Posts Tagged ‘Value Stocks’
Value Investing and the Philosopher’s Stone
Tuesday, April 30th, 2013
by Kevin Simms and Joseph G. Paul, AllianceBernstein
When J.K. Rowling finished her first manuscript of Harry Potter and the Philosopher’s Stone in 1995, she submitted it to 12 publishers, who all rejected the book. In time, those publishers would regret missing the chance to back an unknown author who would later take the world by storm. Like the publishers who passed over Harry Potter, we believe that many investors today risk missing a historic opportunity to invest against the grain in attractively valued stocks across the globe.
In recent years, many investors around the world have shunned value equity strategies, which focus on undervalued stocks that face controversy yet have promising long-term prospects. Since the financial crisis in 2008, as investors fled to safety and away from the riskiest stocks, the most attractively valued quintile of global stocks has slumped, underperforming the most expensive quintile of stocks by 5.6% a year. In contrast, over the last four decades, the cheapest stocks have outperformed the most expensive stocks by about 5.8% a year (Display). Against this backdrop, it’s understandable why value has fallen out of favor.
Yet the crisis also created huge distortions on equity markets that we think will ultimately support a recovery of value stocks. Over the last four years, massive amounts of cash have flowed out of equity mutual funds and into fixed income funds. Passive equities have become increasingly popular. And investors flocked to equity strategies focused on stocks with higher dividend yields while abandoning large-cap value equities, which are considered among the riskier types of stock investments.
As a result of all of these trends, the opportunity in deep value stocks has become very compelling. We measure this by looking at spreads between the most attractive quintile of global equities based on price/book valuations and the most expensive stocks have widened. Even after the equity market rally of recent months, these spreads are wider than almost any time in the last 50 years, except for during the technology bubble. Typically, when this ratio has narrowed and the line has declined, the cheapest stocks have outperformed strongly.
These spreads are also wide across sectors. This means that you don’t have to take concentrated positions in specific areas in order to capture the opportunity. What’s more, the quality of the cheapest stocks is unusually good. For example, the cheapest quintile of stocks has lower debt and stronger free-cash-flow yields than usual. So the inherent risks of investing in deep value stocks are lower than usual.
By the end of 2012, value stocks had slumped for five years—interrupted by a brief recovery in 2009—much longer than a typical downcycle. In contrast, periods of value outperformance tend to run for four consecutive years. So history suggests that there’s plenty to look forward to when a recovery materializes.
The legendary philosopher’s stone upon which the Harry Potter book was based was a substance that was said to be capable of turning base metals into gold or silver. While no investor possesses the powers of alchemy, diamonds in the rough can be identified in stock markets to generate premium long-term returns.
It’s very easy to be paralyzed by hindsight when the wounds of the recent crisis are still raw. Yet it doesn’t require a fantastic imagination to look forward and conceive of a scenario in which behavioral investing principles reassert themselves on global markets. For value investing to thrive, all you really need to anticipate is that cash flows and profitability will ultimately determine stock valuations again—and that’s a belief that doesn’t require any magic at all.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Kevin Simms is Chief Investment Officer—International Value Equities and Joseph G. Paul is Chief Investment Officer of North American Value Equities, both at AllianceBernstein.
Copyright © AllianceBernstein
Tags: Alliancebernstein, philosophers stone, Value Stocks
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Dividend vs. Treasury Yields
Friday, June 8th, 2012
by Econompic Data
The dividend yield of the S&P 500 is above that of the ten year Treasury for the first time since the financial crisis. Before that we have to go all the way back to the 1950′s to find a time when this was the case.
The kicker… stock dividends have only made up about 45% of total S&P composite stock returns over the past 100 years, while Treasury bond coupon payments have made up north of 96% of Treasury bonds returns over that same period (see below). What this means for an investor is unless you think dividends will be cut and/or capital appreciation will be negative (i.e. corporate America will shrink in terms of nominal value), stocks are poised to outperform.
My take… stocks appear to be very cheap relative to bonds for investors with a long-term investment horizon, while near term investors need to be careful as we seem to be in a world that is likely to have binary outcomes (i.e. either a boom or an absolute collapse).
The remaining 55% of S&P stock returns have been in the form of capital appreciation, which has become increasingly important since the 1950′s (see above), as corporations reinvested earnings back into their businesses / bought back shares (vs paying out dividends), while investors evaluated the relative merits of equities relative to bonds (see the much tighter relationship to bonds, which ratcheted up P/E multiples).
Source: Irrational Exuberance
Tags: Capital Appreciation, Composite Stock, Corporate America, Coupon Payments, Dividend Yield, Financial Crisis, Investment Horizon, Irrational Exuberance, Kicker, Long Term Investment, Nominal Value, Relative Merits, Stock Dividends, Stock Returns, Term Investors, Treasury Bond, Treasury Bonds, Treasury Yields, Value Stocks, What This Means
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4 Canadian Value Stocks (Ward)
Tuesday, October 11th, 2011
by J. Royden Ward, editor Benjamin Graham Value Letter, via The Stock Advisors
We screened our Benjamin Graham database to find Canadian companies with rapidly growing earnings and strong balance sheets.
We believe many outstanding buying opportunities exist among undervalued Canadian stocks. We believe the following four offer excellent appreciation potential during the next six to 12 month.
Canada is an excellent place to invest right now because the economy is growing, banks are solid and the national debt is under control.
Canadian banks were not allowed to sell risky loans or buy unsafe investments. The housing market in Canada remains solid, economic growth continues to climb, and the nation’s debt remains low.
Canadian National Railway (CNI) operates Canada’s largest railroad system covering Canada from east to west and the central U.S. south to the Gulf of Mexico.
Canadian National is the most efficient rail operator in North America with high profits and low costs.
The company hauls a wide variety of goods including forest products, intermodal shipping containers, farm products, petroleum and chemicals.
