November 18, 2006
When Value Mavens Lag
Quick note: On Friday November 17, the Hussman Funds paid their 2006 capital gains distributions.
The Strategic Growth Fund paid a distribution of $0.4577 per share ($0.3001 as short-term capital gains, and $0.1576 as long-term capital gains). Shareholders reinvesting distributions now have approximately 1.0292 shares of HSGFX for every share owned prior to the distribution. Post-distribution NAVs can be compared with pre-distribution values by multiplying the post-distribution net asset values by this factor.
If you've read Warren Buffett's letters to Berkshire Hathaway shareholders, you might recall that they start with a table of long-term performance. But notice what's in the table. He doesn't present the year-to-year returns of Berkshire Hathaway stock. Rather, he presents the growth in Berkshire Hathaway's book value – essentially the fundamental accounting value of its holdings. A relatively small portion is in stocks and cash, while most represents privately held businesses that Berkshire owns.
You'll also notice that though Berkshire 's stock price has historically been much more volatile than its book value, they have soared together over the long run. That's not to say that they've grown every year – they haven't. But over time, price has followed value.
That says something. It says that the attention of a good investor should be on the worth of the underlying businesses. If those are solid and growing, market prices will come to reflect that over time. In my view, a good fund manager spends a lot of time thinking about the underlying value of the businesses that are owned on behalf of shareholders, and doesn't gamble a great deal of shareholder capital when the only merit is speculative momentum. The responsibility is to own assets and claims on probable future cash flows, not just hot air. If the underlying values in the portfolio have a solid foundation (and particularly if investor sponsorship supports that assessment, as evidenced by price-volume behavior), market prices generally come to reflect the underlying values over time.
Looking closely at Buffett's performance, a fascinating pattern emerges. From 1965-2002, we can identify 13 calendar years where, over the following 3-year period, the S&P 500 underperformed Treasury bills. If we examine Buffett's investment performance during those 13 calendar years, it turns out that he beat the S&P 500 by just 1.68%, on average. In contrast, Buffett's investment performance in other years beat the S&P 500 by an average of 15.96%.
Repeatedly, Buffett's investment performance was least impressive when the market was approaching a long period of dull and often negative returns.
There's more to the story. Last week, the Financial Times ran the following news comment: “Aronson+Johnson+Ortiz, a Philadelphia fund manager, has for years tracked a simple strategy: buy the cheapest 10 percent (as measured by the multiple of price over earnings) of the 2000 largest stocks in the market, and sell short the most expensive 10 percent. Over time this strategy does well. Since the exercise started in 1962, it gained about 1200 percent (8.4 percent annually).
“This strategy is highly unlikely to lose money. It has only done so when the market is truly out of whack, with the most expensive stocks carried forward by their own momentum.
“A fall in the AJO strategy indicates a major sell-off is in the making. Ahead of the bursting of the internet bubble in early 2000, it dropped 53 percent – an early warning of the juddering halt that lay ahead. Since February 2000, it has gained 380 percent, while the S&P 500 has been flat.
“So it should cause concern that the AJO strategy is now falling, for the first time since 2000. It fell ahead of May's correction, and rose thereafter as the rally gained strength, before falling again. By the end of October, it was more than 10 percent below its peak set early last year. The dearest stocks are once more strongly outperforming the cheapest.
“This is unhealthy. It suggests a correction may be coming sooner rather than later.”
Similarly, the Wall Street Journal had this item last week:
“Another problem for stock pickers, points out ING Investment Management analyst Jeanette Louh, is that fewer individual stocks in the S&P 500 than usual are outperforming the overall index this year. When that's happened in the past, it's usually meant that fewer fund managers were able to best the index.” That's clearly evident in the performance of many good managers this year, including Bill Miller over at Legg Mason. Personally, that's small consolation, but it's worth noting because it may be part of a broader pattern that has historically proved unfavorable for the general market.
Here in our office, Bill Hester makes a hobby of reading through 13-F filings. In recent weeks, he's noted an increase in the number of hedge funds holding the SPDRs (S&P 500 depository receipts – essentially exchange traded index funds). In effect, Bill says, “it looks like they're so eager to get into the market that they've bypassed stock selection altogether.” It's difficult for good stocks to get much traction on the basis of their investment merit if investors don't even stop to discriminate.
At present, I don't see much value in this market. As I've frequently noted, investors are currently paying rich P/E multiples on peak earnings, and those peak earnings are based on record profit margins. In effect, they are paying a premium - twice - for every dollar of normalized earnings. While profit margins have historically been both cyclical and mean-reverting (so high margins tend to normalize over the full economic cycle), the recent upswing has been unusually strong, but I suspect just as temporary.
If profit margins were anywhere near historical norms (even in the healthy range that we saw during the 1990's), the P/E ratio on the S&P 500 would currently be about 23, still on record earnings. Bill Hester has an outstanding research piece on profit margins this week: Profit Margins, Earnings Growth, and Stock Returns. (I'll add another link to his article at the end of this comment).
