April 2006: Managing Other People’s Money: A Few Post-Bubble Investment Market Reflections
We take seriously our mandate to manage client investable assets entrusted us. Our role as a fiduciary imposes a sobering responsibility, one which carries with it a certain ever-present anxiety, since some of the investment market forces we deal with daily are well beyond our control. Periodically, it’s useful to sit back, think about past winners and losers, consider our current position, look for emerging trends and assess the probabilities of future occurrences materializing.
The biggest challenge facing a portfolio manager is to identify change, at best prospectively, hopefully at least while underway. The desire is to recognize structural change before or during its emergence and before it achieves the status of conventional wisdom, something most other serious investors (professional, as well as careful individuals) are all presumably attempting as well. Our chances of consistently achieving any unique competitive information advantage long-term versus other market participants are probably slim to none. Nevertheless, since over time the overall asset class weightings (i.e., equities vs. bonds, large companies vs. small, etc.) generally determine portfolio performance against each account’s investment policy benchmarks, we need to continually test the assumptions underlying each mix.
Into, and since, the dot com bubble’s demise, client portfolios have weathered some serious equity market erosion and fully participated in its turnaround beginning in 2003. On balance, it’s been a productive period. During the past 6-7 years we have operated under a few key beliefs:
(1) The world’s economies would continue to become more integrated;
(2) Global economic integration would lead to worldwide investment market consolidation, narrowing the correlation in price behavior between U.S. and other non-dollar denominated securities markets; and
(3) Although messy on the surface, our politicians would not disturb this seemingly inevitable process toward greater worldwide interdependence.
During the late 1990’s and the naiveté of day trading, “its different this time,” The Dow At 36,000, we avoided the high-tech large company market fiasco, emphasized the small company equity component, tilted toward value, participated in the natural resources run-up, benefited from a substantial allocation to international equity funds and prospered from a modicum of emerging market exposure. We missed the seemingly inexorable run-up in REIT prices and the domestic real estate play, but more than recouped that forgone opportunity with a substantial small company overweighting. On balance, these strategic portfolio sector allocations resulted in better-than-benchmark (vs. S&P 500 Index) investment results achieved with a reduced portfolio risk profile (i.e., portfolio price volatility).
Today’s Investment Realities: Are Portfolios Appropriately Structured to Participate in the Changing Economic Circumstances Ahead?
An honest reply to this question of course would be, we cannot be certain. One constant in the statistical discipline is that where the law of large numbers describes the behavior of many players, reversion to the mean always reasserts itself. In the investment markets, if one outperforms a benchmark for a period of time, the tendency to later fall behind, leading to overall average results, is almost always present. Only a few stalwarts (e.g., Warren Buffett, Peter Lynch, John Neff) have proved to be the exception to this rule. However, historically, earning only equity market average returns (roughly 10% compound annual growth while enduring + 16% price volatility), although not easily attained, has proved rewarding enough. Even if in the future compounding only at 8% per annum, an equity portfolio would double in value in nine years. Our investment goal, as many will remember, is to provide market returns with a lower than average market risk profile.
What structural changes need we recognize today? Of primary importance is the realization that the slow realignment of global economic power continues. Evident primarily at the margin presently, the compounding effect of this continuing shift will tend to accelerate and drive geopolitics in the years ahead. In its Foresight 2020 publication, the Economist Intelligence Unit predicts that by the end of the second decade in this century China’s Gross Domestic Product (GDP) will equal that of the U.S.; India’s will only slightly trail U.S. domestic output. Fourteen years hence, most other free and practically-free economies, including Japan’s, will lag the three economic superpowers, primarily because they are burdened by central planning bureaucracies, welfare state politics and unfavorable demographics (i.e., aging populations and declining birth rates).
Already we can recognize some of the initial effects of these economic displacements. Emerging country treasuries are flush with cash (mostly U.S. Dollars) and are lending to deficit-ridden developed nations. China’s rush to tie up natural resources and energy supplies around the world, while not too subtly politically leveraging these commercial arrangements, is plain enough to even a casual observer. India’s program to become the services outsourcing center to the English-speaking countries of the world is transparent. To date, such developments have been symbiotic, but these mutually reinforcing relationships may not continue to be sustainable into the distant future. Our own politicians, thinking locally and not acting globally, may very well damage the delicate fabric of these commercial ties among nations. It goes without saying, we as individual investors will be operating in a geopolitical minefield in the years ahead.
In the near term, this year and into 2007, the world’s economies appear headed towards continued moderate, non-inflationary growth which should support average to slightly better-than-average increases in corporate earnings. An 11.5% year-on-year gain for the first quarter of this year seems already in hand, according to Barrons. Today’s stock market valuations appear reasonable, and when compared to consensus future earnings growth estimates (see accompanying graphic) are aligned in a classic current-price-to-growth expectation pattern. The anchor plot, illustrating expectations for the U.S. Equity Market in aggregate, would be the Russell 1000. Today, this proxy for the largest 1,000 U.S. companies is selling at just under fifteen times 2007 earnings with an expected future growth rate of around 10% per year. Historically, these price-to-growth relationships (so called PEG ratios) appear quite in line, and unless the U.S. market takes an emotional hit, downside risk would appear to have been fully discounted at present market price levels.