It’s $1.7 billion capital improvement program to expand port facilities, add track, and purchase freight cars and fuel-efficient locomotives will help EPS to roll along at a good clip.
CNI currently trades at just 12.1 times forward 12-month earnings per share, with a dividend yield of 2.0%. CNI is a solid long term investment.
Lululemon Athletica (LULU), founded in 1998 in Vancouver, British Columbia, makes long-lasting athletic clothing for running, dancing, practicing yoga and other active endeavors.
The company sells women’s pants, shorts, tops and jackets in 138 company-owned and four franchised stores in Canada, the U.S., Australia and Hong Kong.
The company will likely increase sales and earnings by 19% during the next 12 months. The stock, as measured by P/E, is expensive at 38.6 times our forward EPS estimate of 1.26, but far less than its 50.0 times EPS of a few months ago.
Potash Corp. of Saskatchewan (POT) is a leading producer of potash, nitrogen and phosphate fertilizers.
Critical demand for food in places like China and Africa will require more and more fertilizer to maximize crop production.
The company is spending $7.5 billion to enlarge its facilities, which will increase its fertilizer production more than 50% by 2015.
Larger global grain crops are boosting fertilizer demand, evidenced by Potash’s sales rise of 54% and EPS jump of 85% during the past 12-month period.
We expect strong sales and EPS growth in 2011 and 2012 as well. POT shares sell at a reasonable 11.3 times forward 12-month EPS.
Silver Wheaton (SLW), based in British Columbia, purchases silver from mines in Greece, Mexico, Peru and Sweden.
The company does not own or operate any silver mines, but purchases silver produced as a by-product of gold mining companies.
Silver Wheaton pays less than $4.00 per ounce of silver from gold miners such as Barrick Gold. Its contracts are immensely profitable and will produce rapid revenue and earnings growth well into the future.
The price of silver has dropped significantly during the past several weeks, but we expect higher prices in 2012. The recent decline in the stock price offers an excellent buying opportunity.
Copyright © Cabot Benjamin Graham Value Letter.
Tags: Active Endeavors, Athletic Clothing, Benjamin Graham, Canadian, Canadian Banks, Canadian Market, Canadian National Railway, Canadian Stocks, Capital Improvement Program, Cni, Dividend Yield, Earnings Per Share, Freight Cars, Gold, Long Term Investment, Rail Operator, Railroad System, Risky Loans, Royden, S South, Shipping Containers, Stock Advisors, Value Stocks, Vancouver British Columbia
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You Are Not as Dumb as You Think
Friday, September 23rd, 2011
by Vitaliy Katsenelson, Investment Management Associates
I was going to write something smart and pithy about this recent market decline, but then I realized that I’ve written about this in the past (more than once). So here is an excerpt from the Little Book of Sideways Markets. In addition, here is a copy of the presentation about sideways markets. – Enjoy.
Secular sideways markets are comprised of many cyclical bull and bear markets [take a look again at the chart below]. Though cyclical bull and bear markets can provide great buying and selling opportunities, our emotions will try to get in the way between us and the right decisions. Markets will constantly try to brainwash us into doing the opposite of what we should be doing. I hope [excerpt from] this chapter provides an antidote to this as it contains two missives. Read the first one [You Are Not as Dumb as You Think] during cyclical bear markets and the second [You Are Not as Smart as You Think, which I did not attach] during the cyclical bull markets. Good luck!
You Are Not as Dumb as You Think (Psychotherapy for Cyclical Bear Markets)
Lately I’ve been getting this nagging feeling that everything I touch turns to dirt. Every time I buy a stock that is already down a lot, the one that my analysis leads me to believe is cheaper than dirt, it declines more. Did I completely lose my ability to value stocks? Did I start ignoring Will Rogers’ advice to buy stocks that go up, and if they don’t go up, don’t buy them?
No, I didn’t get dumber, and my stock-picking skills haven’t diminished. I was simply a willing participant in the latest cyclical bear market. Bear markets make you feel dumber than you are, the same way bull markets make you feel smarter than you are.
Feeling dumb makes you do the opposite of what you should be doing. Fear and pain—yes, continued losses cause a lot of pain—are dangerous things because they can make you and me panic, lose confidence, and do the opposite of what we should be doing. To alleviate pain we sell, we react, we default to the only asset that made us money so far in the bear market—cash! Cash is only king when other assets are princes. When you cannot find a stock with a long-term superior risk/reward profile, then cash is King with a capital K. However, during a cyclical bear market, cash is slowly demoted to a prince as great companies are thrown out the window with the junky ones. You have to actively remind yourself of the eight-letter word T-O-M-O-R-R-O-W! Yes, tomorrow. Think of the lyrics from Annie:
When I’m stuck with the day that’s gray and lonely
I just stick out my chin and grin and say, ohhh
The sun will come out, tomorrow
So you gotta hang on’ til tomorrow
Of course, we don’t know if tomorrow is really tomorrow or five years from now. But investing is a marathon, not a sprint, and do not let the bear market turn you into a sprinter. First of all, remind yourself that you are not as dumb as your portfolio makes you feel. You have occasionally bought a stock that made you money. This is what I do: I pull out a chart of a stock on which I made a boatload of money or one I sold for the right reasons before it declined. I do this with pleasure, trying to relive my smart days. We all have these stocks, the ones we nailed. We tend to forget about them during the bear market phase. But I suggest you remember them now, when you feel lonely and miserable, so you’ll have more of these names to remember in the future, since cash will not bring the pleasure of victory in the long run. The cyclical bull market is still there; it is just hiding under the ugly sentiment of the cyclical bear market. Believe me, it will show its happy face. It is just a matter of time.
