Monthly Investment Commentary | May 2007

April was a strong month for stocks. Carving up the domestic market along its style axes, large-caps did better than small-caps, and growth did better than value. The large-small differential was greater, with Vanguard 500 Index Fund (S&P 500) gaining 4.4%, versus a 1.8% gain for the small-cap Russell 2000 iShares. Growth beat value by about 100 basis points among large caps, and by about 160 basis points in the small-cap universe (based on the Russell indexes). Large-caps now lead small-caps for the year to date. Looking overseas, non-U.S. stocks, as measured by Vanguard Total International Stock Index Fund, gained 3.9% in April, bringing their year-to-date gain to almost 8%. Domestic fixed-income returns were less exciting, with Vanguard Total Bond Market Index Fund gaining a half percent for the month. Commodity futures gained 1.2%, and short-term emerging-market bonds climbed by 2.2% in April; with our tactical positions in these asset classes coming from bonds, both have added value so far in 2007. REITs were flat for the month, and now trail the broader stock market for the year.

The following is a question and answer format to address questions commonly posed by clients during the past several months.

Profits seem to be slowing and Bill Gross [manager of PIMCO Total Return] mentioned on his conference call that they might be negative year-over-year. Given that profits seem to be sharply slowing, what is the risk to the stock market?

Profits are indeed slowing, but they probably won’t go negative in the near term. The important thing to bear in mind, though, is that in our view, valuations are low enough that stocks could do okay even in an environment of markedly slower profit growth. For example, in a scenario in which earnings growth declines to where it is in line with inflation, and the stock market trades at a P/E multiple in line with its 20-year average, the implied return for stocks (somewhere in the high single digits) would be well in excess of what bonds are likely to generate. Having said that, and based on the same analysis, if profits actually do go negative, stocks probably won’t do well. The good news in that scenario is that interest rates would probably be dropping, possibly leading investors to anticipate a profit rebound. We would be much more concerned about slowing profits and possibly negative profits if stocks were selling at higher valuations.

The following chart provides a history of price per earnings of the market.  What is shown is that the current price to earnings multiple is not out of line with the longer term averages.  However, corporate earnings are at a current all time high.

Last year was another huge year for value stocks and there are more analysts suggesting that growth stocks might now be cheap. You have said that you still view the growth and value stock universes as being within a fair-value range relative to one another. What would it take for growth stocks to become a fat pitch? Are they close?

Based on the macro-level data in which we have the highest confidence, growth and value—at least among large-caps—continue to be within a fair-value range of one another, although growth is at the cheaper end of that range. Statistically speaking, the growth/value relationship—based on Russell data—is less than one standard deviation from average, and we like to see a bigger gap than that: at least one standard deviation, and in most cases more like one-and-a-half, although there is no exact number that applies in every circumstance.

We have seen other data—Leuthold’s Royal Blue series, for example—that suggests growth is in fat-pitch territory. But making a judgment based on all the data, we don’t believe the overall picture is clear enough to justify a tactical move.

However, as we’ve mentioned in prior communications, most of the equity fund managers in our portfolios are seeing good stock-picking opportunities in names that are “growthier” than what they’d normally own. This is evidenced by the fact that Morningstar recently recategorized Longleaf and Oakmark Select to the Blend category, even though both are value funds. Several managers in non-value categories have been seeing the same thing: that “higher quality” or “higher growth” names are where the best values are. We could use this as additional support for a tactical move, but because these managers have already addressed these opportunities within their funds, a de facto “growth” overweighting in our portfolios already exists.

It’s worth noting that the macro-level data for small-caps is more definitive: small-cap value looks overvalued, and small-cap growth is at the cheap end of a fair-value range. In other circumstances, the gap between their valuations would probably be big enough to justify a tactical overweighting to small growth, but from a practical standpoint we are not attempting to take advantage of this. The reason is that our tactical overweighting to large-cap is more compelling, and leaves us insufficient small-cap positions to make an additional tactical move in small-cap growth.

