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 trading back in Graham’s day, markets were far, far less global, and the 401(k) and retirement account investing that drives a lot of today’s equity purchases wasn’t a factor. Then there is the notion that once a successful strategy is revealed and becomes widely known, its effectiveness wanes. And, finally, certain variables can go in and out of fashion as investors develop new techniques for evaluating businesses and stocks. All of that makes it seem that yesterday’s winning strategies are doomed to fail today.
Nonetheless, our experience and testing shows that successful strategies tend to continue to work long after they are revealed. In fact, Graham’s Defensive Investor approach is the basis of one of our top-performing strategies, despite the fact that Graham published it 65 years ago. How can this be?
I think there are a few key reasons. The first is that our Graham strategy (like our other strategies) uses a variety of fundamental criteria that look at a stock from multiple angles. The Graham model looks at valuation from three perspectives: the price/earnings ratio using trailing 12-month earnings per share; the P/E using three-year average EPS; and the price/book ratio. That helps ensure that a) a one-year anomaly in earnings doesn’t make a stock look deceptively cheap, and that b) the strategy doesn’t fail if the P/E or the P/B goes out of vogue for a while. (By combining a variety of strategies, we add further “variable diversification” to our portfolios.)
Secondly, good strategies don’t work because of some numerical hocus-pocus. The variables they use are not magic bullets. We’re not buying Graham-style stocks with stable earnings, more net current assets than long-term debt, and low P/E and P/B ratios because we think that, in a year or two, people will greatly value stocks with those qualities. (In fact, when we sell the shares, we hope the P/E and P/B ratios will be much higher.) We’re buying them because those numbers tell us a story about a company and its shares. Each variable gives another piece of the puzzle, whether it be the information on a company’s balance sheet, the effectiveness of its management, or the attractiveness of its share price.
Sure, certain variables may go in and out of favor at certain times. But good strategies work because the variables they use get at the heart of good business and good investing. Might a that metric have come along that is better than the Graham strategy’s net current assets to long-term debt comparison? Yes, perhaps. But the goal of that variable is to give a good assessment of the company’s balance sheet. While one could argue that there is now a better variable to do that, I find it extremely hard to argue that looking for firms with more net current assets than long-term debt will ever be a bad way to assess a company’s financial health. Think about what that metric measures — essentially, it tells you whether a company could liquidate its assets and use the profits and any other cash it has to pay off all of its debts, without going into the red. In what kind of financial world would that not be an attractive characteristic?
As for the issue of strategies becoming less effective once they are known, that can be true. Good strategies succeed because they exploit some inefficiency in the market — a blind spot that the investing world has — allowing you to buy good stocks that were mispriced. Kenneth Fisher’s development of the price/sales ratio is a great example of that. Up until he published Super Stocks in the mid-1980s, most investors were focused on price/earnings and price/book ratios when valuing a stock. But in his book, Fisher showed how sales were often a better indicator of a firm’s business than either book value or earnings. Earnings, for example, can fluctuate greatly from year to year based on decisions to replace equipment or facilities in one year rather than in another, initiatives to put money into new research that will help the company reap profits later on, or changes in accounting methods. That can all turn one quarter’s profits into the next quarter’s losses, without regard for what Fisher thought was truly important in the long term — how well or poorly the company’s underlying business was performing. While a stock might look unattractive based on its earnings or P/E, its price/sales ratio might more accurately signal that it was a bargain.
Theoretically, once that concept became well-known, it should have stopped working. The more investors who moved to exploit the inefficiency, the higher the prices of low-price/sales stocks would become, and the less lucrative their returns. But that assumes that humans are rational, and decades and decades of market history show that they are not. Most people, whether individual investors or professional fund managers, don’t buy stocks based on cold, hard fundamentals and financials. Instead they follow the crowd, or trying to capitalize on macroeconomic factors, or base their decisions on their biased evaluations of a company’s products and services. And if they try to follow the fundamental-based strategy, they often end up ditching it as soon as it hits short-term problems (which any strategy will do), as they can’t take the emotional toll of staying the course when things aren’t going well. Or, they alter the strategy by vetoing some of its picks that they find too anxiety provoking.
In fact, Joel Greenblatt, another of the gurus we follow, found that over a two-year period investors who were able to pick and choose between stocks his quantitative strategy approved of (and pick the timing of their trades) fared far worse than those who had their buying and selling done on automated fixed intervals, with no ability to veto picks the formula recommended. While the latter beat the market by 21.4 percentage points, the former actually lagged the market by about 3 points. One big reason: They tended to miss out on many of the best performing stocks — beaten-down value plays that were the subject of scary headlines.
Successful, publicly disclosed strategies can continue to work over the long term if they incorporate a diverse set of variables that measure real and timeless concepts like profitability, debt levels, and valuation — if, that is, you stick to them through the inevitable short-term ups and downs, as their creators no doubt intended. I believe this not because it sounds good or makes sense theoretically. I believe it instead because I have seen our guru-inspired strategies have great success over the past dozen years. Such strategies won’t work on every pick and they won’t work all the time. But neither will new, successful strategies — I guarantee you that the most successful new stock-picking method of 2015 will stumble at some point. The key is to pick a strategy whose variables analyze important, fundamental business concepts — profitability, debt levels, revenue growth — and which buys at attractive prices stocks that rate highly in those areas. If you employ those types of strategies in an unemotional, systematic manner, you should continue to enjoy success long after the strategies are well-known.
Validea Capital Management: Individual Account Performance
You can obtain graphical performance of your specific account and a detailed list of all your holdings at any time by logging into your account at FOLIOfn using the link below. Please keep in mind that the returns in your account will differ from the returns above unless you were invested in the specified model for the full period.
Validea Capital Management: Changes in Your Personal Situation
In order to allow us maintain an appropriate investment allocation to meet your personal goals, it is important that you keep us updated on any changes to your goals and constraints. If anything has changed in your personal situation that might affect your investment allocation with us, please let us know and we will work with you to build a new portfolio allocation to meet your revised goals.
In addition, we allow our clients to restrict specific stocks and industries from being held in their accounts. If you have any investment restrictions that you have not yet notified us of, please let us know.
ADV Part II
SEC regulations require that we offer our clients the option to view our disclosure form ADV Part II on an annual basis. If you would like to view our latest ADV Part II, you can download it using the link below.
If you have any questions or would like to discuss your account, please feel free to give your investment consultant a call or call me directly at 860-656-6036.
Founder & CEO
Validea Capital Management