In a bear market, it is easy to forget about buying. Selling is a much easier decision to make. Every time you buy a stock you look dumb because it usually goes down afterward. I recently bought a couple of incredibly cheap stocks and, of course, they declined. I don’t feel smart about these buys right now. However, a while back I analyzed these companies, figured out what they were worth, determined an appropriate margin of safety, and got my buy prices. The stocks declined but fundamentals had not changed, so I bought the stocks.
You cannot worry about marking the bottom in every buy. My objective is not to buy at the bottom and sell at the top. No, my objective is to buy a great company when it is cheap and sell it when it is fairly valued. I suggest you do the same. Will Rogers’ advice is great, but unfortunately I have yet to meet a human being who has figured out how to apply it in real life. No, you are not as dumb as bear markets make you feel.
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email, click here or read his articles here.
Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy Katsenelson’s Active Value Investing (Wiley, 2007) book.
Tags: Antidote, Bear Market, Bear Markets, Bull And Bear, Bull Markets, Cheaper Than Dirt, Confidence, Dangerous Things, Emotions, Excerpt From, Fear, Good Luck, Investment Management, Losses, Management Associates, Market Decline, Psychotherapy, Value Stocks, Will Rogers, Willing Participant
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A Bull Market is Underway (Bob McWhirter)
Friday, January 28th, 2011
by Bob McWhirter, Selective Asset Management, Sub-Advisor to NexGen Financial
In Canada the Financials, Energy and Materials subgroups accounted for 94% of the 14.5% gain in the S&P/TSX Composite in 2010. The S&P 500 Composite was up 9.0% in 2010 in Canadian dollar terms.
2010 was a strong year for equity markets as earnings continued to rebound from their recessionary lows.
Strong 2011 forecast earnings growth of 26% for the S&P/TSX companies and 13% for S&P 500 companies is expected to drive stocks higher in 2011. We expect 2011 to be the year when rising earnings momentum distinguishes the performance leaders versus the laggards.
Concerns about rising inflation and the U.S. budget deficit at 10% of G.D.P. are expected to hold back bond prices in 2011. As a result investors should shift their focus from bond to equity funds in 2011.
Growth vs. Value
We favour growth stocks over value stocks at this stage in the market. The S&P/TSX Composite index has outperformed the S&P 500 Composite Index in 7 of the past 8 years due to the strong performance of resource sector stocks. The S&P/TSX is expected to outperform again in 2011 as its over 50% resource stock weight benefits from rising global economic growth and particularly from the strong energizing market economies.
Oil
Ray Hanson, Technical Analyst at RBC Capital Markets, believes that the price of oil will rise above $120 U.S. in 2011 as oil appears to have broken out (to the upside) from an 18 month trading range.
Copper
We noted in the October commentary that “technical analysts forecast that if the price of copper rises above $4.00/pound it could rise 50% to $6.00/pound in the next 12 to 18 months.” Copper has risen above $4.00/pound and because of strong demand and limited growth in supply for the next 2 years it appears that the price of copper will be significantly higher by the end of 2011.
Consumer Spending
The U.S. household debt servicing cost is the lowest it has been in 20 years. This may lead to an upside surprise in U.S. consumer spending in 2011. Small businesses in the U.S. may be the driver of increased hiring leading to further reductions in the U.S. unemployment rate.
Rising energy and raw material costs in 2011 may lead to a squeeze in consumer oriented profit margins. This occurred in 2007/2008 but natural resource companies (the providers of the raw materials) benefited at that time and are expected to benefit in 2011 providing further support of our view that the S&P/TSX should outperform.
In Summary…
Since mid-November $20 billion has been withdrawn from U.S. bond mutual funds to pay for equity purchases. We expect flows from fixed income funds into equities to continue to drive demand for equities.
We see 2011 as a year of opportunity as we believe a new equity bull market is underway. A near term pull back of 5 to 10% would be viewed as an opportunity to increase resource stock holdings. In late August in the growth oriented portfolios we “increased the emphasis on a company’s ability to service its debt as well as reduce its debt.” This change has contributed to the significant performance that has occurred in the growth portfolios since the end of August.
Copyright (c) NexGen Financial
Tags: Bob Mcwhirter, Bond Prices, Budget Deficit, Canadian Market, Dollar Terms, Earnings Growth, Earnings Momentum, energy, Forecast Earnings, Global Economic Growth, Growth Stocks, Household Debt, Market Economies, Performance Leaders, Price Of Copper, Rbc, Rbc Capital Markets, Resource Sector, Resource Stock, Selective Asset Management, Technical Analysts, Tsx Composite, Value Stocks
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Charles Brandes – Why Value Investing Outperforms (Part 2)
Tuesday, September 28th, 2010
Charles Brandes – Why Value Investing Outperforms (Part 2)
Charles Brandes, founder of Brandes Investment Partners (1974), which today manages over $50-billion in assets, globally, discusses why value stocks outperform growth stocks and bonds over the long term, with Dan Richards, Clientinsights.ca.
If you have not seen or read Part 1, you may access it here.
Dan Richards: If value stocks aren’t volatile, and they aren’t riskier, why in your view do they deliver superior long term performance?
Charles Brandes: That’s primarily behavioural. That’s primarily the fear and greed in the stock market and that has not changed for many many years. We can see that obviously, with the way stock prices fluctuate so much more than the actual value of the company.
DR: So you’ve got that behavioural phenomenon at work, that fear and greed, and you know that particularly, when those glamour stocks hit the headlines and investors get all excited and enthused – they want Apple or Google.
CB: Everybody wants those…It doesn’t matter what the price is.
DR: And, the other thing that we look at when we look at stock valuations is stocks are really a price to the function of future earnings. Its the future cash flow that’s discounted today, and that’s often driven by expectations. But really, when you’re buying a share of stock, you’re really buying the expectations that the market has over what those future earnings are going to be. Would that be a fair characterization?
CB: Yes, Very much, very correct.
DR: So the interesting question is what happens when a company announces earnings and the actual earnings are different than what the market expected higher or lower? So lets start with those glamour stocks like Apple or Google. What would happen if the earnings came in and they were less than the market expected.
