Stock Pickers: “Somebody I Used to Know”

Tuesday, August 7th, 2012

by William Smead, Smead Capital Management

Art has a tendency to express culture. One of today’s catchiest songs does a great job of explaining the relationship between institutional/individual investors and US common stock picking. In Gotye’s, “Somebody I Used to Know”, the lyric writer expresses the pain of a love affair gone awry and the feelings coming out of the former couple in words. To us at Smead Capital Management (SCM), the song captures what has happened since the summer of 1999, when Warren Buffett warned investors about forward stock market returns because of a love affair that institutional and individual investors were having with US large cap stocks. It takes us into today as Bill Gross from Pimco, David Rosenberg from Gluskin, Scheff and others encourage investors to underestimate the benefit of US large cap common stock ownership. At the same time, these purveyors of rational despair are driving investors away from stock picking when it is most likely to be advantageous to both institutions and individuals.

Now and then I think of when we were together
Like when you said you felt so happy you could die
Told myself that you were right for me
But felt so lonely in your company
But that was love and it’s an ache I still remember

Let me take you back to 1999, when investors and US large cap stock picking “were together” and investors loved their stocks until they “ached”. Buffett explained at the Allen and Co. gathering in Sun Valley, Idaho that the Fortune 500 index of common stocks was trading at 30 times earnings and was dooming US large caps to 17 years of sub-par performance. Stocks had performed spectacularly from August of 1982 to that summer day in Sun Valley. After 17 years of only occasional and mostly mild market corrections and years of prosperity, common stock investors in US large cap were “so happy they could die”. Their love for stock picking and stock pickers covered the pages of major media.

As Buffett shared, investors told themselves that common stocks “were right for them”. He quoted a UBS/Gallup poll which showed that the clients of UBS/Paine Webber expected 20% compounded returns over the next five years in US large cap common stocks. Picking common stocks and holding them for a long time was the national pastime. As I remember at that time, the over-pricing of US large cap growth/tech stocks made both Buffett and me feel “so lonely in your company”. No Bill Gross or David Rosenberg or any of today’s well known negative nabobs around to tell us where we’d be now beside the Oracle of Omaha.

Now and then I think of all the times you screwed me over
But had me believing it was always something that I’d done
But I don’t wanna live that way
Reading into every word you say
You said that you could let it go
And I wouldn’t catch you hung up on somebody that you used to know

People massively over did their affection for common stocks in 1999 and laid the groundwork for 12 years of extremely poor historical returns. Today both institutional and individual investors can only “think of all the times that you (US large cap stocks and stock pickers) screwed me over”. The times were the 2000-2002 and 2007-2009 bear markets. Two 40%-plus bear market declines in an eight-year stretch. It caused investors “believing it was always something” they had done. Ultimately, they decided “they didn’t want to live that way, reading into every word (Stocks for the Long Run) you say”. Investors decided common stocks “could be let go” and the stock pickers and US large cap companies were “somebody they used to know”.

But you didn’t have to cut me off
Make out like it never happened and that we were nothing
And I don’t even need your love
But you treat me like a stranger and that feels so rough
No you didn’t have to stoop so low
Have your friends collect your records and then change your number
I guess that I don’t need that though
Now you’re just somebody that I used to know

Unfortunately, the rear-view mirror never creates a good vision of the future. Investors for the most part have dramatically “cut off” their allocation of US large cap equity ownership. Worst of all, they “make like” the good years in the history of the stock market “never happened”. Investors have gone to the ends of the earth and to esoteric and illiquid investments to seek investment affection and act like they “don’t even need your love”. Here is how the logic goes. Investors say, “Stocks have performed poorly the last 12 years and haven’t met our return goals. Therefore, we will assume they never will. It will make me feel better if I assume that successful common stock investing was a statistical aberration and a thing of the past.” Isn’t it terrific that numerous self-interested gurus come by to regularly reinforce this rear-view mirror logic (The Cult of Equity is Dead).

You can get addicted to a certain kind of sadness
Like resignation to the end, always the end
So when we found that we could not make sense
Well you said that we would still be friends
But I’ll admit that I was glad it was over

On May 31, 2012, Randall Forsyth wrote at barrons.com that all of this has morphed into what he calls “rational despair”. Like the song says, “You can get addicted to a certain kind of sadness.” You look around you and see unsolvable economic problems, poor backward-looking stock market returns, dysfunctional governments around the world and you despair in a very logical way. You resign the US economy and stock market to a bad end and you hoard cash or invest in doomsday categories to justify your hopeless attitude. Gotye wrote, “Like resignation to the end, always the end”. If I had five dollars for every doomsday email I’ve been sent in the last three years, I’d be flush with cash. People look at US large cap stocks and stock pickers and “found that we could not make sense”. Some folks have gravitated to large cap indexes and ETFs because they said, “that we would still be friends”. Despite strong returns since the market lows of March 2009, those who despair rationally “admit that they are glad it was over”. It was their love for stocks and stock pickers that was gone.

