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Listen to a replay of our fourth quarter 2018 Litman Gregory research team webinar. Topics covered (among others): U.S. equity valuations, REITs, our conviction in European stocks, and managed futures performance. The presentation slides are available at the bottom of the page under Resources.
Hello, and welcome to the Litman Gregory Quarterly Research Webinar. This is Chad Perbeck and I’ll be moderating the event.
Joining me today is Jeremy DeGroot, Rajat Jain, Jack Chee, Jason Steuerwalt, Kiko Vallarta, and Peter Sousa.
To briefly set the stage, the format of today’s webinar will be as follows:
Peter will walk us through an opening slide presentation, which will provide a review of the fourth quarter. He’ll share a few key points about the global investment environment, asset class performance, our current portfolio positioning, and our outlook. We’ll then move on to answer questions that were submitted by you, or audience, prior to the call, showcasing some of the most pressing issues we’re facing when advising clients. We’ll also try to address any questions you submit live, time-permitting. Please note: For those of you who have only dialed-in by phone, you will not be able to ask live questions since your lines are on mute. You’ll need to join GoToWebinar online to type and submit questions using the desktop control panel.
As always, we welcome your feedback and questions. Please email us at email@example.com or firstname.lastname@example.org.
Now let’s move on to our opening presentation – Here’s Peter:
Thank you, Peter. Great summary and set up for the rest of the webinar.
Before we move on, I’d like to encourage our audience to start submitting questions via your GoToWebinar desktop control panel. We’ll aggregate them to be addressed during the webinar, if time permits, or our research consulting team will follow-up with you afterwards.
The first question is on domestic stock valuations. It reads:
Litman Gregory views the US market as very expensive and is underweighted in tactical allocations. However, others take a different view with the US equity markets being in a fairer value range or even undervalued based on economic outlooks. Would the fact that the very poor 2008 earnings being dropped from the 10-year Shiller P/E calculation have an effect on your analysis?
Jeremy, will you please start us off by sharing your thoughts?
The short answer is no, this doesn’t affect our analysis or expected return outlook for US stocks. Our analysis of the US market is not based on Shiller P/E’s. Our analysis is based on forward-looking normalized earnings growth (or trend earnings growth) and valuation multiples.
There is a conceptual similarity between our approach and Shiller’s approach in that neither of us are relying on a single year’s earnings, whether trailing 12-month or 12-month forward estimates, to assess market valuations. We use a long-term normalized trendline of S&P 500 earnings growth for our base case scenario (we may also make adjustments to that trendline based on our analysis). Shiller uses the average of the trailing 10-years real earnings for his P/E ratio. So, both of our approaches are intended to “look through” the shorter-term cyclicality of earnings and smooth things out.
We are also aligned with Shiller’s approach in that a historical analysis of the Shiller P/E ratio demonstrates that high current valuations are strongly predictive of low future returns, and vice versa. But this relationship only holds over longer-term time periods (5 to 10+ year periods). Valuations are not predictive of returns over the short-term.
So, the Shiller P/E is not a formal input to our analysis. But we often include a chart of Shiller P/Es as a quick and simple way of showing relative valuations across different markets. It’s also useful as a long-term data series to see the historical fluctuations and wide range of valuations for the US stock market over time: Shiller P/Es have ranged from around 5 to 45! That’s fear and greed personified.
Here is the latest Shiller P/E chart from Shiller’s website. It shows the sharp drop in the fourth quarter from 33 to 28.5 at year-end. But you can also see that relative to history, it is still quite high – the only higher periods were the crazy tech bubble in 2000 and in 1929.
Based on history, from this valuation level, the prospective long-term return for stocks is still very poor. So even if you are relying on Shiller P/Es, I don’t think this would really change your view on the market. And, the Shiller P/Es for European and Emerging markets also dropped in Q4. So, the relative valuation gap between the US and foreign stock markets remains very large, which is consistent with the results of our analysis too.
Jeremy. We appreciate you laying out the similarities and differences between the two approaches.
The next question also references US stock valuations, but in a different context. Jack, if you’ll tackle this next question which reads:
While US stocks likely have to get a lot cheaper for you to get more equal-weighted with your strategic allocations, is there a chance that you’d add to REITs instead, given that’d be their funding source, the now higher yields, stable economic outlook, less than perfect correlation, and a more benign rate rising environment for the Fed?