CB: We’ve done a study of this in the Brandes Institute, and we found on the glamour stocks that if a surprise earning comes in, if its a surprise negative more than the expectations, the stock goes down, very very considerably. If its a surprise positive, because the market in the glamour stocks is always looking for much much positive, it also can go down.
DR: Even if it outperforms…
CD: Even if it outperforms what everybody expects it to do. ‘Cause everybody’s so enthusiastic about these companies.
DR: How about value stocks? What happens, you know, to those stocks that are relatively cheap, by your standards? What happens… Let’s talk first about what happens when there are positive earnings surprises compared to expectations?
CB: Positive earnings surprises in the value stocks; because nobody expects it at all, there’s no expectation there of them doing anything good, the stock prices will rise considerably, in those instances. We found in the study in the Brandes Institute, that it is so considerable, that is one of the reasons that value stocks outperform.
DR: So that is what happens if you get a positive earnings surprise. How about a negative earnings surprise? You know, results come in below what the market expects.
CB: This is the part that’s really surprising. Even on a value non-glamour stock, if the earnings surprise is even negative, the expectations for these companies is so negative that it makes the stock price go up, because even if they report anything, its amazing, we found this in our study over many years about these earnings surprises.
DR: So when you look at the research that you’ve done, what would be your one overall conclusion, coming out of that analysis that you’ve done over the long term impact of results reporting compared to expectations?
CB: It’s expectations that are so negative for the value stocks that if you buy them that these prices and anything that is considered positive changes, which it does, quite often, that’s why value outperforms the glamour stocks.
DR: Charles, thank you.
END OF PART 2
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Tags: Assets, Brandes Investment Partners, Cash Flow, Cb, Characterization, Charles Brandes, Earnings, Fear, Glamour Stocks, Google, Greed, Growth Stocks, Hana, Phenomenon, Stock Market, Stock Prices, Stock Valuations, Stocks And Bonds, Term Performance, True Loop, Value Investing, Value Stocks
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Charles Brandes – Why Value Investing Outperforms (Part 1)
Monday, September 27th, 2010
Charles Brandes – Why Value Investing Outperforms (Part 1)
Charles Brandes, founder of Brandes Investment Partners (1974), which today manages over $50-billion in assets, globally, discusses why value stocks outperform growth stocks and bonds over the long term, with Dan Richards, Clientinsights.ca.
Dan Richards: We’re going to talk about some research that Brandes Institute team has conducted recently, on the role of expectations when it comes to stock market returns. Let’s start by talking a little bit about what the long term returns for stocks look like going back to 1920 or so.
Charles Brandes: Yes, well the long term return for stocks going all the way back after inflation has averaged about 6.5% to 7%.
DR: How would that compare to bonds?
CB: The return on stocks would be about 2 or 3 times the return on bonds, after inflation.
DR: Academics look at these results and they say, well, the reason, that stocks outperform bonds is because of something called a risk premium, that because are more volatile, riskier, they demand a higher return. What’s your view on the role of risk premium in explaining why stocks outperform.
CB: Well, risk, as the academics define it is wrong. For a long term investor, risk is having to do with how well companies do; the academics define it as just the price changes or volatility. That’s true for speculators, prices changes and volatility in the short term, that’s risk for speculators, but not for investors.
The academics’ explanation for why stocks outperform bonds is not the right explanation. The real simple explanation is that stocks which represent businesses that create goods, they create the wealth that can pay the bond interest. So they have to create more wealth than bonds create.
DR: Talk about the facts that stocks as a whole have outperformed bonds. Now, within stocks there are a couple of different categories; there are value stocks compared to what are called growth stocks. I think you call them ‘glamour’ stocks. Could you talk about the difference between value stocks and what you call glamour stocks?
CB: Yes, its just a definition of the price that they’re trading for, in relationship to the earnings of the company; so again, the glamour stock is the one whose price is high compared to the earnings of the company, because the market is anticipating the earnings are going to grow. They’re growth stocks; glamour stocks growth stocks.
Value stocks are where there is very little anticipation of growth, usually, and their earnings are high, compared to the actual price of their stock.
DR: So we’ve talked about the difference between those two categories of stocks, value stocks vs. glamour stocks. Talk about what the long term performance looks like for those two different kinds of stocks.
CB: If you take those categories and you look at the top glamour stocks vs. the top value stocks, the value stocks over a long period of time will outperform by as much as 5% or 6% per year. In some cases, some periods, you can see them outperforming by as much as 10% per year.
DR: So an academic might look at that and say, well, if you’ve got a category of stocks like value stocks that outperform to that extent, well the reason must be that they’re more volatile and riskier than those other categories of stocks. what’s your observation on that?
CB: Well, there’s a couple of problems with their conclusions. First of all, they’re not more volatile, as they define risk as volatility. So, that is not right. From the other risk standpoint, of how companies do over a long period of time, they’re also not more risky. They’re actually safer, you’re paying for it is a lot less price wise than likewise for future development.
END OF PART ONE
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Tags: Academics, Bond Interest, Brandes Investment Partners, Cb, Charles Brandes, Going All The Way, Growth Stocks, Hana, inflation, Investor Risk, Little Bit, Price Changes, Risk Premium, Speculators, Stock Market Returns, Stocks And Bonds, Stocks Bonds, Term Investor, True Loop, Value Investing, Value Stocks, Volatility
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Asset Allocation Thoughts (Boeckh)
Monday, July 5th, 2010
This article is a guest contribution by Tony and Rob Boeckh, Boeckh Investment Letter.
“Let every man divide his money into three parts, and invest a third in land, a third in business, and a third let him keep in reserve.”
-Talmud, circa 1200 BC – 500 AD(1)
This letter is the start of a process we will, in the future, develop into a more useful and practical asset allocation framework for investors’ portfolios that reflects our macro view, concerns about the general riskiness of the financial world and a variety of issues that go into the asset allocation process.