But you didn’t have to cut me off
Make out like it never happened and that we were nothing
And I don’t even need your love
But you treat me like a stranger and that feels so rough
No you didn’t have to stoop so low
Have your friends collect your records and then change your number
I guess that I don’t need that though
Now you’re just somebody that I used to know

Cutting yourself or your institution off from owning healthy quantities of US large cap stocks based on the logic we’ve explained is like cutting off your nose to spite your face. Women in Northern Europe cut off their nose to look ugly to avoid being raped by conquering armies. In the same way, those who “make out like it (US stocks historically above-average returns among liquid asset classes) never happened” are, in our opinion, dooming themselves to sub-par portfolio performance at a time when above-average returns have never been needed more! Investors treat long duration common stock investing in US large cap stocks “like a stranger and (for stock pickers) that feels so rough”. “You didn’t have to stoop so low” when it comes to your portfolio allocation to US large cap and to active managers in the category.

Today, US large cap stocks are in a more similar position to 1982, than to anything like 1999. In 1982, we had high unemployment, huge budget deficits and loans for home buying or business formation were hard to come by. Stocks had performed poorly for over a decade. Gold, Oil and collectibles were popular among those who saw that era as made up of unsolvable problems and despaired rationally. Fortunately for us, the same guy who warned us in 1999 has laid out the right long-term view for us today. Here is how Warren Buffett puts the current circumstance in excerpts from his annual letter to the shareholders of Berkshire Hathaway called, “The Basic Choices for Investors and the One We Strongly Prefer”:

Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future. More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.

From our definition there flows an important corollary: The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability – the reasoned probability – of that investment causing its owner a loss of purchasing-power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over their holding period. And as we will see, a non-fluctuating asset can be laden with risk.

Investment possibilities are both many and varied. There are three major categories, however, and it’s important to understand the characteristics of each. So let’s survey the field.

- Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge.

Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control. Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power. Its managers would have been kidding themselves if they thought of any portion of that interest as “income.”

Under today’s conditions, therefore, I do not like currency-based investments

- The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.

The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative.

As “bandwagon” investors join any party, they create their own truth – for a while.

Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.”

- Our first two categories enjoy maximum popularity at peaks of fear: Terror over economic collapse drives individuals to currency-based assets, most particularly U.S. obligations, and fear of currency collapse fosters movement to sterile assets such as gold. We heard “cash is king” in late 2008, just when cash should have been deployed rather than held. Similarly, we heard “cash is trash” in the early 1980s just when fixed-dollar investments were at their most attractive level in memory. On those occasions, investors who required a supportive crowd paid dearly for that comfort.

My own preference – and you knew this was coming – is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment. Farms, real estate, and many businesses such as Coca-Cola, IBM and our own See’s Candy meet that double-barreled test. Certain other companies – think of our regulated utilities, for example – fail it because inflation places heavy capital requirements on them. To earn more, their owners must invest more. Even so, these investments will remain superior to nonproductive or currency-based assets.

Our country’s businesses will continue to efficiently deliver goods and services wanted by our citizens. Metaphorically, these commercial “cows” will live for centuries and give ever greater quantities of “milk” to boot. Their value will be determined not by the medium of exchange but rather by their capacity to deliver milk. Proceeds from the sale of the milk will compound for the owners of the cows, just as they did during the 20th century when the Dow increased from 66 to 11,497 (and paid loads of dividends as well). Berkshire’s goal will be to increase its ownership of first-class businesses. Our first choice will be to own them in their entirety – but we will also be owners by way of holding sizable amounts of marketable stocks. I believe that over any extended period of time this category of investing will prove to be the runaway winner among the three we’ve examined. More important, it will be by far the safest.

In our opinion, Buffett is the greatest stock picker of all-time and his portfolio is loaded with undervalued US large Cap stocks. Those who suffer from “rational despair” are massively over-weighted in the currency and unproductive assets that Buffett is warning everyone about. They are just like the bitter former lovers in the song who “wouldn’t catch you hung up on somebody that you used to know”. It is so ironic that investors today are having a love affair with the same asset-class allocation as they did in 1982 (Gold and Commodities). We believe the circumstances today scream for a new love affair to start between investors and US large cap stock pickers. Look at the long-term correlation chart below:

Source: The Big Picture, http://www.ritholtz.com/blog/2011/12/correlation-in-the-markets/

Our advice is to avoid stock pickers when stocks are expensive and correlations are low and milk them for years when correlations are high, like they are now. Correlations were the highest historically in 1982, 1987, 2002-03 and 2008-09. All these instances were around major US stock market low points. It might be time for asset allocators to “collect your records and then change your number” when it comes to US large cap and US large cap stock pickers. In that way you won’t have to look back ten years from now and view US large cap stocks and stock pickers as “just somebody that I used to know”.

Best Wishes,

William Smead

The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results.  It should not be assumed that investing in any securities we recommend will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.

Copyright © Smead Capital Management

Tags: Allen And Co, Bill Gross, Cap Stock, Cap Stocks, Common Stock, Common Stocks, David Rosenberg, Fortune 500, Individual Investors, Love Affair, Lyric Writer, PIMCO, Scheff, Smead, Stock Investors, Stock Market Returns, Stock Ownership, Stock Pickers, Sun Valley Idaho, Warren Buffett
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What History Suggests About the Future of Stocks

Thursday, August 2nd, 2012

by Seth Masters, Chief Investment Officer, AllianceBernstein

Some experts today argue that the world has entered a “New Normal” condition in which stocks have permanently lost their return edge. We’ve heard this before. It was wrong then, and we think it’s wrong now, too.

In 1979, BusinessWeek published a cover story famously called “The Death of Equities.” Then, like now, stock market returns had lagged 10-year Treasury returns for a decade, although for somewhat different reasons.