Foreign stocks don’t seem to be overvalued and they have momentum after several consecutive years of outperformance. Since asset class cycles usually go to excess isn’t it likely that foreign stocks will outperform for a few more years?

Foreign stocks do indeed appear to be right around fair value, and it it’s also true that asset classes often tend to move from undervaluation to overvaluation.

The biggest problem we have with international equities is data related: The data we have to work with for international stocks is far less extensive than what we have on the domestic side, both in terms of the number of sources, and the length of the history. Furthermore, the data do not clearly show that good valuations for international equities relative to domestic equities necessarily result in international outperformance. For example, we did a study that showed that the longer-term returns for European stocks following periods when Europe looked cheap versus the U.S. were not consistently better. In other words, our relative valuation methodology didn’t seem to be a leading indicator of relative performance in these cases.

At the margin, these data limitations give us fewer variables in which to build our confidence when we think a tactical opportunity may be at hand, and in effect make the hurdle for a tactical overweighting higher than it would otherwise be. We’re continuing to look for additional sources of data, but as yet have not found enough to overcome this issue.

In addition to the valuation question, there is also the issue of trailing performance: international has outperformed domestic for five calendar years, and that’s a pretty long time for an asset class to outperform. The magnitude of that lead (nine to 10 percentage points annualized) has also been quite large. So the duration and magnitude of this momentum has already been significant. Asset classes do often go to excess, so it is possible that they will continue to outperform, but this is not always the case, and it’s not something we think we can hang our hat on. Remember that underlying our fat-pitch philosophy is the belief that by having a very high standard for each tactical allocation decision, we increase our odds of being right a high percentage of the time, which also means we minimize mistakes and raise the probability that we will add value versus our benchmark.

One final thought: Our managers who have the flexibility to buy both domestic and international stocks were more bullish on international a couple years ago, but today are less so. This further reinforces our view that international stocks are not a fat pitch right now.

A number of funds you like are run by firms with very large asset bases. For some of these you’ve mentioned concerns about the asset base. At what point does that concern actually lead you to sell a fund? Do you have any rules of thumb?

It’s true that many of these firms have big asset bases. All things being equal, we’d prefer that they close earlier. A smaller asset base gives managers a wider range of potential investments, including smaller-cap names, and helps keep trading costs down. Both of these are potentially important contributors to performance, so we like to see firms that are responsible about managing asset size.

Unfortunately, there is no magic number at which assets become a problem, and this is something we’ve wrestled with throughout the years (and continue to do so). In many cases, we haven’t seen a clear connection between asset growth and a drop-off in relative performance. Clearly we’d like to sell a fund before it starts underperforming, but there’s also a risk that we sell a fantastic fund when assets aren’t causing a problem. For most of the larger funds in our models, asset growth is less of an issue because they have always been larger-cap managers who have a low turnover approach. All things being equal, this style of investing allows for a larger asset base.

In terms of how we tackle this issue, some of the potential warning signs include: growth in average market cap of the fund, an increase in the number of holdings, lower turnover than has historically been the case, and dramatic growth in the size of the investment team. There are often mitigating factors around these issues based on where a fund is finding opportunities, so these issues are not usually clear cut, and it’s made even trickier by the fact that size has some potential advantages that relate to shareholder activism and trading.

Having said that, repeated instances of asset growth-induced issues—not being able to establish a full position before a stock moves away, not being able to sell in the event of a problem—are one of the things we look for when talking to managers, and this issue in particular is something we give a considerable amount of weight.

At the end of the day, determining if asset growth is likely to impact performance and the materiality of that impact is a weight-of-the-evidence judgment call that factors in the above points and our overall opinion of the firm’s competitive advantage. When all of these factors, combined with our direct conversations with managers, convince us that assets are a problem, we’ll downgrade the fund. Selling the fund outright can be a more difficult decision, however, because it is also a function of what alternatives are available. We may think that assets are detracting from performance but that the fund is still likely to beat (or remain competitive with) its benchmark, so unless we have a clearly superior alternative, selling might not be the optimal thing to do. Again, it’s a case-by-case decision.

— Stapp Financial Planning, PLLC

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