As a starting point, it is important to understand what real long-run rates of return have been for different assets.2 Good data exists on developed country equity markets by sector and on real estate. For example, most people know that the real long-run return on U.S. equities is about 6.5%. Small-cap stocks outperform large companies by a wide margin, value stocks outperform growth stocks, also by a wide margin, and small value stocks easily outperform small growth stocks. However, small companies have much greater volatility and business risk.
It is also well known that the real return on bonds lags the real return on stocks, but risk is much less. In a portfolio, the inclusion of some bonds along with stocks lowers risk faster than it lowers returns up to a point.
Real estate is another major asset that is widely held. Real returns have been significantly lower than stocks: roughly ½% on residential property and about 5% on income-producing commercial property. And the swings can be wild when easy access to mortgage credit fuels leveraged speculation. Consequently, perceptions of risk in real estate have shifted dramatically over the last few years.
Emerging markets and gold can also be very attractive additions to portfolios. However, the history of emerging markets is short and these markets are evolving quickly. Gold has been free to fluctuate in the market only since 1971 and there have been just two major bull markets.
The asset allocation process is highly complex. Different investors have very different time horizons and risk aversions. The experience of the past three years has shown that historical correlations can be extraordinarily misleading. Various asset classes unexpectedly became highly correlated and much more volatile than the historical pattern. Understanding future correlations is the critical issue. In the midst of a crisis, liquidity can evaporate as trading volumes dry up, hedge funds close to redemptions and private equity may accelerate capital calls and halt distributions with unfortunate timing. Hidden leverage comes to the fore, exacerbating illiquidity.
Our approach to asset allocation is focused on wealth preservation by controlling the overall exposure to risk assets in relation to macro conditions, valuation and market psychology. We are not attempting to forecast the specific performance of various asset classes as a means of facilitating market timing decisions, as history has shown that this is rarely a winning strategy. Rather, we will attempt to provide analysis that will help investors play a more active form of defence and offense with their portfolios.
In order to achieve these goals, we favour a dynamic approach to asset allocation, reviewing the portfolio and making adjustments on a quarterly basis or as conditions evolve, rather than sticking with fixed allocations come “hell or high water”. Systemic risk in the global economy is far higher than in the previous post-World War II years, volatility promises to remain extraordinarily high and the financial system may be subject to major shocks. This is a major theme running through The Great Reflation. In such an environment, a buy and hold approach to asset allocation will carry a lot more embedded risk than most people expect.
In practice, the execution of dynamic asset allocation is subjective and highly complex for global investors. Many attempts have been made to create models or algorithms that rely on indicators to calculate an optimum asset allocation. However, this sort of quantitative approach inevitably breaks down as the assumptions that underpin the model cannot fit every set of economic conditions. We use indicators selectively to inform decision-making, but at its core, asset allocation is an art, involving equal measures of analysis, intuition and common sense. Above all, investors must have a clear idea of their tolerance for risk, exercise discipline and stick to a plan. Some prefer one of rigid allocations and the literature tends to support this approach. We favour a dynamic allocation process which allows for some flexibility in order to better control risk at important market junctures (e.g. stocks in 1999, housing in 2006-2007).
Tags: Asset Allocation, Attractive Additions, Bonds, Bul, Business Risk, Canadian Market, China, Commodities, Easy Access, Emerging Markets, Gold, Growth Stocks, Investment Letter, Macro View, Margin Value, Mortgage Credit, Natural Gas, Perceptions, Portfolios, Residential Property, Small Cap Stocks, Speculation, Talmud, Value Stocks, Volatility, Wide Margin
Posted in Bonds, Canadian Market, China, Commodities, Energy & Natural Resources, Gold, Markets, Oil and Gas, Outlook, US Stocks | 1 Comment »
Hussman: Violating the No-Ponzi Condition
Monday, May 3rd, 2010
This article is a guest contribution by John Hussman, Hussman Funds.
Over the past few months, the stock market has been characterized by an overvalued, overbought, overbullish, rising yields syndrome that has historically proved unrewarding and often particularly dangerous for investors. It’s important to underscore that even in post-war data, and even if we assume that the economy is in a typical post-war recovery, this particular syndrome has been unrewarding, on average, which places the Strategic Growth Fund in a fully hedged investment stance (essentially, the Fund holds long-put / short-call index option combinations having a notional value equal to the value of the stocks we hold).
As in 2007, the unusually low level of implied volatility, coupled with the syndrome of overextended conditions, has prompted us to establish a tight “staggered strike” position, raising the strike prices of our defensive put options close to the level of the S&P 500. Compared with a standard matched-strike hedge (long put options / short call options having the same strike price and expiration), a staggered position typically maintains about 1% of assets in additional put option premium. The Fund does not establish option combinations where more than one side is “in the money” when the position is initiated. Since we keep the new strike price of the put options below the level of the market, the potential downside (compared with a standard hedge) is limited to a modest loss of time premium if the market continues to advance.
Conversely, if the market declines below the strike price of the puts, the hedge provides a tighter defense for the stocks we hold, which can be helpful if the early sell-off is indiscriminate. This requires us to take day-to-day fluctuations with a slight grain of salt, because once the put options go “in the money” (i.e. the S&P 500 drops below the strike price of the puts), if the market then reverses back toward or above our strike prices before we have a good opportunity to reset our strike prices, we can give back some or all of our recent gains from those puts. So the puts can’t lose more than the amount of time premium we originally invest, even if the market advances, but can result in gains (that are occasionally transient) if the market drops below their strike prices.