Adding REITs as a tactical allocation is always a consideration. As the question highlights, REIT yield have increased from their lows, and today are in the 4.25% range. Meanwhile, the Fed has signaled a more benign rate environment. On the surface, REITs seem more attractive. But below the surface, there are a number of factors we are wrestling with when it comes to evaluating REITs. One point we’ve made in the past is the uncertainty we have when it comes to having confidence in evaluating REITs as a tactical allocation. We’ve commented in that past that REITs seem to be trading on technicals more so than fundamentals and valuations. In recent years, amid low interest rates, we observed that REIT performance was highly correlated to moves in the 10-year Treasury and their stock prices seemed to have little to do with fundamentals or valuation.
Further complicating our analysis of REITs as a group is the make-up of the sector. For example, you have hotels, which are essentially over-night leases, you have multi-family with one-year leases, and you have offices with 10 years leases. So, there’s a wide range of what I’ll call “duration.” You also have the broad mix of businesses such as data storage, hotels, and malls, which really don’t have much to do with each other, which further complicates the analysis. You also have the issue of real estate being a very local business, so geographies also muddies the water.
Backing up, one question we continue to wrestle with is, are REITs a legitimate asset class or should we be thinking of REITs as a business structure? Should we be thinking of REITs as dividend-payers? And if we do, should we be lumping them into a broader group of dividend-paying stocks, such as utilities, and other dividend-paying equities in general? One trend we see is that REITs and utilities often trade similarly. Earlier this week when stocks were down sharply, REITs and utilities outperformed. There was no fundamental news, there was no Fed statement regarding rates, but yet they were ahead of stocks by about a percentage point. We suspect it has to do with the perceived safety of dividend-paying stocks.
The bottom line is that these uncertainties result in a very high bar for adding REITs to our models. And if we did add REITs, given the disparity of lease terms, business types, geographies, etc., would it make sense to gain exposure via an index or active management? So, for now, the answer is no, we would not be adding REITs in lieu of the broader equity market.
Jack. Clearly a lot of questions and too much uncertainty to meet the conviction level we’d require to initiate a tactical asset allocation to the space.
Moving on, our next question is about revisiting the case for an allocation to foreign stocks. It’s a long question, but here goes:
After really a tough ten-year period for foreign stocks, clients are starting to wonder (and maybe we are as well) whether investing overseas is beneficial. LG has been defending European and emerging markets stocks that past few years, and we have stayed with you. However, it seems like “So goes the USA so goes the world”. The rationale seems to be why we SHOULD NOT to be in the U.S. (valuations, market cycles, etc.) but other than relative CAPE ratios, not so much why we SHOULD be overseas. Could you reinforce the SPECIFIC (not just historical) positives of the foreign markets? We want to reinforce to our clients where the opportunities are and how to ignore the isolated pockets of bad news in the foreign markets.
Rajat, will you please share your thoughts on this?
If I’m not mistaken, the question relates to why the need to diversify outside US stocks. I think we have another question related to our tactical view on foreign stocks. So, I shall focus on the strategic case for this question.
There’s nothing new to say except reiterating some simple, time-tested reasons why we believe a globally diversified portfolio serves clients well. Important to remember foreign and US stocks tend to go in cycles (see chart). Individual politics, monetary and fiscal policies, currency movements etc. can accentuate these natural cycles. That’s one reason.
Importantly, at the micro level, you gain access to different risk and return drivers. A globally diversified stock portfolio gives investors access to a broad set of opportunities: different business models tapping into different growth and return drivers inside and outside the U.S. And the foreign opportunity set is vast—larger than in the US, while in the US the public market is shrinking. So, we believe active managers have more opportunities to add value and improve overall portfolio returns.
Foreign stocks, especially emerging markets, have a different beta to global growth. It means for higher volatility you can expect to get compensated with higher returns over the very long term. It may not appear that way given foreign stocks are undergoing a wretched cycle of underperformance right now [refer to chart/Kiko’s table of long term results]. In a well-diversified portfolio that have other low-risk low-correlated assets, having a dedicated allocation to foreign stocks can improve a portfolio’s return potential without increasing risk. Again, over the long-term is when this benefit comes through…over complete market cycles.
Finally, we should all be wary of putting all or most of our eggs in the US or USD basket. USD on some currency-valuation measures is overvalued. And when you factor in an expensive US stock market (which when it adjusts is bound to put pressure on USD) and budget deficits historically high after adjusting for where we are in the economic cycle, then we’d say it’s a risk worth thinking about. But currencies are notoriously difficult to time. So, foreign stocks help manage USD risk.
