The market shrugs off a wall of worries

Quarterly Letter

The market shrugs off a wall of worries

“The market is climbing a wall of worries” and the first quarter of 2011 is the ultimate example. After a brief correction triggered by several unexpected events – Tunisia, Egypt, Libya, Bahrain, the earthquake in Japan and the ensuing tsunami followed by “nuclearophobia” from the resulting damaged nuclear power plants - the market continues to shrug these off and resume its climb since March 2009.

We still expect a meaningful correction (perhaps 10% to 20%) in 2011 so that valuations return to more reasonable levels, especially in sectors like cloud computing and their related software companies. For example, a company called Salesforce.com with a current market capitalization of USD 17 billion has sales of USD 1.6 billion and profits of only USD 65 million, i.e. it is trading at more than 10 times its annual sales and 260 times its annual earnings, valuations reminiscent of the internet bubble...

2011 is shaping to be a stock picker’s year. We can’t say that the market is cheap, considering that the Price/Earnings ratios of the Dow Jones index and the Standard and Poor’s 500 are 14 times and 15 times respectively. However, using a bottom up approach reveals many companies with decent future growth rates and solid balance sheets that trade at reasonable valuations, some more reasonable than others. With interest rates being so low and possibly for an extended period of time, equity investments should be a better alternative to fixed income instruments in terms of purchasing power protection.

THE CASE AGAINST GOVERNMENT FIXED INCOME

Remember that old rule of thumb used by most financial planners that the percentage in bonds that you should allocate to your portfolio should equal to your age? For example, if you are 50 years old, you should have 50% of your assets in bonds; if you are 60, you should have 60% of your assets in bonds and so on.

We wish it was that simple. Not only do people live longer today, all that financial planning advice was also based on a very different interest rate environment:

  • Fixed income returns come from 2 sources: the fixed coupon attached to the bond and the capital gain achieved if interest rates decline. The first source one is fairly stable in terms of cash flow while the second one is quite variable.
  • Since 1980, bond investors have enjoyed a long period of abnormally high returns thanks to the secular decline of interest rates after the inflationary period of the 70s. Hence, bond investors enjoyed enhanced total returns to their bond holdings due to higher than normal interest rates as a result of this inflationary period.
  • Since 2008, the wind has changed. Interest rates might not increase rapidly but they don’t seem to decrease anymore as well. Combined with global monetary stimulus (past and perhaps yet to come), i.e. money printing policies, inflation seems to be something we should pay attention to.

As we see it, the popular disclaimer “Past performance are not indicative of future results” cannot be more accurate as far as fixed income returns are concerned (i.e. bonds, bond mutual funds etc.). Let us explain through an example:

  • In January 2006, if you had purchased a Government of Canada bond with a coupon of 4% maturing in 2016 at $100 and 3 years later (January 2009) it was trading at $111, your return would have been the sum of $12.00 (the 4% coupon times 3 years) and the capital gain of $11.00 (the increase in price), thus representing a total return of $23.00 over a 3 year period on the original investment of $100 (approximately 7.5% a year, not too shabby). Of course, this assumes the bonds were sold.
  • Let’s assume the bond was sold and, after deliberating, you decided that this was still a good investment, so you bought it back at $111. By January 2011 (2 years later), the bond was trading at $107. The total return from this investment that you would have achieved from 2009 (the year in which the bond was repurchased) is the sum of $8.00 (the 4% coupon times 2 years) and a capital loss of $4.00 (you paid $111 in 2009 and it was sold at $107). This would have netted $4.00 ($8.00 - $4.00) and yielded a total return of 4/111= 3.6% (roughly 1.8% a year, not too good)
  • Being very unhappy about a potential loss if you sold the bond, you decide to hold it until maturity. What will the return look like in year 2016 (maturity)? Well, you will receive the sum of $20.00 (4% coupon times 5 years) and the return of your capital of $100, for a total of $120.00. Your return will be (120-107)/107 = 12.15% for the 5 years, roughly 2.5%.

If you consider the 3 points mentioned above as 3 consecutive periods in time, you will realize that the entry point is very important when fixed income investments are concerned. Using the above example as a timeline, we are at somewhere between Period 2 and Period 3. Unless interest rates keep declining, the total return achieved in Period 1 is very unlikely.