I note this because when the S&P 500 moved well above 1200 in recent weeks and implied volatility dropped toward 16-17%, we raised our strikes to the 1200 level at relatively low cost. Those strikes are now in-the-money, so we expect to be well-protected against the impact of general market declines. Though we continually adjust our position to reduce the potential for “give back” (as we did near the market close on Friday), it is probably best to anticipate a few transient day-to-day gains and give-backs if the S&P 500 extends its decline substantially below 1200.
More generally, the primary source of our day-to-day fluctuations when we are hedged is the difference in performance between the stocks held by the Fund and the indices we use to hedge. For example, the most notable source of fluctuation in the Strategic Growth Fund last week was not hedging, but volatility in restaurant stocks that led the recent rally.
Geek’s Note: This asymmetry or “curvature” in the profile of option returns is called “gamma” (the second derivative of the option value with respect to price). Ideally, you would prefer to let this curvature run, and only adjust your position at the turning points of a market trend. In practice, we look for short-term overbought and oversold conditions to reset our strikes – a practice known as “gamma scalping.” Gamma is really what you are paying for when you purchase an option. If the actual short-term volatility of the market is greater than the implied volatility that was priced into the option when you established the position, effective gamma scalping can substantially reduce the impact of time decay even if the market is ultimately unchanged.
Violating the No-Ponzi Condition
The credit picture remains mixed at present, though the next several months are likely to provide significantly more clarity. The Greek debt concerns are interesting in the lesson that investors are hoping to be taught, which is that all debt, no matter how foul, should be considered risk-free and can be counted on to be bailed out, so that market discipline need not provide any impediment to the poor allocation of the world’s financial resources.
The basic problem is that Greece has insufficient economic growth, enormous deficits (nearly 14% of GDP), a heavy existing debt burden as a proportion of GDP (over 120%), accruing at high interest rates (about 8%), payable in a currency that it is unable to devalue. This creates a violation of what economists call the “transversality” or “no-Ponzi” condition. In order to credibly pay debt off, the debt has to have a well-defined present value (technically, the present value of the future debt should vanish if you look far enough into the future).
Without the transversality condition, the price of a security can be anything investors like. However arbitrary that price is, investors may be able to keep the asset on an upward path for some period of time, but the price will gradually bear less and less relation to the actual cash flows that will be delivered. At some point, the only reason to hold the asset will be the expectation of selling it to somebody else, even though it won’t be delivering enough payments to justify the price.
Transversality forces the price of the asset to be equal to the value of the discounted cash flows. It’s not enough for a borrower to keep the payments up over the short term, and it’s not enough for price of an asset to be on an upward track for a while – over time, securities actually have to be able to deliver enough cash flows to justify the price that investors pay. When investors abandon this requirement (as they did with dot-com and technology stocks during the runup to the market peak in 2000), the price they pay stops having any relationship with the stream of cash flows that will be delivered to them over time. An increasingly large portion of the asset price represents real money that is being paid for a “phantom asset” in the distant future, that bears no cash flows, and yet gets assigned positive value because investors assume they’ll be able to sell it to a greater fool. Every asset bubble fundamentally reflects this error in thinking. Ponzi schemes violate transversality conditions, as do sub-prime (not to mention Alt-A and Option-ARM) mortgages when they are assigned higher values than the expected cash flows can justify. If not for the ability to print money, which will become increasingly handy in future years, the U.S. government might be in the same situation, resulting from existing debt, probable future deficits, and unfunded liabilities.
Unless Greece implements enormous fiscal austerity, its debt will grow faster than the rate that investors use to discount it back to present value. Moreover, to bail out Greece for anything more than a short period of time, the rules of the game would have to be changed to allow for much larger budget deficits than those originally agreed upon in the Maastricht Treaty. One can’t rule this out, seeing as how our own nation has proved quite adept at dispensing with accounting provisions and other discipline that might have threatened bondholders. But if that is the case, our concerns about inflation pressures in the second half of this decade will only become more pointed.
We may very well see some short-term bridge financing in return for promises of greater fiscal discipline. This will do little but kick the can down the road a bit. [Late note - The EU and IMF announced late Sunday a 110 billion euro - roughly $146 billion - rescue plan for Greece, attached to an austerity plan that unions immediately denounced as "savage"]. Greece is a beautiful country, but its economy is not a model of flexibility. Anecdotally, having been, in my earlier years, among a train full of passengers tossed out near a field in the middle of the night upon arriving at the Greek border, hoofing it in the dark to the nearest town, bumming a ride to Thessaloniki, and eventually hiring a taxi to drive the full length of the country to Athens with five chain-smokers who refused to crack a window, while every other form of transportation was on a nationwide strike, I suspect that budget discipline to the extent required will not be easily implemented, and may be so hostile to GDP and tax revenues as to make default inevitable in any event.
With respect to mortgages, the most recent figures from Bloomberg covering residential delinquencies for over 12 million active, non-agency loans continue to show a record proportion of troubled loans. Non-agency (Fannie/Freddie) loans are those originated by the private sector, typically at even less stringent credit standards than Fannie and Freddie imposed. Bloomberg reports that delinquent, REO (real-estate owned), foreclosed, and bankrupt loans represented 33.78% of the total in March, the same level as in February. Of these, more than half (16.93%) were delinquent but not in foreclosure. While Subprime loans in foreclosure declined from 16.85% in January to 16.35% in March, and 30-day Subprime delinquencies declined from 4.86% in January to 4.34% in March, these declines were offset by increases in Alt-A foreclosures (12.23% to 12.43%) and delinquencies (4.18% to 4.45%). Overall, we clearly appear to be past the trouble in Subprime, but the rates for Alt-A and Option-ARM mortgages are trending the wrong way.