These would be the strategic or very long-term reasons to help clients ignore the pockets of “bad news” in foreign markets we are reading these days. Each cycle appears unique and, in each cycle, there is always something to be worried about. Things close to home are more familiar than things away. This is understandable.
In the late 1990s clients would ask why we need to invest in international equities. As you may recall, back then the US was in a bull market driven in good part by the tech/internet and telecom sectors. Europe was, and still is, not heavy in tech, so it lagged. There were uncertainties surrounding the formation of the euro. And Germany, the largest economy in Europe, was known as “The sick man of Europe.” Investors missed European equities had become cheap relative to the US and Germany implemented labor reforms that made it globally competitive.
Something similar is happening today. We are getting questions from clients why invest in Europe (and Emerging Markets) given the US is doing so well and things outside seem so bad. Our response is similar as nearly two decades ago: Europe is historically cheap, meaning a lot of these concerns are likely priced in, and companies are restructuring and becoming more competitive which bodes well for future earnings growth. Part of the reason why Europe has been held back since the GFC is it had no TARP facility, akin to the U.S., to quickly re-capitalize its banks. After all, Europe is not a fiscal union, at least not yet. This meant the bank recapitalization process was a long and painful one, weighing on the economy and company-level profits. Based on our conversations with stock pickers we respect it appears in general European banks are much better capitalized than around the GFC.
These turnaround situations are hard if not impossible to time consistently for most if not all investors. So, to minimize whipsaw and regret, a strategic allocation to a globally-diversified mix of stocks, with the majority still being in US stocks that have historically traded at a premium because of their perceived higher quality, makes a lot of sense in our minds.
Makes sense, thanks for sharing the long-term thinking there, Rajat. It’ll be good to hear the more medium-term tactical view later in the webinar, as you mentioned. For now, let’s move on to our next question, which is also on the topic of foreign stocks. The question reads:
I really like the historical information you furnish, particularly like that recent chart on rolling period returns and the narrowing range of outcomes as timeframe extends. I am interested in finding more historical information on how foreign equity markets have behaved over the years. I can advise clients on some of the key averages on how often we have bear markets, the average decline, and average length as it relates to US markets. I have seen little similar information on foreign markets, so I have little to share in that area to appropriately set client expectations.
Kiko, will you please address this question for us?
We’re glad you’ve found the historical information on US stocks helpful with educating clients. Looking past short-term noise and extending a time horizon are very beneficial messages for clients. Given that, here are a couple charts showing the narrowing range of returns for developed international and EM stocks. [SHOW EAFE CHART OF NARROWING RETURNS]
For developed international stocks (MSCI EAFE index), the story is very much the same: returns converge to a much narrower set of potential outcomes for those with longer investment horizons. Over a 12-month period, EAFE returns have been anywhere from up 100% to down 50% (from 1970 to end of 2018) – there’s a lot of potential returns for investors trying to predict a 12-month return. Over a longer 20-year period, returns have always been positive and ranged from a much narrow band of up 2% to up 16% annualized. [SHOW EM CHART OF NARROWING RETURNS] And as you can see in the same chart but for EM stocks, the outcomes are very similar. EM stocks have returned between up 90% and down 60% (a band of 150 percentage points!) over a 12-month period. Alternatively, returns have narrowed to between 5% and 16% annualized over 20-year periods.
To your point about foreign equity markets and their historic bear markets as they relate to US markets, here is a chart showing both EAFE and US drawdowns from their all-time highs. The black line shows EAFE drawdowns and green shading is for US stocks. (I would note that this chart uses monthly returns and not daily/intra-month returns for simplicities sake.) You can see drawdowns in the same neighborhood as US stocks, as well as the frequency and timing of the larger drawdowns. The three deeper bear markets (mid-70s, early-2000s and the financial crisis) each coincide with US stocks falling a similar amount. A general takeaway would be that developed international equities have similar large drawdowns that have happened at similar frequency over the last 50 years. Hopefully these charts help put more context around international stocks.
Thanks for sharing that historical analysis and helping our clients set appropriate expectations with their clients.
Speaking of expectations, our next question is specific to overall portfolio risk. It reads:
We have been reviewing some of our client accounts and we noticed that some of them are approaching the downside threshold for a twelve-month time period. It is a little alarming to us because it seems like with the market’s reaction to namely Fed movements has resulted in the dips becoming less frequent, but much higher in magnitude. What is Litman Gregory’s take on the current market environment? Has it changed compared to the past and do the downside thresholds need to be revised?
