There are a variety of investment decisions we need to make when building
diversified portfolios. The most important is first determining the most appropriate
asset allocation for our clients depending on their unique considerations including
objectives, time horizon, risk tolerance, cash flow and many other factors.
The definition of “asset allocation” is basically the mix of stocks,
bonds, cash and alternative investments to achieve a desired objective. By “appropriate”,
we essentially mean the level of risk (generally defined by volatility) that
is suitable for each client’s particular situation. There is no reason
to take on more risk than is necessary to achieve your financial goals, particularly
if an adverse outcome could materially change your financial condition and
jeopardize that goal. Conversely, you don’t want to avoid a certain amount
of risk that is necessary to achieve your goals and risk falling short.
The basic (or neutral) asset allocations that we use for growth, conservative,
and balanced investors are a blend developed from a combination of academic
studies, industry practices, and our own experience. One common element is
the importance of investing in the riskiest, yet highest returning, asset class:
stocks. To achieve long-term real (after inflation) growth in one’s investment
account, investing in stocks is critical. In our diversified, all-weather portfolios,
having some dedicated equity exposure is essential. Even the most conservative
investors should arguably have some equity exposure to help maintain some long-term
purchasing power.
Once we have made the basic asset allocation determination for a client, we
need to make several more decisions:
- First, we must decide how we will adjust our neutral asset allocation, based
off our market outlook and concerns. In other words, based on our outlook,
do we favor stocks a bit more or a bit less? Bonds? Cash? Alternatives?
- Second, within our stock or bond allocations, we must decide how to tilt
the complexion of those holdings. For instance, within stocks, we look at international
versus domestic holdings. We also examine equity style considerations such
as value versus growth stocks as well as our preferences for company size such
as large-cap stocks versus mid- or small-cap stocks. We also consider whether
there are particular economic sectors (i.e. energy or technology) that we particularly
want to overweight or underweight.
- Third, once this is accomplished, we want to select those managers and funds
that best match those market exposure preferences, as well as have the ability
to pick the best securities within those market exposures. For example, among
mutual funds that focus on domestic large-cap growth stocks, which ones have
the market exposures (style/size/sector considerations) that we desire, as
well as have managers with the capability to display above-average stock selection
skills.
This last decision — picking mutual funds — is what we spend most
of our time doing. That said, we have a systematic, disciplined process to
help us with the asset and sub-asset allocation decisions. While the process
has many formal quantitative elements, there are also many informal inputs,
such as “watercooler” chats where our analysts bounce their views
off one another, or internal e-mails where they pass along their recent favorite
articles. Plus, in the course of our due diligence on mutual funds, we have
daily conversations with some other of the best and brightest minds in the
industry.
Five Factor Equity Model
Once a month, we package this information into a simplistic one-page report
that we share with our clients: The Five Factor
Equity Model. It is used to
synthesize our views on the stock market into an easy to read (we hope!) format.
This view should be consistent with how we are actually allocating the equity
portions of client portfolios. I’d like to briefly describe what each
factor is, how we “build” our outlook on each one and why each
is important.
Earnings
It is often stated that stock prices follow corporate earnings. Over time,
that is definitely the case. But, the relationship between earnings and stock
prices isn’t quite that simple. Over shorter time periods, earnings expectations
often drive stock prices, not actual earnings. A stock that disappoints its
earnings expectations, even if the growth rate is still high, will often suffer
in price.
For instance, a stock that shows an earnings growth rate of 20%, but was
expected to grow even faster, will often perform much worse in the near
term than a
stock that just announced earnings growth of 15%, when it was expected to
grow slower. The rationale is that investors will now “readjust” each
company’s stock price respectively to incorporate the new information
(i.e. lowering the price of the company that “disappointed” and
raising the price of the company that came in with a positive “surprise.”)
Absolute rates of growth, stability of growth, earnings guidance, the growth
rate of the growth rate, and other derivatives of earnings are all factors
that may move stock prices and there are investors who make decisions on each
variable.
