Last week I was in New York visiting several of the money management firms we employ on our clients’ behalf. During the return trip home, I had occasion to read a number of Sir Arthur Conan Doyle’s stories about a favorite character, Sherlock Holmes. In one of the stories Holmes notes that “The little things are infinitely the most important.” That seemed to sum up the conversations I had with managers during my trip. Recent market volatility has investors trying to sort through the little things to determine what is most important to the future of asset prices.
Asset prices are made up of a lot of little things. Securities markets move up and down on a daily basis based on many different factors, some more relevant than others. The market events during October have proven that these little things can lead to greater volatility as investors attempt to sort out the most relevant facts from those with less meaning. Much like Mr. Holmes, our objective, and that of our investment managers, is to sift through these details to discern what has relevance and what is noise during the trading day.
We often discuss the importance of paying attention to the details of those fundamental factors affecting stock and bond prices. Corporate earnings and revenue growth are great examples of what is most important to the value of stocks. Future interest rate expectations are driven by the rate of economic growth, inflation and labor market improvement. Of course, the challenge with discerning how these fundamentals impact asset prices is that we are interested in where they are going less so than where they’ve been.
Earnings and Cash Flow
Last week about half of the S&P 500 Index companies had reported earnings for the third quarter. Almost 80% of those companies exceeded their earnings forecasts and 61% beat their sales forecast. It was interesting to note that many indicated some concern about future earnings expectations, but not so dramatically as to indicate that we should be worried about the range of earnings in place for next year. The current estimate for 2015 S&P 500 Index earnings is $135.99. The estimate for all of 2014 is $119.05. This represents a growth rate of 14.2% year over year. If you look at the closing price of the S&P 500 on Friday it was 1949.50, dividing that by next year’s earnings you get a market multiple of 14.33 times. If we haircut that earnings expectation by $10 then the multiple is 15.4 times earnings, still reasonable. While there are concerns about unrest in the Middle East, a slow-down in Europe and an Ebola outbreak in the U.S., the market remains somewhat reasonably valued. This may be the reason that we saw a better than 3% rally in stock prices last week.
I met with the portfolio manager for one of the equity income strategies we deploy. When asked about the current market environment for stocks he was optimistic. He noted that there are many good large companies that are producing reasonable free cash flow and able to compound their dividend growth rate at a pace which should “provide a good return for investors.” He indicated that while “we’re seeing below average capital investment, it is resulting in more capital being returned to investors” because cash flow is strong. He also mentioned that capital investment isn’t down because companies don’t want to make investments in their businesses. He believed that it is down because companies are benefitting from an increase in productivity through technology deployment which reduces the need for labor, their most expensive investment.
An equity income strategy such as this focuses on companies that have an above market dividend yield. However, as this portfolio manager noted, that doesn’t mean screening stocks just based on their yield. Their strategy is to find companies trading at below market value who have stable cash flow generation and a history of returning that growing cash flow stream to investors.
Risk Management
During another meeting with a fixed income manager we discussed the importance of managing risk in the current environment. The quantitative analyst I first met with walked me through the methods of measuring risk in their absolute return bond strategy. He explained that they measure risk at many levels throughout each day. These include: security, allocation, currency, derivatives and liquidity across global bond market sectors. The manager believes this level of risk management combined with performance attribution allows them to understand how fundamental factors are affecting the portfolio. Each day they try to discern price-movement due to those fundamental factors versus daily market noise.
We believe this type of risk management, especially in global fixed income, is an important component to generating returns in a low interest rate environment. All of the developed countries in the world have low interest rates as a result of slow growth and in some places, deflationary forces. We believe that in order to combat this, a strategy where allocation to global markets and an emphasis on earning total (i.e. price) return, not just income, is important in a portfolio diversified with fixed income investments. Doing this without a rigorous risk management framework focused on the “little things” would be problematic in our view.
There are many talented investment professionals employed on our clients’ behalf. They all have a unique set of talents they bring to bear on the particular market we’ve hired them to manage. They mostly pay attention to those little things that matter most regarding security prices in their respective markets. We prefer they spend time analyzing the fundamental factors affecting those prices, managing risk and taking advantage of opportunities created when markets move away from fundamental value on the basis of news not fact.
Using this approach, the outcome should be better for investors, it’s elementary.