Jeremy, will you please share your view with us on this? (Show chart of historical loss threshold analysis)
We don’t intend to revise the formal downside thresholds for our model portfolios. We think they are still valid representations of each model’s short-term downside risk potential. But it is critically important to remember that these thresholds are not guaranteed to never be violated. Our historical analysis (going back roughly 50 years) indicates that each model would have violated their 12-month loss thresholds roughly 5% of the time – typically this happens during severe equity bear markets. So, it’s important for clients to be aware of this: there will be periods when the loss thresholds are violated. To manage a portfolio so conservatively as to never violate such a threshold would entail huge foregone returns over an investor’s lifetime.
However, getting to the thrust of the question: On a forward-looking basis, given that core bond yields are much lower now than they have been historically, we do believe the odds of the strategic portfolio allocations violating their risk threshold are higher than the historical data suggest – probably more in the 10% probability range for a 60/40 Balanced model. We’ve written about this before, and can point you to those materials offline, if you’d like. (September 2012 commentary)
Core bonds play a crucial risk-reduction role in our balanced portfolios. They dampen the volatility and provide positive expected returns during a typical equity bear market. But with the starting yield currently so low, core bonds’ potential return in a 12-month bear market period is much lower than history. The lower yield of course also limits core bonds’ medium-term (five-year) expected return. And that is a key reason why we have diversified our fixed income exposure beyond core bond funds to include flexible and absolute-return oriented bond funds and floating rate loan funds as well as selected alternative strategies, such as managed futures.
Jeremy. It’s always good to have that long-term historical perspective to try and educate clients, set appropriate expectations, and keep them on track with their financial plan.
The next question is one that’s been coming up more in my recent conversations as short-term rates have come up. The question reads:
Will you address the performance of your managed futures positions? Personally, I was disappointed in how they performed over the last quarter and am therefore interested in your perspective. What do you think is wrong with the strategy, and how long will you stick with it if a rebound does not occur? Wouldn’t I be better off just investing the liquid alternatives in cash? It’s cheaper, doesn’t lose money, rates have improved, and can be used as dry powder.
Jason, will you please address this question for our audience?
Given the circumstances, I don’t find it that disappointing. Remember that trend following funds are not hedges. They’re uncorrelated sources of return that have a very high likelihood of delivering their best performance during periods of extended equity market declines. The benefit of this is that we expect them to have positive returns over time, as opposed to buying put options, which have a negative return over time but react immediately to produce gains when equities decline.
We do expect trend followers to do best when the rest of the portfolio does worst over an extended period. But again, they won’t necessarily react to equity market losses with instant gains, particularly if existing trends are reversing going into a negative equity market, which is what happened in February 2018 and in October. In fact, there were a large number of trends that suffered very sharp reversals early in Q4, including the ones that are pretty obvious, like US stocks and oil, but also in lesser-followed markets like heating oil and the NZD vs USD. It was largely a dramatic risk-off move that came after a sustained increase in risk assets. Despite this, our managers all outperformed most equity markets during the quarter (except EM, perhaps because EM markets were already so beaten down). While ASG and AQR had negative absolute returns, PIMCO actually generated a significant gain of 6.4% for the quarter, and over 2% for the year. In December, the worst month for equities in some time, our managers ranged from flat to up almost 5%. So, again, for the quarter, they did their job of diversifying, but because it came in a sharp reversal, the beginning was painful, which is exactly the pattern we should expect. By December, the worst month, they were materially outperforming.
If markets had continued in their risk-off trajectory, the value would have been dramatic, as it was in January of 2016 when equities were down double digits and trend followers were up about the same amount. In that case, a somewhat negative Q4 had them positioned the right way, and you really saw the convexity kick in during January, which is what you’re looking for in an allocation of this type. AQR simplifies it to say that trend following does best when things go from good to great, or bad to worse. In the handful of periods where that’s happened in recent years, trend followers have done what we expect. So, I don’t worry that the strategy won’t work as intended in extended stress periods because we’ve seen it twice in the last few years, although we haven’t experienced a tough stretch of more than 3 months in quite some time. If the strategy ever doesn’t provide that so-called “crisis alpha”, we’ll almost certainly be eliminating our allocation.