Stock returns had been dragged down by the bursting of a bubble (the Nifty Fifty) and bleak economic conditions. OPEC had unleashed its second oil-price shock in five years. The so-called misery index—the sum of the unemployment and inflation rates—was 20% in the US, double its level today (because inflation is now very low). And corporate profits were very weak (today, they are very strong).

BusinessWeek was capturing widespread sentiment about the economic and market outlook. Nonetheless, stocks handily beat bonds over the 10 years starting in 1979.

As the ubiquitous legal disclosure says, past performance does not guarantee future returns. Indeed, performance often reverses sharply.

Between 1901 and the onset of the recent credit crisis, there have been 11 10-year rolling periods in which bonds beat stocks, all of them coinciding with the Great Depression or the stagflation of the 1970s. And after each and every one of them, stocks beat bonds for 10 years—on average, by 5.8%, as the Display below shows.

Because we are human, we all tend to expect the future to resemble the recent past—to become “anchored” in our recent experience. It takes guts to buck the trend. But at a September 1983 client conference, we cited good fundamental reasons in making “The Case for the 2,000 Dow.” The Dow Jones Industrial Average was then slightly below 1,300. It reached 2,000 in January 1987, about three-and-a-half years later.

Today, our median annual return projections for global and US stocks are about 8% over the next 10 years, far ahead of our projected 2% median return for 10-year Treasuries. At that rate, the Dow could hit 20,000 in five to 10 years. In the same time frame, the S&P 500, a more representative index, could hit 2,000. (It’s now around 1,300.)

Our projected stock returns may sound optimistic. They’re not. They are well below the long-term average for US and global equities, and are based on conservative assumptions about economic and market conditions.

Still, many pundits argue that stocks today are overpriced. My next blog post will assess stock valuations.

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.

Seth J. Masters is Chief Investment Officer for Asset Allocation at AllianceBernstein and Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein.

Tags: Businessweek, Chief Investment Officer, Corporate Profits, Credit Crisis, Different Reasons, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Average, Fundamental Reasons, Future Returns, Great Depression, Inflation Rates, Legal Disclosure, Market Outlook, Misery Index, Oil Price Shock, stagflation, Stock Market Returns, Stock Returns, Stocks Bonds
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Country Default Risk (YTD April 2012)

Saturday, April 14th, 2012

In our prior post we highlighted year to date country stock market returns.  Below we highlight the change in sovereign debt default risk for 50 countries.  For each country, we show where its 5-year CDS (credit default swaps) currently stands and where it was at the start of the year.  Prices are in basis points.

As shown, just 3 of the 50 countries have seen default risk increase in 2012 — Portugal, Greece and Spain.  Spain is the main problem, with default risk now up 32.31% year to date.

Norway, Switzerland, the US and Sweden have seen huge drops in default risk so far this year.  Norway now has the lowest default risk of any country at 22.05 bps, followed by the US at 29.6 bps.  It’s been awhile since US CDS has been below 30.

Tags: April, Basis Points, Bps, CDS, Countries, Country Risk, Country Stock, Credit Default Swaps, Debt Default, Default Risk, Greece, Norway, Portugal, Sovereign Debt, Sovereign Risk, Spain, Stock Market Returns, Sweden, Switzerland
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2012 YTD Country Stock Market Returns

Saturday, April 14th, 2012

Below is an updated snapshot of 2012 equity market returns for 78 countries around the world.  Of the 78 countries shown, 64 are in positive territory for the year, while 14 are in the red.  The average YTD percentage change for all countries shown is 7.11%.  Of the G7 countries, Japan, Germany and the US are outperforming the overall average.

Four of the G7 countries are significantly underperforming the average.  The UK and Canada are currently up just over 1% year to date, France is up just 0.93%, and Italy is down 4.84%.  Spain has been the worst of any country in 2012 with a year to date decline of 15.36%.

Tags: Canadian Market, Countries Around The World, Country Stock, Decline, G7 Countries Japan, Italy, Japan Germany, Percentage Change, Snapshot, Spain, Stock Market Returns, Year To Date, Ytd
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YTD 2012 Country Stock Market Performance

Friday, January 27th, 2012

Below is a table highlighting the year to date stock market returns for 78 countries around the world.  Of the 78 countries shown, 59 (75%) are in the black for the year, while 19 are in the red.  Twelve countries have posted double digit gains already in 2012, with Argentina leading the way at 18.11%.  Russia ranks second with a gain of 13.70%, followed by Hungary in third and Greece (yes, Greece) in fourth.

The US currently ranks 33rd on the list with a gain of 4.73% year to date.  The US ranks fourth among G7 countries behind Germany (10.88%), Italy (6.77%) and France (6.44%).  The UK has been the worst performing G7 country so far in 2012 with a gain of 4%.

Last year the BRICs were significant underperformers versus the rest of the world, but they’ve bounced back so far in 2012.  As mentioned above, Russia is up 13.70% year to date, which is the best of the BRICs.  Brazil ranks second with a gain of 10.92%, India isn’t far behind at 10.50%, and China ranks fourth with a gain of 5.44%.

