To My Clients, Friends & Observers:
And you have to love it. It’s been a six-year bull market, up on good news, up on bad news, up on no news, without so much as a 10% correction in the last 30 months. For a few years now I have been sharing my concerns about the quality and relative paucity of corporate earnings – despite what’s reported in the indexes. It is hard to get adjusted to what some call “the new normal” of slow growth. When the present value of future cash flows is declining and the market appreciates almost 30% it should get somebody’s attention, and it certainly has mine.
The market has been engineered to its present level by the Federal Reserve Bank, which owners are principally the same banks that created the financial mayhem of the last decade. The Fed indicates that it will continue tapering its monthly bond purchases by approximately $10 billion a month. Investors have been shoe-horned into the stock market by the zero, short-term interest rates. It has forced me to get yield from utility stocks for my retired, fixed-income clients. We’re not alone; the utility index is the biggest gainer so far this year, up over 5%. The Fed has been fighting a war against deflation and has won, inflating the financial markets mostly.
The “strong corporate earnings” of 2013 ran out of gas in the 4th quarter. Corporate share buybacks, which in December I had estimated at approximately $380 billion, actually topped $538 billion for the year. We track the reported earnings of each of the S&P 500 Index companies without regard to weighting. For the third quarter 2013, 161 companies (32%) of the Index had trailing twelve months (TTM) declines in earnings. Fourth quarter earnings have just finished reporting. As of 3/17 the TTM earnings of 226 companies (45%) had declined compared to the prior quarter. Looking at earnings this way, they broadly declined at an increasing rate.
As a result, the P/E ratio of the Index has expanded to 20 from 18 at year-end, reflecting shrinking earnings and indicating a market getting ahead of itself. I mentioned in my December comments that a fair value rule of thumb for the Index is the P/E + CPI = 20, and in December we were at “fair value.” Yale professor Robert Shiller incorporates inflation more realistically and calculates the Index’s P/E ratio using 10 years of inflation-adjusted earnings instead of TTM reported earnings. The Schiller P/E is over 25, 54% above the long-term average, and putting it in the top 10% of historical valuations since 1881, as reported by Spencer Jakab in the 3/24 Wall Street Journal. Mr. Shiller accurately called the tech and housing bubbles.
While the economy is strengthening, albeit at a snail’s pace, several fundamentals are still not improving. It is disturbing that the labor force participation rate is just 58.5%, the same as it was in 2010. Retirees and others no longer seeking employment are likely explanations. This translates into lower incomes, less consumer spending, stagnating revenues, lower corporate earnings and eventually, pressure on stock prices. Growth in earnings from cost cutting, lower wages and offshore outsourcing, are eventually exhausted. While profit margins of the S&P 500 are forecast to increase and exceed 10% for 2014, I expect to see this revised down.
On Trading and Turnover
As this letterhead indicates, there is a tag line underneath the name that accurately describes what the company does: “Systematic Portfolio Management.” There are periods, sometimes extended periods, of little or no trading in some portfolios. Occasionally some may feel that there should be more trading in their accounts to justify the management fee. A client told me once that he felt I was “babysitting” his stocks. Well, in fact they are my “babies” and they’ve outperformed the indexes for him over the years. More frequent trading would not increase the probability of better returns, in fact, just the opposite. The system dictates our trading activity. Let’s review.
The system dictates positioning portfolios of companies that are significantly more profitable, higher yielding, and lower priced than the S&P 500 Index. Such a portfolio will have a Price to Earnings ratio (P/E) significantly lower than the S&P 500 Index. There is compelling data that low P/E portfolios outperform over time. This is the value component of the system. We buy shares of companies that, for one reason or another, are out of favor. While I am anticipating that such companies will eventually become favored, and consequently rise in price, I cannot predict the timing of that eventuality. And while occasionally certain specific stock selections are wrong, the overwhelming percentage of the time the system is absolutely right.
I’m always looking for new companies. I read the Wall Street Journal daily, Barron’s weekly, Forbes bi-weekly, and various investment research services daily (Credit Suisse, Standard & Poors, J.P. Morgan, and others.) On a quarterly basis I do a systematic search by screening all exchange-traded stocks. The initial screening is electronic and extensive. Regardless of the number and scope of parameters thousands of stocks are screened in seconds. Companies that meet my first screens I’ll inspect for sector and trend. The vast majority I reject. The ones that I keep will generate more thorough research reports and a review of financial statements and ratios. My screening doesn’t yield a large crop. Two or three attractive companies is a typical result after screening thousands of stocks and picking through the candidates. New portfolios that have to be invested are populated with companies already included in my aggregate. New discoveries are added to all suitable portfolios as soon as reasonable.
