase. We have been more focused on absolute returns in stocks, which has led to relative underperformance. As the market has continued to make new highs, with few pullbacks, many names in broad indices have become fully valued and their opportunity for appreciation is a function of market momentum. The only things that can happen when stocks reach fair value is that those stocks become overvalued – and we don’t want to own overvalued stocks – or we risk becoming a closet index portfolio.
Cash may be present in the portfolio as a residual to portfolio transactions and short-term overbought markets. However, we will put less emphasis on attempting to add value through an overt cash decision, preferring instead to lower portfolio risk through sector allocation and quality.
We would expect the Stock Fund to outperform in a strong down market and underperform in a strong up market. Our goal is to not lose money and to participate in an up market, minimize losses in down markets and focus on stocks which represent valuation opportunities and for which we believe a catalyst is on the horizon. And while we do pay attention to percentile rankings of competing equity funds, this year’s lack of volatility has created a bunching around the median and makes these comparisons less meaningful. Importantly, we are not disheartened. We believe the results for the next several years will be better, in part due to our adjustments but also due to the return of valuation sensitivity.