Tags: Argentina, Brazil, BRICs, China, Countries Around The World, Country Stock, France 6, G7 Countries, G7 Country, Greece, Hungary, India, Italy, Leading The Way, Rest Of The World, Russia, Stock Market Performance, Stock Market Returns, Stock Performance, Year To Date
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A Gift from Risky Markets

Friday, December 30th, 2011

By Scott Ronald, Steadyhand Investment Funds

Michael Nairne, president of Tacita Capital, wrote a good piece in the Financial Post last weekend, titled A Gift From Risky Markets, which looks at historical stock market returns and valuations (dating back to 1825) and provides some perspective on the level of long-term returns investors can expect going forward.

If you got stiffed this holiday season or are looking for a little cheer as the bills come rolling in, this short article may be just the elixir you need.

Tags: Cheer, Elixir, Historical Stock Market Returns, Holiday Season, Investment Funds, Investors, Perspective, Steadyhand, Stock Market Returns, Tacita, Valuations
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US Stock Market Returns – What is in Store?

Thursday, April 28th, 2011

Stock market movements since the start of the credit crisis have been characterised by relatively high volatility as uncertainty became paramount. And as new pieces of the economic recovery puzzle are added every day, investors are increasingly struggling to make sense of the most likely direction of stock prices.

It seems to be a case of so many pundits, so many views. Has the market started topping out and is a primary bear market about to resume, or will the secular bull market merely be correcting the strong rally that commenced in March 2009, before moving higher? Or is a “muddle-through” trading range in store?

It is one thing to trade the market’s rallies and corrections, but this is easier said than done, with not many people actually getting it right with any degree of consistency. Others are of the opinion that the recipe for creating wealth is simply to follow the patient approach, saying that “it’s time in the market, not timing the market” that counts.

This gives rise to the all-important question: does one’s entry level into the market, i.e. the valuation of the market at the time of investing, make a significant difference to subsequent investment returns?

In an attempt to cast light on this issue, my colleagues at Plexus Asset Management have updated a previous multi-year comparison of the price-earnings (PE) ratios of the S&P 500 Index (as a measure of stock valuations) and the forward real returns, as done by Jeremy Grantham’s GMO. Our study covered the period from 1871 to April 2011 and used the S&P 500 (and its predecessors prior to 1957). In essence, PEs based on rolling average ten-year earnings were calculated and used together with ten-year forward real returns.

In the first analysis the PEs and the corresponding ten-year forward real returns were grouped in five quintiles (i.e. 20% intervals) (Diagram A.1).

The cheapest quintile had an average PE of 8.9 with an average ten-year forward real return of 11.0% per annum, whereas the most expensive quintile had an average PE of 25.5 with an average ten-year forward real return of only 2.1% per annum.

This analysis clearly shows the strong long-term relationship between real returns and the level of valuation at which the investment was made.

The study was then repeated with the PEs divided into smaller groups, i.e. deciles or 10% intervals (see diagrams A.2 and A.3).

This analysis strongly confirms the downward trend of the average ten-year forward real returns from the cheapest grouping (PEs of less than six) to the most expensive grouping (PEs of more than 21). The second study also shows that any investment at PEs of less than 12 always had positive ten-year real returns, while investments at PE ratios of 12 and higher experienced negative real returns at some stage.

A third observation from this analysis is that the ten-year forward real returns on investments made at PEs between 12 and 19 had the biggest spread between minimum and maximum returns and were therefore more volatile and less predictable.

As a further refinement, holding periods of one, three, five and 20 years were also analysed. The research results (not reported in this article) for the one-year period showed a poor relationship with expected returns, but the findings for all the other periods were consistent with the findings for the ten-year periods.

Although the above analysis represents an update to and extension of an earlier study by GMO, it was also considered appropriate to replicate the study using dividend yields rather than PEs as valuation yardstick. The results are reported in diagrams B.1, B.2 and B.3 and, as can be expected, are very similar to those based on PEs.

Based on the above research findings, with the S&P 500 Index’s current ten-year normalised PE of 27.1% and dividend yield of 1.8%, investors should be aware of the fact that the market is by historical standards in “extreme overvaluation” territory. As far as the market in general is concerned, this argues for unexciting long-term returns, and possibly a “muddle-through” trading range for quite a number of years to come.

Although the research results offer no guidance as to calling market tops and bottoms, they do indicate that it would not be consistent with the findings to bank on above-average returns based on the current valuation levels. As a matter of fact, there is a distinct possibility of below-average returns.

Tags: Bear Market, Creating Wealth, Credit Crisis, Economic Recovery, Investment Returns, Jeremy Grantham, Muddle, Patient Approach, Pe Ratios, Predecessors, Price Earnings, Pundits, Quintile, Rallies, Secular Bull Market, Stock Market Returns, Stock Prices, Stock Valuations, Store Stock, Volatility
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Inflation Fears Dampen Pension Plan Gains?

Thursday, April 21st, 2011

by Leo Kolivakis, Pension Pulse

Barbara Shecter of the Financial Post reports, Inflation fears dampen pension plan gains:

You can read the full RBC Dexia release by clicking here. Late this evening I spoke to a senior fund manager from an insurance company and he told me 2010 was one of their best years whereas Q1 2011 isn’t as strong because their bond portfolio isn’t doing as well.

