Putting the Odds in Your Favor
The key to building and maintaining individual and organizational wealth is to compound returns. Every investment decision builds on every prior decision. There are also no do-overs. Your portfolio’s value reflects the cumulative outcome of your investment process and the wisdom of your choices.
The power of compounding is among the first lessons young professionals learn. It’s simple, so it takes on an unsophisticated tone. Many take the concept for granted, yet wealth rarely exists or persists without compounding. It’s not just an occurrence, it’s the objective and every decision should be considered through this lens. And while it seems fundamental, it takes a sophisticated, repeatable investment process and a great deal of discipline to achieve it.
Compounding Investment Returns is Different
There is a critical difference between the compounding of interest, which we learned early in school, and the compounding of investment returns. With the latter, you can lose money. If you’re not careful, the loss can be so large that some part of it becomes permanent – you simply won’t have enough time to ever recover. The math is exponential. Losing 10% takes 11% to get back. At 50%, it takes 100% to get even and much more to get to the place you would have been had the loss never occurred.
To effectively compound returns, you need to be very clear about your investment objectives and the process needed to achieve them. Our portfolios have two simple goals. The first is to build high-quality absolute returns in light of the fundamental opportunities and risks that today’s environment presents. The second is to protect hard-earned capital by carefully managing risk so losses are manageable, recovery comes more quickly, and future returns can build on past returns. Ideally, we swing at the fat pitches and avoid reaching for returns when the upside is not worth the risk on the downside.
Not all investment processes are the same. To unleash the full compounding potential of your investments, we employ a forward-looking, research-intensive process that is both dynamic in nature and repeatable. Assets are viewed as opportunities and possibilities, not mandatory holdings. Our goal is to continuously align the investments you own with today’s attractive opportunities and steer them away from unacceptable risks.
In making our decisions, we focus on the fundamentals because they ultimately drive investment returns. We seek to deeply understand the impact that economic forces, government actions, and valuations will have on the performance of global assets. We evaluate each asset class based on its expected return over the next 18-24 months. Often it takes this amount of time or even longer for fundamental factors to assert themselves. Generally, little weight is placed on recent price movements because, over shorter periods, financial markets tend to trade on sentiment, momentum, and speculation – all of which can be unsustainable and prone to rapid reversal or change.
18-24 months is short enough to allow us to peek over the horizon. Winning investing is about looking forward, understanding how it all fits together and anticipating where markets are going. Our process seeks to isolate the specific fundamental forces that will drive returns over this time frame. Real understanding requires heavy doses of research, continuous analysis, challenging our existing views, asking all the right questions, and checking all the boxes. And then doing it again and again and again.
Search for Value
As we consider investments for you, our goal is to always put the odds of success in your favor. We do this to deliver absolute returns, which is the actual return you receive on the capital you place at risk. How these returns compare to financial market returns has no real meaning to your financial independence and goals. These comparisons may provide valuable perspective, but investing for market returns can expose your investments to unacceptable risks and large losses that arrest the compounding process.
If you break investing down to its basic elements, it’s about purchasing the future cash flows of an asset (e.g., business earnings, interest, or rents) at a fair price – a price that produces an acceptable profit for the risks you assume. This is true whether we’re making a new investment or evaluating one we already own. What we always know is yesterday’s income and today’s valuation. What’s not clear is tomorrow’s income and tomorrow’s valuation. It’s these two unknown variables that will determine your future return. While certainty is not possible, we believe a strong research process allows us to put the odds in your favor.
When we evaluate stocks through this lens, we continue to see limited upside opportunity due to expensive valuations and a gloomy outlook for sustainable business earnings. Using the S&P 500 as a representation, the index now trades at about 22x operating earnings for the 12 months ended March 31. This translates to a 4.5% annual return from earnings if they were to continue. Historically, that’s expensive. On average, the S&P 500 trades at about 16x earnings and provides about a 6.25% earnings return.
Often, the relationship between prices and earnings will stretch in anticipation of accelerating profits. Based on today’s price, profits would need to rise to record levels that are far above 2019 earnings to get to a more normal 16x earnings multiple. However, instead of increasing, earnings plunged in the first quarter of 2020 as we entered into the early stages of the current recession. Based on annualized first-quarter profits, the S&P 500 now trades at a more expensive 29x and a 3.5% earnings yield. To get to 16x, either earnings would need to double from their first-quarter pace or prices would need to fall well below their March lows.
So, the key question is where is the recent massive government stimulus taking earnings? We’ve spent countless hours analyzing this question and will continue to update our work as new data is received. Currently, it appears over the next couple of quarters, earnings will dramatically improve, but only with the help of unprecedented government spending – much of which will end this year. Without it, corporate profits would likely drop precipitously. Therefore, we believe more stimulus should come.
Eventually profits will need to stand on their own. After all, it’s sustainable earnings that investors are buying. Currently, it does not look like this will occur until the end of 2022. Then, profits are likely to just recover to 2019 levels. This would mean that at today’s prices the S&P 500 would trade at about 21x earnings and provide about a 4.7% earnings yield – not exactly a bargain or a can’t-miss opportunity.
In the face of high valuations and dismal fundamentals, stock prices have experienced a powerful rally since late March. Increasingly it appears that those buying stocks are uninitiated retail investors with a casino mentality buying on the dip. Online brokerage firms are being flooded with new customers, and retail trading volumes have reached a fevered pitch. Trading stocks seems to be the pastime of a new generation, and markets are moving on momentum and speculation. Holding periods are frequently measured in hours and days, and social media is jammed with stock tips. Further, there appears to be widespread belief that the stock market is a can’t-miss opportunity and the government will not let bonds fail or stocks go down. It’s a very dangerous environment that warrants great caution.
All of this is very reminiscent of the late 90s. Then, the market seemed to go up daily with small investors bidding up the prices of large technology companies and chasing shares of flimsy companies that had .com attached to their names. Today, it’s large-growth companies and companies on life support. Eventually, it ended badly with the S&P 500 dropping about 50% and the Nasdaq losing about 80%. Difficult lessons were learned, fortunes were permanently lost, and compounding was suspended for years. Unfortunately, it appears a whole new generation is destined to learn these same hard lessons.
While the indexes have rallied, beneath the surface much of the stock market is suffering. A few fortunate winners have generated most of the market’s gains, while the majority of stocks are down – many by 20% or more. This disparity in performance is creating opportunities in both industries/sectors and asset classes alike. While things need to develop further, we continue to follow their progress and are waiting for the odds to line up in your favor.
As always, thank you for the continued privilege of allowing us to guide you through this very complex and challenging environment. We will continue to do so with your future in sight.