What’s been the problem, and what we’re pondering, is that there have been fewer strong risk-adjusted trends (meaning high signal-to-noise ratio in the directional movement) in recent years than there have been on average historically. I’ll caveat that by noting, as I usually do when discussing this topic, that 2014 was an excellent year for trend following, and that wasn’t even related at all to an equity bear market. Speaking from a historical perspective, 2014 wasn’t all that long ago. Speaking from the perspective of someone who knows the frustration trend following has caused for clients, because I’m invested there too, 2014 feels like a long time ago. But four years compared to the long live history of the strategy, and the even longer backtested data that multiple managers and academics have produced, is a small sample size.
It seems unlikely that there will be permanently fewer strong trends because trends generally come from human behavior and the participation of non-profit-seeking actors like hedgers and central banks. As long as those things still exist, trends should still exist at roughly the same long-term average, and we may just be in a random bad period. That’s what we think is the case. If you want to be more pessimistic, the fear is that increased capital in algorithmic/quant trading that is mean-reversion oriented has made TF returns during non-crisis periods lower. We don’t have enough evidence to believe that’s true, and again, 2014 was recent evidence to the contrary of that potential hypothesis. But even if it was true and returns in non-crisis periods were permanently lower, TF still has value in a portfolio...unless non-crisis returns are degraded to a point that leaves them materially negative instead of only slightly positive or even flat long term. That would require a pretty significant degradation from historical returns.
As to the part about cash, yes, you’d be better off holding cash if you never want to see it with a negative return (in nominal terms). But you could say the same when you compare cash to any other risky asset class or strategy. You’d be better off holding cash if you never wanted losses from your equity allocation either. We obviously don’t think TF is going to lose money over the long term or we wouldn’t be including it in portfolios. Of course, we could be wrong, I can’t rule that out. But it seems like a stretch to say it’s going to stop working based on all the evidence we’ve seen and knowing what makes the strategy work.
Regarding fees: yes, it’s annoying to be paying high fees relative to the rest of your portfolio, particularly when it’s not working. But assume in the future that the strategy goes back to working as expected and everyone is happy with it. You have to pay these fees to get the strategy. Nobody provides it for 3 basis points like an equity index ETF, or some provide that for free now, I guess. So, if TF is ultimately valuable, like we think it will be, you’ll want access to the strategy in spite of the perceived high fees. This whole question basically all comes down to whether you’re confident the strategy is broken. If yes, then of course you should hold cash or bonds or anything else that you’re confident has long term positive returns. But if you’re not highly confident it’s broken, then you should have an allocation and accept that unfortunately, it for now requires higher fees than traditional assets.
Rates have improved, yes, which gives you a better return on cash, but it also gives a better return on the collateral portion of a TF manager’s portfolio. (Remember that these funds are basically just a pile of cash or very high quality fixed income and then a bunch of futures contracts that the cash collateralizes.)
If you want guaranteed dry powder then, yes, you should hold that in cash, but again, that’s the case for any risky strategy you’re investing in that’s not cash. To reiterate, this isn’t an explicit hedge. We’re not saying this will be up at exactly the right time you want dry powder, as October proved, but we are saying that in an extended drawdown, it’s very likely to provide value (like in December), and the steeper and longer the decline lasts, the more value TF provides because of that convexity. If it doesn’t, then as I said before, we’re very, very likely to be done with the strategy. And based on the evidence, it should provide gains on average in other periods too. If it doesn’t do that, which is the part we’re a little less confident in, the strategy can still be useful in a portfolio, but it’s certainly less attractive.
So, the bottom line is, we think the strategy will make portfolios more efficient, or we wouldn’t recommend it. It would certainly be easier not to recommend it, particularly when it’s something that most people don’t understand as well as stocks and bonds, which understandably makes them more skeptical. Believe me, I don’t like talking about why it’s not working as much as I have been on these calls. We would also have one less negative thing to discuss in client meetings in quarters when it’s down. So, we clearly think it’s something worth suffering through for the long term benefits we expect. However, we know that everyone’s clients’ pain tolerance is different, so if owning managed futures is unbearable, then we understand not owning managed futures. It’s just not our recommended course of action since we still think the ultimate results will be valuable.
Thanks, Jason, appreciate you reiterating the historical thinking on including the strategy and sharing our ongoing analysis, or questioning of that original thesis, and ultimately affirming it remains intact.
Switching gears and going back to international stocks, this next question is specific to our tactical overweight to European stocks. It reads:
Why the ongoing play in Europe given political, economic, demographic, and social challenges? I have different pieces from those that I believe are reputable that indicate Europe is not really that cheap and potentially slightly overvalued. Gundlach believes Europe is a value trap. Can you speak to value traps, generally, and your case for Europe more specifically?