The big question is inflation already a problem in Canada, forcing the Bank of Canada to resume increasing interest rates? According to Stéfane Marion and Yanick Desnoyers of the National Bank of Canada, the brisk rebound in March CPI will put pressure on the Bank of Canada to raise rates in July:

After the February low core inflation rate, a brisk rebound occurred in March with almost all of the components showing strong acceleration. As a result, the twelve- month core CPI experienced a substantial change from February to March (0.8 percentage points). In our opinion, the underlying trend of inflation in Canada is closer to 1.5% rather than the February number of approximately 1%. Core goods CPI registered its biggest March increase in more than 20 years. Despite the high flying Canadian dollar, core goods CPI is now back in positive territory on a y/y basis. Thus, the cyclical low for core CPI is now behind us. In its last monetary report, the BoC described Canada as an economy with “material excess supply”. In light of this morning’s inflation data this wording appears to be too strong. The process of normalizing interest rates must resume in Canada. We think that a July rate hike is the most likely scenario.

Will the Bank of Canada resume increasing rates? Given the rise in core inflation, it’s highly likely but remember, the Bank of Canada can’t veer too far off from the Fed, so any rise in rates will be slow and gradual. Also, the Bank of Canada is concerned with the rise in personal debt. And then there is the bigger problem of the Canada bubble fueled by Canada’s mortgage monster.

In other words, while inflation pressures are building, I wouldn’t be reducing my exposure or actively shorting Canadian bonds, because when the Canada bubble bursts — and mark my words, it will eventually burst — those Canadian bonds will outperform all other asset classes.

Copyright © Pension Pulse

Tags: asset class, Bond Holdings, Canadian, Canadian Market, Canadian Pension Plans, Canadian Stocks, Composite Index, Coupon Payments, Dexia Investor, Don Mcdougall, First Three Months, Inflation Fears, Jitters, Loonie, Money Managers, Pension Assets, Pension Plan, Price Declines, Rbc Dexia Investor Services, Shecter, Stock Market Returns, Tragic Events
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Searching for Growth in Asia (Matthews)

Thursday, March 24th, 2011

Searching for Growth in Asia

by Taizo Ishida, Portfolio Manager, Matthews International Capital Management, LLC

March 2011

Date of publication: March 8, 2011. This piece was written prior to the earthquake and tsunami that took place in Japan on March 11, 2011.

There are many ways one might define “growth” and go about uncovering it. In my experience, I have found that there is an abundance of growth available if you know where to look and how to find it. There are a few key elements I look for: main drivers of growth, sustainability and scope of growth, and market expectations (in terms of valuation).

Many global investors today are seduced by the last several years of strong stock performance in China and India, fueled by robust economic growth. However, economic growth alone does not guarantee good stock performance—as evidenced in the chart below, comparing India’s stock market returns to the country’s GDP growth. In fact, many studies argue that, historically, there has been little correlation between stock market performance and economic growth.

Regardless of whether these empirical studies are still valid, my interest as an equity portfolio manager, revolves around one main concern: how does a company grow? How does it grow from US$100 million market capitalization to US$1 billion market cap, from US$1 billion to US$10 billion and so on.

Asia’s “Obvious Growth” Areas

“Growth” is often associated with something new and exciting, such as new technologies, new industries and new territories. It may seem obvious that as incomes grow, the average basic needs of households (housing, food and clothing) should also rise. With about 3 billion people in Asia waking up to the idea of increasing personal consumption, the region can certainly be considered to be growing and exciting.

Let us first consider a few examples of perhaps more apparent areas of growth in Asia. Prior to 2000, annual automobile sales in China had barely reached 2 million vehicles, while U.S. auto sales were approximately 17 million a year. In 2010, China’s auto sales reached about 18 million vehicles, surpassing U.S. car sales at 11 million. Autos have certainly been a growth sector, but will this continue to be the case going forward? There are many questions one should ask before making a quick investment decision in this sector. Is this growth secular or cyclical (like many other markets in history)? Which segments of automobiles—sedans, SUVs or trucks, for example—should see the fastest growth? What about electric cars? Should more investment go toward local companies or multinational joint ventures? We believe that growth in this sector will be less obvious over the next 10 years than it was over the past decade, and that identifying primary drivers of future growth is essential.

Another example of an “obvious growth” area is the wireless telecommunications sector in Asia’s emerging markets. India’s cell phone market grew from 2 million handsets sold in 2000 to about 545 million in 2010. The industry is still growing with approximately 18 million new subscribers a month. However, the stock performance of Indian telecom firms over the last five years tells a different story: Stock prices for this sector fell, most likely as a result of overvaluation just prior to this period. The sustainability and scope of growth for a business, therefore, are key elements to consider.

Emerging Growth

Growth is emerging in less obvious areas or, in what some might consider, the most unlikely of places. Much recent press on Japan has emphasized “how cheap” it is for investors, but we also see compelling growth as a reason to be interested. The trick here is to select companies on a bottom-up basis, rather than considering the sector overall. Retail industries in developed countries tend to be quite mature and, as such, investors don’t tend to get very excited about the prospects. But there are, in fact, a few Japanese retail companies doing very well domestically. One is a retail bicycle chain, and another is a retail electronics chain. Both generate revenues almost entirely from the domestic market, yet their revenues have grown each year for the last 10 years, a notable achievement for any part of the world. There is also another type of emerging Japanese retailer—the type that is seeking new territories within Asia. A few are even targeting select major U.S. and European cities. While the bulk of their operations are in Japan, in the coming years, a primary driver for this type of firm is faster overseas growth. None of these retail companies is an obvious investment candidate. However, they show attractive potential in their fundamentals.

