Investment advisors around the globe breathed a sigh of relief as the closing bell passed on the last trading day of 2015. While the major indices posted an essentially flat year, advisors who seek to add value to their client’s portfolios through asset allocation and use active fundamental analysis in their security selection (myself included) had trouble posting positive results. Indeed, other than the S&P index, most other indices produced negative returns:
A good question, and one it pays to ask. Essentially, the answer comes down to the stocks of four companies: Facebook, Amazon, Netflix and Google…. now commonly referred to as the “FANG” stocks. Due to the methodology for calculating returns for the S&P 500 index, the strong performance from each of these four stocks (which ranged from +34% to +134%) heavily influenced the return of the S&P 500. Because of the “Capitalization Weighted” structure of the S&P, these four companies make up slightly over 5% of the index… meaning that their performance has an outsized impact on the return of the index. Indeed, the stocks of these four companies added a return of +3.7% to the S&P, meaning that the inclusion of the other approximately 495 companies in the index contributed to a decline of -2.3% (I used the year end data of the index ETF “SPY” to calculate this.) Clearly, while these four did great, the broader market had a tough go for the year. In this environment, even the biggest and best of investment management names delivered disappointing returns, with Warren Buffet’s Berkshire Hathaway -12%, Bill Ackman’s Pershing Square Capital -19%, David Einhorn’s Greenlight Capital -20%, and the investment powerhouses of Bain, Fortress, and Blackrock all closing existing hedge funds. Even legendary investor Ray Dalio, who runs the largest ($80bn) hedge fund in the world, posted a drop of -7%. Individual investors, rightly so, are asking, “How can we be experiencing such negative returns in an environment where the index is basically flat?”
To complicate matters further, the other markets typically relied upon by investment advisors to provide diversification in down markets didn’t help much. Bonds were finally impacted by an expectation of higher interest rates, foreign investment faced a number of challenges, including a stronger dollar, and gold, oil and other commodities had very difficult years. Market environments like this always generate a very similar conversation: Investors start to question what value advisors provide, and investor interest in the concept of indexing always spikes.
In markets where we see a strong outperformance in a small segment of the market, we often see this same segment being avoided by fundamental investors. The primary reason for this is that such segments often fail two primary fundamental analytics: Profitability and Valuation. Valuation for stock investors is often discussed using price-to-earnings ratios, or “P/E” ratios for short. For comparison purposes, the “average” P/E ratio over the 25 years has been 15.8. Thus, in its simplest form, valuations above a 15.8 P/E are considered to be “expensive,” valuations below are considered “inexpensive.” For perspective, the most “inexpensive” company from our list of four strong performers would be Google, with a P/E of 33… more than twice what we consider average. On the other end we have Amazon with a P/E of 867… meaning investors are essentially paying $600 for every $0.70 that Amazon earns. Clearly, with P/E ratios this far out of the norm, it’s pretty easy to see why these companies are being ignored by investors who have been around, and been very successful, for a very long time.
Fortunately, virtually all of us have had the opportunity to see a situation like this before, and hopefully to learn from it. In late 1999 and early 2000, the Dot-Com craze was in full swing. Returns for the NASDAQ skyrocketed, and buying the “QQQ” NASDAQ Index ETF appeared to be the only strategy an investor needed. Financial advisors were suddenly irrelevant, and asset allocation to any other asset class besides dot-com stocks only served to reduce your returns. The only saving grace for investment advisors was that other asset classes performed at least positively, so a well balanced portfolio could actually return a comfortable, double digit number in that environment. In March of 2000, the P/E of the NASDAQ shot over 175, and the index level broke 5,000 for the first time. We all know what happened from there. Indeed, it took 15 years, until March of this year, for the NASDAQ to recover those losses, and break the 5,000 limit again.
A key difference between 2000 and today is the extreme narrowness of the top performance band in this market. In 2000, virtually any company with “dot.com” in the name was assured investor attention. Today, returns have been limited to our FANG friends, with the broader market trending significantly lower. Take a look at the current valuation levels of the S&P:
As the chart shows, P/E’s are at a reasonable valuation level. I’d note that in the few short trading days since the beginning of 2016, these have dropped even lower, with the S&P now being at 15.5, and the P/E of the NASDAQ 100 at 22.01 (As of 1/12/16).
Next, the global economy is growing. True, there are a number of measures of global growth, and plenty of argument as to what the real numbers are. However, I just want to point to one demand growth number that should pique your interest… yet it’s been the focus of many dire predictions, which is the demand for oil.
As we all know, the price of oil has retreated, with many pundits explaining that this should be a sign about the slowing global economy and a cause for concern.
Yet, a look at this chart points to something that is not intuitively obvious:
Look at the consumption numbers in the chart. What do you see? According to the Energy Information Administration, demand for oil has been growing consistently, and that growth is expected to accelerate in the coming year. What has changed is supply, driven largely by the progress of U.S.-Technology driven recovery techniques. The low price of oil should not be cautionary… but should be seen as additional “fuel” (pun intended) for economic growth.
So, we are looking at reasonable valuations, low commodity prices, and slow but persistent global economic growth. Frankly, that sounds like an environment ripe with investment opportunity. What are investors doing?
Apparently, they are abandoning domestic equity investments in droves, as they have been essentially since 2007. As the fund flow chart shows, every year investors as a group have moved significant wealth out of domestic equities. For many years, this money went into bonds. Today, more seems to be flowing to world equities. It is interesting to note that while investors have worked to avoid US Stocks, the S&P 500 returned in excess of 80% from 2007-2014, inclusive of the 2008 drop. Could this be why so many investors feel that the market does nothing but go down? The fact of the matter is many have missed the market, and simply rely on news headlines to provide their perspective on the markets. Investors, for the most part, have experienced a solid recovery of domestic stock prices since the dot.com bust, and US equities have proven to be an asset class worth owning.
So what to do today? Let’s say it again: We have reasonable valuations, low commodity prices, and slow but persistent economic growth. In my opinion, it looks as though we have a pretty normal investment environment, punctuated by a very noisy media. Based on that, our strategy should remain: prudent allocation using solid fundamental investment analysis… and ignoring the turbulence.