Jonathan Weil of Bloomberg made some observations a few weeks back about last year’s FASB change, which suspended “mark-to-market” accounting for banks. He notes that in early 2009, the Federal Home Loan Bank of Seattle was the “poster child for everything supposedly wrong with mark-to-market accounting.” While mark-to-market rules had forced the bank to write down its portfolio of mortgage backed securities by $304 million, the bank’s executives said they expected to lose only $12 million on these loans. At a March 12, 2009 congressional hearing, this disparity was presented as a “disturbing” example of the problem with mark-to-market. Paul Kanjorski pointed to a similar “absurd” example that “fails to reflect economic reality”, where the Federal Home Loan Bank of Atlanta was forced to report an $87 million mark-to-market writedown on a portfolio the bank expected to generate losses of only $44,000. In response to this pressure, the FASB ultimately caved. Unfortunately, the Federal Home Loan Bank of Seattle now says it expects $311 million of credit losses on its portfolio, while the Federal Home Loan Bank of Atlanta has raised its credit loss estimate to $263 million – both even worse than the original mark-to-market indications. The Seattle FHLB has filed lawsuits against Goldman Sachs and Morgan Stanley, among others, seeking refunds for mortgage-backed securities they underwrote.
Overall, it strikes me that the markets have wholeheartedly embraced the view that the recent downturn was nothing but a typical and purely transitory post-war wrinkle. Yet income continues to deteriorate once government transfer payments are backed out, in stark comparison to other post-war recoveries (see Bill Hester’s recent piece Business Cycles, Election Cycles and Potential Risks).
Investors have looked past the effects of temporary stimulus and opaque accounting, maybe on the Madoff-like thesis that neither sustainability nor accurate disclosure really matter as long as the numbers are good. Yet there’s also no denying that this thesis has worked beautifully, and we’ve missed out by questioning it. As I detailed last week in Looking Back, Looking Forward, the criteria for accepting risk – on the basis of valuation and market action – have been more stringent in periods of credit crisis (both U.S. and internationally) than we could have, in hindsight, got away with last year. I continue to believe that the market’s enthusiasm may turn out badly, given the extent to which GDP gains have been induced by unparalleled deficit spending, and earnings gains have been predominated by financials enjoying suspended accounting transparency. But we’ll see how this plays out over time.
That said, even the guidance from strictly post-war models has been decidedly defensive during 2010, and remains so today. If the evidence based on post-war data improves, we’ll become moderately more constructive. We’re currently giving about as much weight to a standard post-war recovery as we are to a continued credit crisis, but the evidence currently suggests a fully hedged investment stance for both cases, so these possibilities represent a distinction without a difference. To the extent that valuations or market action improve in a manner that would, in a normal post-war world, justify accepting some amount of market risk, we would presently move about half-way in that direction. If we observe no further crisis-level credit strains, I expect that we’ll be applying strictly post-war criteria by year end. So we’re allowing some time to move into our main window of concern, but our defensiveness won’t persist indefinitely without obvious evidence of credit deterioration.
Market Climate
As of last week, the Market Climate for stocks was characterized by strenuously unfavorable valuations, and a syndrome of overvalued, overbought, overbullish, rising-yield conditions that has historically been associated with poor outcomes. As noted above, our present hedged position is not dependent on the expectation of further credit strains. Needless to say, the additional clarity regarding credit risks that we expect in the months ahead will be welcome, regardless of the outcome.
In bonds, the Market Climate remained characterized last week by relatively neutral yield levels and unfavorable yield pressures. Credit spreads have been generally widening in recent weeks, with a somewhat unstable spike in the credit default swap spreads of major banks. I say “unstable” because it may be based on immediate concerns about Greece, rather than more persistent risk concerns. Broader measures of credit risk have ticked up modestly, but not as notably as CDS spreads. My expectation continues to be that inflation pressures will pose a significant challenge to the economy in the second half of this decade, benefiting inflation hedges and TIPS. However, over the shorter term, commodities appear overbought and a bit vunlerable.
The uncertainty about Greece and, by extension, the euro, has been a positive for precious metals recently, and while a default event could generate a “fear” spike in the metals, intermediate concerns about economic consequences and deflation in that event could result in a subsequent period of commodity weakness. In contrast, a near term agreement to provide bridge financing would ease fears and might take some air out of commodities more immediately. In short, the longer term prospects for precious metals and inflation hedges continue to diverge somewhat from near and intermediate term prospects. We closed our small 2% of precious metals exposure from the Strategic Total Return Fund last week on strength, and also have a limited exposure of only about 2% in foreign currencies here. Among currencies, the euro appears somewhat undervalued on our metrics, and possibly for good reason (versus a central value of about $1.49-$1.51 based on our “joint parity” methodology – see Valuing Foreign Currencies), as does the British pound, while the yen appears about fairly valued, and the Canadian dollar appears somewhat rich. I continue to believe that a credit shock would provide the best opportunity to accumulate longer-term positions in commodities, TIPS and certain foreign currencies, but I expect that we’ll respond to smaller opportunities – particularly fresh precious metals weakness – to establish more moderate exposures.
copyright (c) 2010 Hussman Funds
Tags: Assets, Call Options, Commodities, Defense Stocks, Downside, Economy, Fluctuations, Gold, Grain Of Salt, Hussman Funds, Implied Volatility, Index Option, Investors, John Hussman, Money, Notional Value, Option Combinations, Post War, Stock Market, Stri, Value Stocks
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Beating the Market
Thursday, July 30th, 2009
By Michael Nairne, Tacita Capital
For many investors, beating the market is the holy grail of investing. In fact, google the phrase “beating the market” and you get 14 million hits, more than seven times “passive investing”. Yet, beating the market over the long-term is extremely difficult. By definition, the market includes all stock owners and hence, investors as a group earn the market return – for every winner there must be a loser. In confirmation, a litany of studies has found that fund managers in aggregate achieve market-like returns less fees and costs.
However, the potential to beat the market does exist. Over the past several decades, the painstaking examination of historic stock performance in numerous countries has pointed the way to outpacing the market. The findings indicate that value stocks – those low-priced in relation to earnings, dividends and book value – have higher expected returns than growth stocks – those high-priced in relation to earnings, dividends and book value. Over the long-run, value investors are the winners; they earn a premium to growth investors who are the losers.