There really is no easy slam dunk or truly “obvious growth” in the world of investing as so much changes so quickly (even as I write this). Particularly in Asia, the pace of change seems faster than in other regions simply due to the region’s rapid economic growth. As these changes continue, one of the more encouraging developments is the improvement of living standards in certain pockets of Asia—though not necessarily for a country as a whole. GDP per capita alone would not lead to good investment decisions because big cities are often completely different from the rest of the country. The needs and lifestyles of those living in some big Asian cities, such as Shanghai and Mumbai, are becoming quite similar to those in New York or Tokyo. This is good news for global companies that see the potential for an expanding customer base, but it may indeed be even better news for Japanese consumer companies due to their proximity and cultural similarities. Chinese tourists with spending power, for example, are quickly becoming a permanent fixture in Tokyo’s high fashion area of Ginza. Who knows? Perhaps my next investment idea may come from Ginza!

Also stemming from Japan, one “new” and less-hyped industry—unlike today’s social networking companies—is the robotics industry. Robotics firms are generally off the radar screen of many global investors simply because few of these companies are listed anywhere, except in Japan. It is no secret that Japan loves robots and more than 30% of the world’s robots are estimated to “live” in Japan. Most of these industrial robots can be found in factories as essential partners to human laborers, and the cost of replacing people with industrial robots has decreased dramatically over the last 20 years. As a result, factories in China are increasingly installing these robots at a faster-than-expected pace. Rising Chinese labor costs are encouraging more Japanese-led automation in China, and many robotic component companies are also benefiting. It would not be difficult to imagine the continuation of this trend as long as China maintains its status as the “factory of the world.”

Japan’s Growth Curve

The fact that Japan once dominated the mobile Internet space (prior to 2000) escapes most people. That was almost a decade before the average American began busily engaging in social media and games on mobile devices as they do now during their daily commute. “I-Mode,” launched in Japan in 1999, was a pioneering technology used to connect mobile phones with various Internet-related services, including e-mail and games. It was an instant hit and became a de-facto standard in Japan, though it was used only domestically.

The emergence of smartphones and third-generation (3G) and fourth-generation (4G) networks changed all this as standards became more universal, and began enabling many Japanese companies to participate in markets overseas. Some of Japan’s up-and-coming companies offering interactive mobile Internet game platforms are already attracting much interest from around the world, including the U.S. and China.

Why have I focused so much on growth related to Japan? As I mentioned earlier, I look for companies that possess certain elements, and many Japanese companies I am finding fit the bill very nicely. For me, they offer attractive company valuations and robust compliance levels that meet the standards of the developed world. Meanwhile, many actual operations of Japanese firms are increasingly taking place in more emerging nations in the region.

An Analogy for Japan

For those who have concerns over investing in Japanese companies, I would suggest considering Japanese stocks as if you were considering Swiss stocks. This is less farfetched than it may sound: both Japan and Switzerland are older, smaller countries with few natural resources. Moreover, both countries are established tourist destinations within their regions, with the added attraction of clean air and water. If you are beginning to see my analogy, I would pose this question: Would you think about the overall Swiss economy or demographics in considering whether or not to invest in some of Switzerland’s strong, global companies? If your answer is negative, you may see my point about investing in Japan from the bottom up.

Ultimately, the growth we encounter as investors is the growth of businesses and the value they create for shareholders. Finding these opportunities is never the result of simplistic processes—whether they be top-down, macroeconomic, theme-based or driven by historical data. It is a constantly surprising search to challenge conventional wisdom.

Taizo Ishida
Portfolio Manager
Matthews International Capital Management, LLC

Tags: Automobile Sales, Capital Management Llc, China, Emerging Markets, Empirical Studies, GDP Growth, Global Investors, Good Stock, Growth Areas, India, Ishida, Last Several Years, Market Capitalization, Market Expectations, Matthews International, New Territories, Personal Consumption, Portfolio Manager, Publication March, Robust Economic Growth, Stock Market Performance, Stock Market Returns, Stock Performance
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Negative Annualized Stock Market Returns for the Next 10 Years or Longer? It’s Far More Likely Than You Think

Tuesday, February 8th, 2011

Negative Annualized Stock Market Returns for the Next 10 Years or Longer? It’s Far More Likely Than You Think

by Michael ‘Mish’ Shedlock, Global Economic Trends Analysis

Market cheerleaders keep ratcheting up expected earnings, failing to note that much of the recent earnings growth is simply not sustainable.

Reasons for Unsustainable Earnings Growth

• Much of the recent earnings growth is directly related to federal stimulus that will eventually end.
• Much of the earnings in the financial sector are a mirage, based on assets not marked-to-market and insufficient loan loss reserves. The Fed and the FASB have repeatedly postponed rules changes for the benefit of banks and other financial institutions.
• Earnings in both the financial and nonfinancial sectors have margins outside historical norms, based on very low headcounts and outsourcing.

Nonetheless, let’s ignore the above factors and assume earnings will keep rising. Does that mean the stock market will go up, or is even likely to go up on a sustainable basis?

Stock Market Cycles and PE Ratios

Crestmont provides stock market returns and PE Ratios, for every year going forward, from every year since 1900.