Annual portfolio turnover averages about 20%. Unless there is a compelling reason to sell a stock that continues to meet my screens, I will continue to hold it. Our portfolio objective is P/E expansion due to increases in P. P/E expansion can also occur because of shrinkage in E. As the P/E of a portfolio approaches, meets or exceeds the P/E of the S&P, it compels selling to realize profits and/or losses and re-balance to a P/E that is significantly less than the Index. When a market corrects or crashes it is the high P/E stocks that get hurt the most. Lower P/E portfolios are more defensive in this regard.
I have added the P/E ratio of each client’s portfolio to our quarterly performance summary letter. Remember what a P/E ratio does: it tells us how many years it would take for a company to earn back the price we paid for it at its existing level of earnings. That’s not very sophisticated financial analysis but it’s a very practical dose of reality.
I monitor every stock held in client accounts, and many others that aren’t, every market day in real time. A 10% drop in a stock, or any incongruous movement, provokes a review of the company. A 20% drop requires a carefully calculated reason to continue to hold. A 20% drop requires a 25% gain to get back even. That’s another reason why minimizing losses is more important than maximizing gains.
I never hired a babysitter that I didn’t trust. Who would?
There is a series of ads for Standard & Poors Depository Receipts (SPDR’s) touting their “precision.” The most popular of this series of Exchange Traded Funds (ETFs) is SPY, which attempts to duplicate the S&P 500 Index – with a great degree of “precision.” SPY trades at 1/10 of the price of the S&P 500 Index. The Index closed today 3/18 at 1872.25. The last trade on SPY was at $187.66. Ten units of SPY trade within .25% of the Index. That is the precision the to which the ad refers.
Most ETFs are set up as Trusts. Others may be structured as Limited Partnerships. The value of the ETF is determined by market price action, supply and demand - for the unit, not its underlying securities. Differences that occur between the ETF and the securities in the underlying Index create arbitrage opportunities that are immediately covered by the ETF sponsor using electronic trading systems. The continual execution of these arbitrages keeps the fund and the index closely aligned in price. They also are a perpetual profit center. Transaction costs, such as brokerage commissions, are not reflected in the annual Trust operating expenses.
ETFs are traded on exchanges by market makers or between broker-dealers. Market makers determine the appropriate bid and ask prices for each ETF unit just as they would a stock. This is where “precision” can go out the window. Market makers can manipulate the bid or ask, creating an arbitrage opportunity for the trust sponsor and leaving the uninformed investor with a significantly more expensive trade. I speak from personal and painful experience. They are never to be traded early or late in the trading session and should never be entered without a limit price.
There are presently over 1,500 exchange traded products and more to come although growth has slowed and many are being shut down. I have used certain ETFs myself as a default investment, i.e., when I want exposure to the whole market immediately, I will buy SPY for the S&P 500; when I want immediate exposure to gold I will buy GLD. These are never long-term holds. There are also hundreds of ETF’s that represent notes, debt obligations, or derivatives. These are nothing more than a professed effort to duplicate somebody else’s obligations – a must to avoid.
What I cannot understand about the current drum-beating for ETFs is the naïve public embrace for indexes, the best of which have lost money for the better part of a decade, and derivative-based units that have repeatedly demonstrated disastrous unreliability. I fear the do-it-yourself investor is being led to the abattoir, again. The SEC has announced it is investigating ETFs for “style creep,” i.e. funds that are not constructed to function as they are advertised and marketed. That is a common, long-term complaint about mutual funds. Investors seduced by ETFs know not what they do. They provide less, not more, control. Warren Buffett and Charlie Munger don’t use ETFs. They must know something.
Memo to Clients
Portfolios holding Vodaphone American Depository Receipts (ADRs) have recently had reorganization activity. Vodaphone, an English company, divested itself of its 45% ownership of Verizon Wireless by distributing cash and Verizon shares to shareholders, thus shrinking itself.
One ADR = 10 English shares of Vodaphone. Portfolios will show an unrealized capital loss on the Vodaphone position, offset by the addition of Verizon shares and cash.
Dennis M. O’Connor