This premium is evidenced in the following graph which illustrates the growth of $1.00 U.S. invested in large value stocks (in red) compared to large growth stocks (in green) 
and to the S&P 500 (in blue) from August 1927 to May 2009. The investment in value stocks grew to $4,454 – more than four times the $868 of the growth stocks and nearly three times the $1,578 of the S&P 500 which, although growth-tilted, contains both value and growth stocks.
The historic outperformance of value stocks is not restricted to the U.S. market. In a study on the United Kingdom stock market from 1900-2000, Dimson, Marsh and Staunton (DMS) found that value stocks achieved an annual return of 11.5 percent, a 2.9 percent premium to the 8.6 percent return of growth stocks and a 1.4 percent premium to the market overall. They conclude that “over the long term, the historical record of value investing has been positive … we now know that value stocks did better than growth stocks in the earlier as well as later parts of the twentieth century.”
In fact, in a sweeping review of the research on the value premium in international markets, DMS found that value stocks outperformed growth stocks in thirteen out of fourteen countries including Canada. Italy was the only exception. The value premium is therefore a global phenomenon.
But this begs the question … why? Without a meaningful explanation, it is possible (although not probable given the length and breadth of its occurrence) that the value premium is a statistical fluke or worse, an historic anomaly now widely known, avidly pursued by knowledgeable investors and hence as prices are bid up, no longer available to future investors.
Economic theory offers us two explanations for the value premium. First, behavioural finance experts argue that cognitive biases hardwired into the human psyche often lead to the systematic mispricing of value stocks. David Dreman, a leading apostle of this view, believes that investors routinely overreact to recent news concerning a given stock. If it is good news, they tend to project a continuance of this favourable trend and bid up the price of the stock. When bad news confronts investors, an opposite reaction is triggered. Believing a negative trend to be firmly in place, investors either hold or sell and the stock price subsequently languishes. Yet, inevitably, some negative event occurs to cause the higher-priced growth stocks to tumble while conversely, enough positive surprises occur to send the value stocks spiralling upwards.
Investors appear to naively extrapolate recent earnings trends and only adjust their expectations slowly as recurrent surprises occur. One study by Fuller, Huberts and Levinson
found that while high-priced glamour stocks initially have much stronger earnings growth rates than low-priced value stocks, after five years or so this difference becomes negligible. As the market slowly adopts scaled-down earnings expectations as the new norm, value stocks enjoy superior returns as their price moves up at a relatively faster pace than that of the slackening growth stocks.
Another behavioral view holds that investors often confuse the characteristics of a good company (e.g. powerful brand, positive image, superior growth) with the elements of a good stock (i.e. a price that is low in relation to discounted future cash flows). One study found that the stocks of companies considered “excellent” according to the standards outlined in the best-seller In Search of Excellence materially underperformed the stocks of “unexcellent” companies!
The second explanation for the value premium comes from the efficient market school of thought. Under the efficient market hypothesis, the prices of stocks reflect all available information and hence, higher expected returns must rationally reflect higher risk. Originally, efficient market supporters did not believe there was sufficient evidence of a value premium. Then, in a 1992 landmark study covering the period 1963-1990, Professors Eugene Fama and Ken French found that value stocks outperformed growth stocks by a statistically significant margin. In 2000, a second study covering 1929-1963 contributed strong out-of-sample confirmation of the existence of a value premium.
According to Fama & French, however, value stocks are generally shares of companies that are in comparatively worse financial shape than companies whose shares are growth stocks. Investors demand a higher return for their investment in value stocks because of the greater risk the company will deteriorate financially or even go bankrupt. This is no different from bankers or bondholders who charge a higher rate of interest to companies in poor financial shape. The poor performance of value stocks during the Great Depression may be indicative of this risk.
Both the behavioral and efficient market explanations for the value premium are compelling. In academia, a vociferous debate exists as to which is the foremost cause of the value premium. From an investor’s perspective, however, the critical aspect of both explanations is that each supports an enduring value premium that is unlikely to disappear. However, the exploitation of the value premium rests on one key characteristic – patience – since the premium is highly volatile and can disappear or even go negative for years.
This volatility is evidenced in the following graph which depicts the 36-month rolling average annual return of the Fama-French Large Value Premium (i.e. the return of large value stocks minus large growth stocks) for the U.S. market for the period August 1929 to May 2009. Although value stocks outperformed growth stocks by an average annualized 3.24 percent, there are intermittent periods where growth stocks outperformed, sometimes by a significant margin, and some of these periods can persist for a number of years, such as occurred through much of the 1930′s and 1990′s.
To the thoughtful investor, the volatility of the value premium is reassuring. A premium which showed up with any regularity would disappear almost immediately since it would be arbitraged away by traders. Instead, the value premium is available to patient, long-term investors who are interested in beating the market. Impatient investors will need to look elsewhere.
July 23, 2009
Tacita Capital Inc. (“Tacita”) is a private, independent family office and investment counselling firm that specializes in providing integrated wealth advisory and portfolio management services to families of affluence. We understand the challenges of affluence and apply the leading research and best practices of top financial academics and industry practitioners in assisting our clients reach their goals.
Tacita research has been prepared without regard to the individual financial circumstances and objectives of persons who receive it and is not intended to replace individually tailored investment advice. The asset classes/securities/instruments/strategies discussed may not be suitable for all investors and certain investors may not be eligible to purchase or participate in some or all of them. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. Tacita recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a financial advisor.
Tacita research is prepared for informational purposes. Neither the information nor any opinion expressed constitutes a solicitation by Tacita for the purchase or sale of any securities or financial products. This research is not intended to provide tax, legal, or accounting advice and readers are advised to seek out qualified professionals that provide advice on these issues for their individual circumstances.
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