1. Nominal Returns (not inflation adjusted), including dividends (reinvested), transaction costs, and taxes paid: S&P 500 Nominal Returns + Dividends
2. Nominal Returns (not inflation adjusted), without dividends, transaction costs, or taxes: S&P 500 Nominal Returns
3. Real Returns (inflation adjusted), including dividends (reinvested), transaction costs, and taxes paid: S&P 500 Real Returns Including Dividends

PEs in the matrix tables are Case-Shiller normalized PEs.

The matrix tables listed above are for taxable accounts. Crestmont also provides matrix tables for tax-exempt accounts.

The concept may be hard to visualize until you see it, but as word of warning I have a 24 inch monitor and the matrix tables will not come close to fitting on my screen. To read the text and numbers in the PDFs, you will need to enlarge the size making it impossible to see the entire table at once.

Nonetheless, please open up one of the above tables to get an idea of their size. The diagonal black line running through each table is a 20 year-line.

Essential Ideas

1. In spite of what efficient market theorists say, for a period of at least 20 years, it very much matters whether the starting valuation (PE) is high or low when one starts to invest.
2. However, in any given year (or even for several years), stock market returns may do random things. In other words, just because a market is richly valued does not mean it cannot get more so. Likewise, just because a market is cheaply valued, does not mean it cannot get cheaper.
3. As a result of the preceding point, many think that returns are random. While that may be true in a given year, over a sufficient period of time, expected future returns are anything but random.
4. The stock market fluctuates over long periods of time, between low and high PE valuations. Those cycles can last 20 years, and in that timeframe, people are apt to forget or ignore long-term cycles of PE expansion and PE compression.
5. The bulk of stock market gains frequently come from PE expansion, not from improved earnings.
6. It is important to know where in the cycle one is (whether PEs are in a state of expansion or contraction).

It is invalid to exclude dividends, so I used the matrix (nominal returns + dividend) as the starting point for the following tables and analysis.

The table below shows a sampling of years (some high valuation years and some low) along with annualized returns for two decades.

Annualized Rates of Return for Select Years

Click on any table to see a sharper image

Note how much the starting PE valuation matters. Someone who started investing in 1929 received an annualized rate-of-return of 0% for two full decades, even if they religiously reinvested dividends every year.

However, someone investing in 1982 received an excellent annualized rate-of-return for two full decades (12% for the first decade and 9% annualized for 20 years).

Note year 2000. Starting valuations were the highest in history. It should not have been a surprise to discover that 10 years later, the annualized rate-of-return was -2%.

Bear in mind, the Case-Shiller normalized PE for the year ending 2010 is 23. Does that bode well for the next decade?

Of course no one knows what this year or next year will bring.

Take a look at 1996 in the above table. In spite of several years of huge stock market gains, the annualized rate-of-return to date sits at 3.

Cycles of PE Compression and Expansion

Over long periods of time PE ratios tend to compress and expand. Unless “it’s different this time”, history says that we are in a secular downtrend in PEs. From 1983 until 2000, investors had the tailwinds PE expansion at their back. Since 2000, PEs fluctuated but the stock market never returned to valuations that typically mark a bear market bottom.

Moreover, demographically speaking, the current decade not only starts with very rich valuations, but also comes at a time when peak earnings of boomers have passed. Those boomers are now heading into retirement and will need to draw down savings, not accumulate large houses and more toys.

Of course, the market can of course do anything this year (or the next few years), but history strongly suggests that stock market returns for the next 10 years will be lean years, perhaps negative years.

Annualized Rates-of-Return Starting PE Above 21

The following table shows annualized rates-of-return for the current year, the 10th year, and the 20th year for each year in which the PE started at 21 or higher.

Variance over Time

• The first year rate-of-return ranges from -30 to +33.
• The annualized rate-of-return for the first decade ranges from -4 to +7.
• The median rate-of-return for the first decade is +1.

That median rate of return going forward will be influenced in an unknown but likely negative fashion from the current starting point and high PE valuations for the years that have yet to be determined.

Annualized Rates-of-Return Starting PE Less Than 13

The following table shows annualized rates-of-return for the current year, the 10th year, and the 20th year for each year in which the PE started at 13 or lower.

Variance over Time

• The first year rate-of-return ranges from -11 to +34.
• The annualized rate-of-return for the first decade ranges from +4 to +15.
• The median rate-of-return for the first decade is +10.

Valuations Matter in the Long Run

Please consider the following snip is from the Sitka Pacific 2010 Annual Review.

Depending on how closely you follow the financial markets, it may be surprising to learn that profits are at new highs even though stock prices, as measured by the S&P 500, are still 20% below their highs. In other words, new highs in profits haven’t translated into new highs in stock prices. If we go back even further, after-tax corporate profits soared 175% from the first quarter of 2000 through the second quarter of 2010. However, during that same time, stock prices fell roughly 15%.

In fact, there is nothing novel about a period of falling stock prices and rising earnings. Since the end of World War II, corporate profits have more or less trended continuously higher, with only minor interruptions during recessions. However, stock prices have gone through long periods in which they trended sideways or down, even though earnings continued to rise. From 1966 to 1980 after-tax corporate earnings rose 244%, but the price of the S&P 500 rose only 18% during that period. In contrast, earnings grew only 112% during the next 14 years from 1980 to 1994, but the S&P 500 rose 327% over that time.

Although very short-term returns are influenced by corporate earnings, beyond the short-term it is not trends in earnings but valuations and trends in valuations that determine stock market returns. In short, when valuations are low and increasing, long-term stock market returns are high. When valuations are high and decreasing, long-term stock market returns are low—even negative at times of peak valuations.

