Fourth Quarter 2005
Stapp Financial Investment Letter
Quarterly Investment Commentary
The lessons of 2005 reflect the importance of discipline and patience. It was a year with many of macro-level worries. For much of the year markets were flat or falling but there were short periods when returns came in bunches. Timing these short bursts of performance would have been difficult. It was also a year when diversification away from the most mainstream asset classes paid off. Committing to a fundamentals-based asset allocation paid off. So, in the end, even though 2005 didn’t feel like a very good year for investors, it wasn’t too bad.
Stocks, as measured by the S&P 500, returned a boring but respectable 4.8%. But foreign stocks de-livered a downright exciting 15.6% return (in dollars) mostly thanks to the performance of stocks in Japan and emerging markets. Overall, investors with global equity exposure had the opportunity for a reasonably good year. Within the U.S. stock market, based on most benchmarks, value-type stocks outperformed growth-type stocks for the sixth consecutive year (though in the second half of the year growth began to outperform). Value’s outperformance was largely due to energy stocks, which were far and away the year’s strongest sector. Outside of the equity markets, fixed income offered only small nominal returns and non-dollar bonds delivered slightly negative returns due to a stronger dollar, which resulted in currency losses. Other asset classes did better, including commodity futures (up 21.4%), which we owned, and REITs (up 11.9%), which we did not own. In short, in 2005 investors were rewarded for diversifying beyond domestic stocks and bonds.
Performance Commentary
We would love to deliver fantastic performance for our clients every year. However, we’ve learned that pursuing greatness year in and year out is not only unrealistic, it is not wise. Even the best are wrong sometimes and miss out on some opportunities. Eventually, for virtually all investors, at some point the experience is humbling. Acknowledging this, we focus on the more realistic goal of having a high batting average. We do this by following our discipline and only deviating from each portfolio’s neutral asset allocation when there is a clearly compelling (“fat-pitch”) opportunity that we strongly believe either raises the portfolio’s return potential without materially increasing the risk, or lowers the portfolio’s downside risk level without lowering return potential. If we pursue only high-conviction opportunities we believe we greatly increase the odds of being right more of-ten than we are wrong, which in turn can lead to good performance most of the time. Reasonably good performance most of the time can result in a very good performance over a very long time.
The year just completed was a good, though not spectacular, year for us. Our clients benefited from positions that added value at the asset-class level and also at the fund-selection level. We also were hurt by some of our asset-class and fund positions. Overall though, both asset allocation and fund selection added value.
It’s also important to evaluate our performance over longer time periods. The period we believe is most relevant is the post-1998 period. This is because, based on a self-critical review of our prior performance and our strengths and weaknesses, as of the beginning of 1999 we made two impor-tant enhancements to our investment approach: we created neutral allocations for each portfolio type and instituted our fat-pitch approach to asset allocation. We also significantly raised the bar with respect to the level of mutual fund due diligence we conduct. In the seven years since 1998 our models have out-returned their benchmarks by a wide margin.
We know that we will suffer through periods of poor performance again at some point. But we’re confident that we have an investment process that can lead to a high batting average and that our team has the talent and discipline to continue building on our historical track record.
We Think In Years (Not Months or Quarters)
What was the popular thinking back in 1999?
- Large companies had a competitive advantage compared to smaller companies in the global economy. Small companies were at the mercy of their larger and more powerful peers who set prices and terms.
- “New economy” companies were the future and would continue to grow at very high rates. “Old economy” stocks would not deliver strong returns. Investors were discour-aged from factoring in valuation or even profitability into their company/stock analysis. Revenue growth and price momentum were the keys to identify winning stocks, valua-tion be damned.
- U.S. companies and the U.S. economy had a competitive advantage. And because so many U.S. companies operated globally, foreign diversification was not necessary for investors.
For a while the conventional thinking continued to work. But by early 2000 many numbers were clearly signaling “danger” and others were flashing opportunity (though few investors were pay-ing attention at the time). Large-cap growth stocks as measured by the Russell 1000 Growth Index were trading at 48.1x earnings and had delivered an average annual return over the prior five years that exceeded 30%. This return was a red flag all by itself and the P/E was impossible to reconcile when the average value stock was selling at almost one-third that level. In another area, opportu-nity knocked with REIT dividends approaching 9% and REIT prices lower than they had been three years earlier.
As is usually the case, the markets did not cooperate with the conventional wisdom. Since 1999 small-cap stocks decisively outperformed large-caps and value massively outperformed growth. In fact growth stocks, as a group, remain below their levels of early 2000 and many of the “you can hold ’em forever” darlings like Cisco, Sun Microsystems, Nokia, Oracle, and Nortel Networks still sell at mere fractions of their prices back then. Over the same period REITs have compounded at over 20% per year and foreign stocks also strongly out-returned U.S. stocks.