Yet, most mutual funds still advertise their past fixed income performance numbers to lure in new investors. Worse yet, financial planners and life insurance salespeople still use fixed income past performance to market their products.

We would argue that the only fixed income return an investor can count on in their financial planning is the yield to maturity of their securities, and the return enhancement from the potential capital gain is likely nonexistent (it could actually be a capital loss) or at best, insignificant, especially in our current low interest rate environment.

THE BENEFITS OF DIVERSIFICATION AND ITS LIMIT

We all know about the benefits of diversification in equity investments: by increasing the number of stocks held in a portfolio, an investor can decrease the risks he is taking by only owning 1 or 2 stocks. Intuitively, you would probably agree that there is an advantage to holding a diversified portfolio so that one or two lousy stock picks do not unduly ruin your confidence and worse yet, your pocketbook. Thus the question is: what is the “right” number of stocks to hold in order to achieve a “properly” diversified portfolio? 50? 100? Or even 200?

It turns out that diversification can only address a portion of the overall risk of investing in the stock market. Even if you take the precaution of owning every stock listed in the US and Canada (we could include the whole world if you want), you are still at the whim of the daily ups and downs of the entire market. Let’s call this risk “market risk”.

Diversification can only help you avoid a different type of risk – the risk that comes from the misfortunes of any individual company (like the BP oil rig disaster, the Dow Corning breast-implant disaster etc.). Let’s call this risk “stock-specific risk”.

Statistics dictate that by owning more than 50 stocks and less than 150 stocks, an investor can reduce the stock-specific risk of his/her portfolio by 98% but is still subject to the market risk, something that cannot be eliminated by adding more stocks.

THE CASE AGAINST MUTUAL FUNDS...

Institutional money managers and mutual fund managers in particular are faced with many interesting dilemmas:

  • They sometimes don’t know exactly who their clients are;
  • They have to find scores of great stock ideas from a limited universe of mostly widely followed stocks;
  • Buy and sell large amounts of individual stocks without affecting their respective share prices;
  • Perform in a fish bowl as their returns are scrutinized quarterly and even monthly.
  • Adding insult to injury, the market tends to be priced in such a way that if mutual fund money managers want to outperform and set themselves apart from the crowd, they have to take bigger bets and risk looking like an idiot. To outperform, they have to deviate from their benchmark, therefore increase the risk of underperformance and, in the extreme case, getting fired.

As a result, most of them end up managing their career instead of your money. Multiple studies have shown that most mutual funds are basically closet-index funds, i.e. mirroring a stock index that is chosen as the benchmark (such as the S&P/TSX). If you wonder why the long term return record of pension and mutual fund managers resembles the performance of the market averages less the amount of the annual fees, there you have it. The more mutual funds you own in your portfolio, the closer you get to market averages, minus of course the management fees, advisory fees and commissions that is.

...AND WHAT DO WE DO AT CLARET?

Our philosophy is based on bottom up fundamental analysis. In other words, we look at stocks on a one by one basis. Most of all, we try to stay consistent in the way we choose our investment ideas and analyze the numbers.

We don’t believe in closet indexing. You don’t need us to index. We do stick our necks out and take the risk of looking like idiots in the short-term because we feel strongly that above average long-term performance involves being different.

Before investing, we ask ourselves 2 questions:

  1. How much can we lose if we are wrong?
  2. What is the potential upside?

Based on those 2 questions we then try to figure out what the risk/reward ratio is in order to determine whether the investment is worthwhile.

We strongly believe that human emotions are best left out of the equation when it comes to investing. Unfortunately, even after having spent so much time reading and writing on the subject of behavioral finance, as human beings ourselves, we sometimes still struggle to fight against our own instincts.

We have added a quantitative dimension to our portfolio management model and we believe that it will help us stay disciplined and focused on some market phenomenon we know quite well.

While our approach to investing does help us stay away from major market declines such as the internet bubble in 2000, the banking meltdown and the correction in commodity prices in 2008, it does have its drawbacks. Given our focus on undervalued companies, we tend to miss the euphoric part of a bull market cycle where everybody seems to make money regardless of valuation. Moreover, we also tend to miss out on major discoveries, be it in exploration, technology or biotechnology since the companies involved tend to have no revenues, let alone earnings. However, it has not affected our long term performance up to now and we do sleep very well at night (we hope you do, too).

The Claret Team