There are many ways to measure the valuation of the stock market, but relatively few ways that have value when they are applied across many types of bull and bear markets. Over the past year we have focused on the price-to-earnings measure popularized by economist Robert Shiller, which uses a 10-year average of earnings. Since earnings have at times fluctuated wildly in the short run, a 10-year average captures a much more reliable snapshot of the long-term profitability of public companies.

As you probably know, the stock market peak 10 years ago was the largest bubble in this country’s history. Previous bull markets ended with a 10-year P/E ratio in the 23–33 range, with the high point being the peak in 1929 at 33, just prior to the Great Depression. However, the bull market that ended in 2000 recorded a peak 10-year P/E ratio of 44, a valuation that was 33% higher than in 1929.

To really understand on a practical level how high valuations were at the peak in 2000, it helps to look at market returns from different valuation levels before the bubble in the 1990s. The chart below has a blue dot for every month from 1881 through 1990. The horizontal axis at the bottom shows the 10-year P/E of the S&P Composite during that month, and the vertical axis to the left shows the subsequent 20-year inflation adjusted return of the market.

Click on chart to see a sharper image

Prior to 1990, each month in which the 10-year P/E was under 10 (to the left of the green line) had a positive inflation-adjusted return over the next 20 years. That means that at those low valuations, you could confidently buy-and-hold stocks for the long term and know that the market would beat inflation over time—often by a significant amount.

However, for 10-year P/E ratios above 22 (to the right of the red line), there is not a single month between 1881 and 1990 in which the market had a positive inflation-adjusted return in the subsequent 20 years. And for P/E ratios above 25, past returns have approached �’10% annualized, a rate of return that gives an 88% inflation-adjusted loss over 20 years.

Since 1995, the market had been above 10-year P/E valuations of 22 for 13 consecutive years, until July 2008. After a brief decline in 2009 into valuations that would be considered “average” historically, the market ended 2010 with a 10-year P/E of 23. Although this is about half of the peak valuation in 2000, it is still above valuation levels that have produced positive inflation-adjusted returns in the past.

With a peak 10-year P/E ratio of 44 in 2000, it is no mystery why returns over the past decade have been poor. On a consumer price index adjusted basis, the S&P 500 ended last year 31% below its 2000 peak, for an annualized return of �’3%. Although we’ll have to wait another 10 years to see the S&P 500’s 20-year inflation-adjusted return from its record P/E of 44, it is almost certain to be a negative number, and probably a large negative number.

Notes:

• The above chart was produced from data from Robert Shiller: Real Returns (inflation adjusted), including dividends (reinvested).
• The PE of 44 mentioned above is a midyear high and thus differs slightly from the tables I created.
• To reiterate the key take-away from the above chart: 20-year real returns are negative for any starting 10-year PE over 22. At the end of 2010, the 10-year PE was 23.

Swimming Upstream

History shows that stock market valuations range from extremely cheap (10-year normalized PEs near 10 to extremely overvalued, 10-year normalized PEs of 44). Peak to trough changes in valuation occur over long periods as the market goes from one extreme to another.

Here is another chart looks at things from the point of view of PE compression (stocks moving from extremely overvalued conditions to extremely undervalued conditions).

Bear Market in PEs

Click on chart to see a sharper image

The 10-Year PE declined from 44 in 2000 (the richest valuation ever), to a current valuation of 23. That is about a 47% decline in the PE ratio, yet as discussed above, a PE of 23 is a very rich valuation.

When PE valuations are declining, and history suggests we are nowhere near the bottom of the PE compression cycle, generating positive returns in the stock market is much like trying to swim upstream.

Even if earnings increase (a dubious point to start with as noted in the beginning of this article), prices will likely be dragged lower by the weight of declining valuations.

Where to From Here?

Hopefully you now realize that expectations of rising earnings being tremendous for the stock market is a fallacious construct. Such talk ignores high valuations, the long-term trend in valuations, and demographics. Moreover, it’s debatable if earnings are likely to rise in the first place.

With that in mind, people chasing this market as well as those fully invested do not realize how lucky they have been.

Last week I received an email from someone who fears being out the market. I heard the same thing in 2007. I suggest people ought to fear being fully invested with no hedges. The same applies to pension funds. Note that most pension plan assumptions are on the order of 8% annualized rates-of return, and pension funds are typically 100% invested, 100% of the time.

However, I do not know where the market is headed this year, nor does anyone else. 2011 may turn out like 1998 or it may turn out like 2008.

Either way, history strongly suggests that 10-year and 20-year returns looking ahead are likely to be low, if not negative.

Investing, like life, is a marathon not a sprint. Sometimes the prudent thing to do is sit on the sidelines waiting for better opportunities, even if it means enduring cat-calls and taunts from those who do not have any understanding of risk or history.

Mike “Mish” Shedlock
http://globaleconomicanalysis.blogspot.com

Tags: Case Shiller, Cheerleaders, Crestmont, Dividends, Earnings Growth, Fasb, Financial Institutions, Financial Sector, Global Economic Trends, Loan Loss Reserves, Market Cycles, Michael Mish, Mish Shedlock, Norms, Pe Ratios, Rules Changes, Stimulus, Stock Market Returns, Sustainable Basis, Transaction Costs
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