We formally collect data from a variety of sources on earnings expectations
for the upcoming quarters and years. The level and trend of earnings are the
critical numbers we watch. We then overlay that data with the information we
collect from our own observations and conversations. Strong and/or rising earnings
growth is attractive; weak and/or decelerating earnings growth is unattractive.
Valuations
No matter how attractive a company’s or security’s fundamentals
(ability to make money) are, if the security isn’t priced right, it’s
not easy to extract a competitive return out of the investment. Valuations
matter. Prices paid matter. The return going forward depends on the starting
valuation. In its simplest terms, think of a stock with a dividend of $1/share.
If you purchased the stock for $10, your dividend yield is a juicy 10%. But
if you paid $20, your yield drops to 5%. As value manager Scott Black often
says: “Value will out.”
There are many different valuation ratios to look at. The list includes price
over earnings (P/E ratio), price over book value (P/B), price over sales (P/S),
and dividend yield (Y/P). One can also look at historical measures or at expected
future fundamentals.
We look at a variety of valuation measures. Not only do we look at the absolute
level, but also the trend of valuations. High valuations and/or decreasing
valuations are negative; low valuation and/or rising valuations are positive.
Interest Rates
There are many interest rates to look at when determining the market environment
for stocks. First, there are short-term rates like the Fed Funds rate. A lower
rate, and/or a decreasing rate, is positive for the stock market. For starters,
low interest rates support stock market valuations by making higher valuations
more competitive (to fixed-income investments), but lower interest rates also
suggest more liquidity into the economy and markets. The level and trend of
longer maturity interest rates also carry the same message.
The relationship between short and long maturities is also important. If the
gap is wide, with the longer maturities yielding a lot more than shorter maturities,
(a steep yield curve), that is generally seen as a positive for the economy
and market. One reason why, is that under this environment, financial service
firms, such as banks, earn more interest on their (generally long-term) loans
than they have to pay in (short-term) interest to attract deposits, and thus
are better able to support lending activity which stimulates the economy.
If the yield curve is flat (little difference between short and long term
rates), or worse inverted (short rates higher than long rates) that is not
a plus for the stock market.
Yet another interrelationship that is important is the yield difference between
(high-credit quality) government bonds and (lower quality) corporate bonds.
The level and trend of this spread can say a lot about the current economy
and the risk appetite of investors in the marketplace. A low and/or rising
spread is unfavorable, while a high and/or contracting spread is favorable.
Sentiment
Sentiment is used as a contrarian indicator: in short, when everybody is bullish,
who is left to buy? When that is the case, all else being equal, it is better
to be defensive on a market, rather than looking for fresh investments. That
is the basic concept behind most contrarian investing.
Another concept I learned many years ago is that “the markets (almost)
always move in the direction that causes the most pain.” Following this
simple rule, may often result in some uncomfortable investments (at first),
but it can save you from plenty of investment pain later.
We monitor a variety of measures on this factor as well. We will look at everything
from investor surveys, to “smart money polls,” to insider activity,
to the technical condition of the market. Sentiment is not necessarily a very
useful long-term factor for determining future stock market returns, the way
earnings and valuations are, but it can be excellent for shorter, more tactical
types of investment decisions.
Liquidity
Liquidity is a catch-all for a variety of indicators that try to measure the
supply and demand forces that effect individual securities. Some liquidity
measures can overlap with our previous
factors, such as interest rates (low
interest rates often help spur fresh investments) and sentiment (investors’ cash
levels often capture their sentiment, but also indicate their ability to
buy new securities). A variety of technical indicators can also be monitored
to
try and capture liquidity trends. Government spending can also be a liquidity
consideration. As with sentiment, liquidity is often THE answer to determining
short and intermediate term market direction until the fundamental earnings
and valuations prevail.
The last step in this process is to weigh all of these factors together (admittedly
subjectively rather than by any numerical formula) to determine our overall
outlook for the stock market.
Sincerely,
Rusty Vanneman, CFA
Director of Research
Co-Portfolio
Manager