Beyond this, U.S. corporate coffers are awash in cash which this year and next will fuel increased levels of business capital investment and beefed-up share buyback programs; the latter tending to reduce the supply of common stock in circulation, an added source of support for higher stock prices near-term. The boost in corporate capital expenditures could be coming at a time when consumer spending, which until now has been a consistent source of domestic economic strength, is beginning to tail off.
The Attraction of Alternative Investments: Here Today, Gone Tomorrow?
As mentioned in his book Unconventional Success, David Swensen, Yale’s highly regarded endowment manager during these past 18 years, was hopeful he could translate his many endowment portfolio investment techniques into a blueprint for individual and personal investment success. He admits in the early chapters, however, that just about all of the component strategies employed to achieve Yale’s, and other large tax-exempt portfolios’ similarly remarkable results, are not available to even most wealthy taxable investors. Consisting primarily of creative, illiquid, locked-in, long horizon alternative vehicles, including hedge funds, highly leveraged real estate and bond management strategies, one must get aboard early and pay very high entry fees to yield the desired results. For taxable investors today, it’s a playing field for the extremely wealthy, the super-rich and very sophisticated. For merely affluent investors today, the fee structure for many of the more accessible, so called fund-of-funds alternative vehicles in this over-crowded market can reach as high as 30% of profits, plus base fees of up to 3% annually.
There is also evidence that the diversification value of such alternative investments is diminishing (think “reversion to the mean”); not surprising, since in the hedge fund world alone there are now nearly 7,500 players with roughly $1.0 trillion, each manager attempting to uncover investment market anomalies that can be profitably arbitraged. Richard Bernstein of Merrill Lynch has compared the correlation patterns (i.e., diversification characteristics) of a number of alternative investment categories during the past 15 years and finds a rather strikingly rising correlation relationship with the U.S. equity markets (i.e., S&P 500 Index). Since one of the arguments for taking on the added liquidity risk inherent in alternatives has been the chance for greater return with more or less assured diversification benefits, the case for alternatives seems weaker today.
Missing from this analysis are data on the correlation characteristics between the S&P 500 Index and a suitable proxy for private equity funds. However, even if this alternative investment category continued to exhibit beneficial portfolio risk diversification attributes, cautionary flags need to be observed. Cash has been pouring into the private equity sector these past few years, prompting the need to generate larger, more creative deals, some of questionable economic workout potential. This has also fostered a more activist shareholder role on the part of private equity fund managers, sometimes forcing the managements of target corporations to sacrifice longer term shareholder value enhancement on the alter of short-term results. At the moment, there would appear to be too much liquidity seeking too few real opportunities in the private equity world.
What About the Fixed Income Portion of A Balanced Account: Interest Rates, The FED and its New Chairman, Mr. Bernanke?
In most instances we think of client portfolio management assignments in a balanced account context. Working from the background of a client’s combined personal net worth statement, usually anchored by ownership of a substantial principal residence, we construct portfolios aimed at achieving a reasonable future total rate of return. Dividend and interest income are but ingredients of this equation, not objectives in and of themselves. With capital gains tax rates on the bargain table today, relatively speaking, the Federal tax code, for the most part, takes taxes out of the portfolio investment decision process. The fixed income (i.e., cash, bonds, life insurance cash value, fixed annuity, pension income, Social Security benefits, etc.) portion of a balanced portfolio plays the role of diversifier, ballast for the combined account, a cushion during periods of declining equity markets.
Preserving the real value of the fixed income allocation during rising equity markets and low interest rates has been our goal during the past few years. Anticipating that interest rates were headed higher (bond prices lower), our strategy has been to own short maturity high quality fixed income funds which charge minimal fees (or bonds in larger accounts). Today, returns in the short end of the bond market have risen and are competitive with longer maturities, a so-called flat interest rate curve environment. How will this interest rate puzzle resolve itself?
Exit, Mr. Greenspan, enter Mr. Bernanke; how will the new Federal Reserve Board Chairman deal with the flat yield curve conundrum? The world watches and waits for an indication of a new FED policy direction, but if recent history is a guide, such a shift will be gradual and more evident in retrospect than recognizable in real time. The indication is that Mr. Bernanke, focusing on his primary role of keeping inflation under control, may allow administered short rates to rise further in the near term; a prospect the equity markets will have to interpret and come to grips with during the next few months. If we were in a betting mode, one would wager that rates would escalate still further from present levels. However, one tenet the new FED chairman seems to bring to the table is a firm belief that there is a cost in lowered economic growth and reduced productive efficiency from increased tax burdens. Even though his role in tax policy political discussions will be advisory, as our global competitive battles unfold during the next few years this understanding may be very helpful in the domestic debates ahead.
Move to 30 Federal Street Delayed to Mid-June
Construction delays now seem behind us and we expect to move into our new location on the 7th floor of 30 Federal Street (between Franklin and Milk Streets) during the week of June 12th. If possible, should you have a meeting scheduled for this period, it would be a good idea to check to make sure where we are located. As mentioned, one of the entrances to our new offices faces Post Office Square. If you drive, the Post Office Square Underground Garage is immediately across from the entrance to our building. Bring your parking ticket with you and we will have it validated.
As always, we welcome your questions, comments, and suggestions.
Sincerely,
James L. Joslin
Chairman, CEO