That said, there's still a good amount of relative value (i.e. many stocks appear priced to deliver better long-term returns than the major indices – and are perfectly reasonable investments, provided we have an offsetting hedge in those market indices). The difficulty, as I've noted lately, is that our normally strong stock selection approach has lagged the major indices by about 3% over the past 6 months. Short periods like that are nothing unusual, but at present, it makes for flat and unimpressive returns at the exact time that the indices are enjoying a speculative blowoff.
The more-than-doubling of the NYMEX initial public offering on Friday was also interesting. The equities of securities exchanges like the NYSE and NASDAQ, among others, have soared lately. Among offbeat indicators of sentiment used to be the price of seats on the NYSE (which are now no longer traded). Soaring seat prices were generally a good sign of the exuberance of market tops. Friday's NYMEX “shooter” brought that element together with a bubbling IPO market, and is an indication of the increasingly speculative tone of the stock market here.
All of that said, it's exactly that speculative tone, evident in the ease of market advances and the lack of “heavy” price-volume action, which prevents any good forecast of when the market will turn down or complete its cycle. Still, as long-term investors, we don't really need to know. Once stocks become richly valued, further market gains are typically not retained over the full cycle. In richly valued markets, the primary source of sustainable returns is good stock selection that is hedged against general market fluctuations, plus the implied interest earned on those hedges.
Should we chase this advance?
In the Strategic Growth Fund, the decision to accept or not accept market exposure is based on the prevailing combination of valuation and market action at any given time. Various combinations of these conditions have historically produced very different profiles of return and risk. The idea is to accept large market exposures when the expected return/risk profile is favorable, and avoid much exposure when it is not.
We welcome exposure to market risk when we observe some combination of favorable valuations and market action. The best combination in recent years emerged in 2003, though valuations were still well above historical norms so we removed 70%, rather than 100% of our hedges. Conversely, as of last week, we are essentially back to a full hedge because stocks are overvalued, market action is strenuously overbought, and investors are overbullish (the latest Investors Intelligence figures show only 22.3% bears among investment advisors).
But the trend is up! Shouldn't we just ignore the prevailing overvalued, overbought and overbullish conditions, assume the trend is our friend, and chase this market anyway? Well, let's try a thought experiment. At these levels, even if we bit the bullet (against our best evidence) and lifted our hedges, there's little chance we could justify even a 40% exposure. Suppose we did. Then what? Is there a reasonable expectation that the market will plow another 10-15% higher before correcting? If so, would we be able to close down our exposure prior to the market giving that gain back, given that a correction is already so long overdue? Without a perfect exit, how much of the gain would the market give back before we reestablished our hedges? On a 40% exposure, how much impact would our risk-taking have on overall performance?
Once you go through this sort of thought process, it becomes clear that establishing a exposure to market fluctuations here and now, even provided a further advance and a good exit, would still be most probably be associated with a low single-digit impact on Fund performance. In my view, the downside risk is at least as great. In any event, our investment positions are a function of prevailing conditions, and are not based on scenarios about future short-term market direction. Given the overvalued, overbought, and overbullish character of the market, the evidence weighs against taking a significant speculative investment position here.
That isn't to say that nothing would justify some amount of speculative exposure in the near future. If we were to establish a moderate amount of exposure after a reasonable correction in the market, provided internal market action remains relatively favorable, the expected return to that speculative position would at least be positive and perhaps in the mid-to-high single digits. In any event, until we see better valuations, I expect that our primary source of returns will continue to be stock selection and the implied interest on our hedges.
As of last week, the Market Climate for stocks was characterized by unfavorable valuations and favorable market action. On last week's market strength, I took profits on our call option position, so the Strategic Growth Fund is again about fully-hedged. The prevailing overvalued, overbought, overbullish combination has generally been associated negative returns, on average, even when overall market action has been favorable. Still, even a correction of a few percent will again warrant at least some constructive exposure to market fluctuations. Until we actually observe a shift back to unfavorable market action, it would be premature to place much expectation on a near-term market top or an extended decline. We can't rule them out, but as always, our focus is on prevailing, observable conditions, not scenarios or “market calls.”
Meanwhile, in stock selection, we continue to stick to our knitting. I continue to expect disciplined stock selection to be the primary driver of returns in the Fund over time. Market exposure will play a far greater role in our investment returns once valuations move down from the extremes of historical experience.
In bonds, the Market Climate remains characterized by unfavorable valuations and moderately favorable market action. Inflation news has been surprisingly tame in recent reports. While our investment positions don't rely on any particular expectation for inflation, the data are uncharacteristic. It's possible that U.S. government liabilities (currency and Treasury securities) are still enjoying good demand from China and other foreign holders, which we would observe as even deeper current account deficits, but that's still unclear. In any event, without evidence from widening credit spreads, yield levels are currently not sufficient to warrant much duration risk here.
Yes, it would be possible for bonds to achieve reasonable total returns if yield levels move even lower, but as in stocks, the prospect of bonds actually sustaining those returns appears low. The Strategic Total Return Fund presently holds a portfolio duration of about 2 years, mostly in TIPS, with about 20% of assets in precious metals shares.
New from Bill Hester (a must read): Profit Margins, Earnings Growth, and Stock Returns
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