Thankfully, back in 1999 and for several years thereafter, our portfolios were underweighted to large-cap growth stocks, overweighted to smaller-caps (including mid-caps) and value stocks, and included REITs, high-yield bonds, and foreign stock exposure. These were unconventional posi-tions in the late 1990s and we did not know when we would be rewarded. Initially we were not re-warded. But our valuation work was clear and we believed that regardless of the timing of the re-turns, at some point, maybe years into the future, we would look back and know that we made the right decisions. This is always how we think about our decisions—not expecting immediate gratifi-cation but with the goal of looking back years later and knowing we did the right thing. As it turned out, these asset class moves were major contributors to our strong record over the subse-quent years.
Then Versus Now
When any investment or asset class is universally loved, investors should beware. But when an in-vestment or asset class is hated, investors are often presented with great opportunity. Back in early 2000 it was easy to see what was loved and what was hated. Currently, we are not excited about any asset-class opportunities from a valuation standpoint. But we’re not wringing our hands in worry, either. Very important to our “most likely case” is that current valuations throughout the equity markets suggest that over the next few years returns, while not spectacular, will be reasona-bly good compared to inflation. And relatively attractive equity valuations suggest that the market is adequately pricing in the big-picture risks that exist (more on those below).
The trick in this type of environment is not to try too hard to find something that isn’t there. As we repeat often, it’s a time for patience. At some point there will be a shock to the global economy and markets. When that happens our portfolios will feel some pain but that is also when a fat-pitch op-portunity is likely to appear with the potential for much better returns.
What about the Economic Imbalances?
The trade deficit, budget deficit, debt levels, and housing prices are all issues that we have written about over the years and that continue to worry us. Macro forecasting is notoriously difficult—with that caveat, here are our thoughts. It appears likely that the global economy will continue to put off any day of reckoning for some time. In the words of PIMCO, a fixed-income firm we regard highly, we are in a state of “stable disequilibrium.” As long as it is in the interest of Asian central banks to provide the funding for the U.S. consumer (when needed), the U.S. and the global economy will experience adequate growth. It is likely that this environment will continue for the next several years unless Asian inflation spikes higher. This will likely occur within a backdrop of only moder-ate inflation given healthy productivity growth and an abundance of global labor and productive capacity. Thus, consumer spending, though slowing, is likely to stay strong enough to support the U.S. economy. And, happily, Europe’s economy is showing signs of strengthening and so is the Japanese economy. A worry is that the housing market is showing signs of rolling over in some ar-eas and that if this spreads it would be very likely to slow consumer spending. However, the most likely scenario is that house prices slow and flatten but do not collapse. In that scenario, research we have reviewed suggests that spending would also slow but not collapse and could be largely offset by a healthy corporate sector and improved growth in the rest of the developed world. In the very long run the imbalances cannot indefinitely continue to grow worse. There will have to be a reversal. However, the large supply of global capital is the ultimate reason why it seems likely that the day of reckoning is not near. And even layering in some pessimism and assuming some of the structural imbalances end badly, current equity valuations suggest that after accounting for a bear market at some point, long-term (10-plus years) returns can still turn out okay, which is to say, competitive with inflation. That is the more negative outlook.
Watchful in 2006
As we head into the new year we take comfort in the reasonable valuations we see in almost all as-set classes and the risk reduction we gain from prudent diversification. We are not particularly worried about the slight yield-curve inversion that was widely reported as 2005 drew to a close. It is true that when short-term interest rates move higher than longer-term rates a recession often fol-lows, but there have been exceptions and this is likely to be one. Dan Fuss, manager of Loomis Sayles Bond, and others we respect believe that the overall level of interest rates is too low to con-strain economic activity to recession levels. He also believes that the inversion is impacted by the imbalance between long-dated bonds and the demand for them. These views make sense to us. While the inversion is not a major worry, as always we will be watchful for signs that the big-picture risks that lurk in the background are becoming more threatening. If, for example, the hous-ing market takes a severe and more widespread hit than what we think is likely, the U.S. and global economy would almost certainly fall into a recession and equity markets would suffer a sharp sell-off. Our models would be hit in that scenario, though we believe in most scenarios they would not violate their stated risk thresholds. In general, inflation and interest rates, income growth, spend-ing, and currency relationships will be some of the variables we’ll watch. These factors all have the potential to impact earnings. Most importantly we will stick with our core competency and care-fully assess asset-class valuations (which are also impacted by many of these variables), for signs of opportunity or increased risk. Through it all we will patiently wait for the next fat pitch.
We thank you for your confidence and trust.
Stapp Financial Planning, PLLC
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