Validea Capital Management’s letter to investors for the first quarter ended March 31, 2015.
Validea Capital Management: Market Update & Factors Influencing Performance
The US economy continued to outshine other economies across the globe in the first quarter of 2015 — helping Main Street but creating headwinds for Wall Street.
One of the biggest bright spots in Q1 was a long-awaited jump in wages. After averaging less than 2% annually for the past six years, wages jumped nearly a full percentage point in the first quarter. Job growth remained solid, though not as strong as it was in the stellar fourth quarter of 2014. Payrolls rose by an average of 197,000 during Q1, down from 289,000 in Q4 — still a very solid pace. The unemployment rate dipped slightly to 5.5%, while the broader “U-6” rate (which unlike the headline number takes into account those working part-time who want full-time work, and discouraged workers who have given up looking for a job) fell to 10.9%, the first time it came in under 11% since before Lehman Brothers collapsed in September 2008, triggering the financial crisis.
The manufacturing renaissance America has enjoyed in recent years seems to have hit a rough patch, however. Industrial production declined 0.3% in January and rose just 0.1% in February, with March’s data not yet available, according to the Federal Reserve. Manufacturing and mining activity both declined in January and February, and the overall industrial production numbers would have been worse if not for significant increases in utility output, which is greatly impacted by weather. The Institute for Supply Management’s data indicated that the manufacturing sector did expand in each month of Q1, but it did so at a decreasing rate every month. The service sector fared better, according to ISM, expanding in each month of the quarter at about the same strong pace it did late in 2014.
There was some speculation that rough winter weather impacted production in Q1. That may be the case. But part of what also seems to be happening is that a.) certain areas of the economy are feeling the negative impact of the oil price plunge that began last summer, and b.) consumers have yet to start spending the money that they are saving at the pump. In terms of the former, a number of downward revisions in the energy sector have meant that Q1 earnings for S&P 500 companies are now expected to decline 4.6%, according to FactSet. Recent retail sales data supports that notion, showing that retail and food service sales fell 0.8% in January and 0.6% in February, led lower by a sharp 8.5% decline in gasoline station sales. But while wage and job growth and lower pump prices have been increasing income (real disposable personal income surged 0.9% in January and another 0.2% in February), real personal consumption expenditures have been close to flat over that stretch. That has meant a sharp increase in the personal savings rate. Over the past three months, the savings rate has risen from 4.4% to 5.8%, its highest level in two years. As consumers get used to having more money in the bank, don’t be surprised if their spending starts to pick up.
With earnings declining, share buybacks continue to be a big factor keeping stocks in the black. In February, buyback authorizations for S&P 500 companies totaled over $118 billion, the highest monthly figure on record, according to Birinyi Associates.
Overseas, the continued problems in Europe also have impacted US markets. With Europe’s economy still scuffling, the European Central Bank finally agreed to engage in significant quantitative easing. With Europe and other parts of the globe knee-deep in QE, and the Federal Reserve appearing to be on track to raise US interest rates sometime this year, the dollar continued to strengthen against most currencies in Q1. (By the end of the quarter, the dollar was actually closing in on parity with Euro, in fact.) This strength has pushed Treasury rates lower. The 10-year Treasury started the year yielding 2.12%; by the end of the quarter, that figure was down to 1.94%. Ultra-low fixed income yields may well be helping buoy demand for stocks.
Overall, however, America’s economic strength compared to Europe and most of the rest of the world may somewhat counterintuitively have led to international markets outperforming the US in Q1. Europe’s weak economy led to the ECB opening the quantitative easing spigot, which heartened investors there and sent markets higher. In the US, meanwhile, the dollar’s strength and economic weakness in Europe and emerging markets have meant headwinds for larger US companies, which tend to get a good chunk of their profits from overseas (in non-dollar currencies).
Despite that, our strategies fared quite well both at home and abroad in the first quarter, with all but one of our portfolios beating its benchmark, most by wide margins. The table below summarizes our performance for the three months ending March 31, 2015.
Validea Capital Management: Key Observations and Lessons to Share from Q1
After a rough 2014, our guru-inspired strategies bounced back nicely in the first quarter, with all but one of our long-only US portfolios beating the market by at least 5 percentage points and our other three portfolios all beating their benchmarks.We got a boost from the general bounce-back of small stocks, which had lagged significantly in 2014, but stock-picking also played a key role in our outperformance, as most of our long-only portfolios were well ahead of the Russell 2000 index of small stocks.
Overall, equity valuations are on the higher side, though not exorbitant — something you’d expect six years into a bull market. At the end of the first quarter, the median price/earnings ratio for the US market was almost 23, about 17% higher than the year-end average since 2005. But a closer look reveals some good news for our models. Since the end of 2005, small- and mid-cap stocks on average have traded at a 22.3% premium to mega-cap stocks and a 10% premium to large-cap stocks. At the end of Q1, the small-cap sell-off of 2014 had knocked small- and medium-sized stock valuations down sharply, greatly reducing the small stock premium: Compared to mega-caps, small- and mid-caps were trading at just a 12.5% premium. Compared to large-caps, the smaller guys were trading at just a 6% premium.
While I had no idea about the timing of our portfolios’ bounce-backs, the fact that our strategies have rebounded is not a surprise. We’ve been using these strategies long enough to know that they are strategies that work over time — if you stick with them. The principles behind the strategies our gurus developed — buy shares of solid companies at good prices — are timeless, we believe. So while these approaches won’t work all the time (no strategy will), we’re confident that they will work more often then they won’t work, which over the long term makes for very strong returns.
Not everyone has that kind of faith in long-term, guru-inspired strategies. Recently I read an article contending that the strategies of Benjamin Graham — “the father of value investing” — can’t work in today’s environment because times are so different from when Graham managed money. The reasoning sounds logical — after all, there was no high-frequency