Rajat, we foreshadowed this topic earlier, will you please share your thinking with our audience?
This is a fair question. First, the US has its own sets of social, demographic, and political challenges. How they transpire only time will tell. On trailing and/or one-year forward earnings Europe may not look cheap to investors. But this is not how we gauge value. Our valuation discipline is based on a normalized earnings framework. And we believe it’s cheap because Europe is severely underearning relative to its historical normalized potential (and it’s also the reason why Europe doesn’t look cheap on some traditional earnings-based valuation metrics).
I cannot comment on Gundlach’s Europe being a value trap since I don’t know over what time horizon he has this view. Still, we overweighted Europe back in April 2015, so you can say it’s been a value trap since then. Knowingly, no one would want to get into a value trap. It follows that fundamentals have not panned out or normalized as we expected. [BCA’s euro earnings chart.]
From the outset, though, one of the main issues we have debated internally is how countries with different cultures and competitive levels were brought together in a monetary union without a true fiscal union (which normally requires a political union). Offsetting this concern were the long-term economic benefits from this union and the strong political will to continue to integrate Europe further (this integration process has been in the works for over 50 years after all, and progress has been made even if it has appeared stalled at times). However, the weakness of this system is more exposed as Europe has had to deleverage post the GFC.
Because of the above-mentioned considerations and weighing both the positives and negatives related to Europe, before initiating our tactical overweight, we waited for a higher margin of safety than we otherwise would had we thought it was a normal cycle [price chart – Europe vs US]. And we had less of an overweight than what our numbers suggested and what we’d have in a normal cycle--our net overweight, factoring in our underweight to broader international stocks, is roughly 2.5%, half of our typical overweight. And, we’d be adding more to Europe stocks today if Europe’s broader economic and political environment posed normal risks. So, it’s important to keep these points in perspective—we have been and are factoring in the risks Europe poses during our portfolio implementation (we were not acting on the return numbers we were showing); it’s not a large overweight at all; and we added to it at valuations that we’d consider very attractive in a normal cycle.
It’s only in hindsight we can say it’s been a value trap. As Ken Gregory, our firm’s co-founder once said, “It’s hard to not know something you now know.”
So, what do we now know? We know that Europe’s deleveraging has not progressed as well as it has in the US. That Europe monetary and fiscal policy steps were not as timely and/or enough as they were in the U.S. (what’s enough can be known only in hindsight). Brexit didn’t help as it stymied intra-Europe growth drivers, and when it seemed Europe was coming out of its disinflationary funk trade wars have detracted from its reflationary efforts. This was unfortunate timing.
As such, the financial system has taken longer to de-lever and that’s weighed on Europe’s economic growth and profits. (Since the GFC, annual sales growth in Europe has been less than one pp versus over three pp for the U.S., according to Bloomberg data.) These factors we’d say fall largely under the unknown or hard-to-predict-with-confidence category given so many variables that can impact economies and markets at any point, including how policy-makers would act. There are other factors that are different in this cycle for Europe:such as less or no financial engineering (a positive) and lack of FAANGs compared to the US (a negative in this cycle, although Europe too will benefit longer term from the productivity benefits these technologies unleash)). But we think policy differences has been an important factor behind Europe’s relative underperformance.
Historically, often macro risks and negative news tend to be temporary. Things work out in unanticipated ways, so for long-term investors negative macro headlines typically present good opportunities to buy an asset cheaply. Which is what we did in April 2015, while adjusting for factors that might be unique in the current cycle. Not acting at all, even in a measured way as we did, going back in time to what we’d known back then and the positives and negatives we’d weighed, would have implied we were potentially getting too wrapped-up in macro noise and letting a historical opportunity pass us by.
Thanks for sharing the details behind the qualitative thinking to factor in the risks and weighing that with the cheap relative valuations. Taking into consideration what we’ve learned looking back three years after initiating the moderate tactical overweighting to Europe, where do we stand today?
Retracing our decision-making framework and what’s happened since our modest tactical overweight is not meant to give excuses but to learn from what we missed or underappreciated and take stock of what we should be doing now and looking forward. We have observed first-hand the challenges of Europe’s monetary union without a proper fiscal union. We have already taken significant haircuts in terms of our earnings assumption and in our portfolio implementation to account for Europe’s structural weaknesses.
On the positive side, while Europe’s deleveraging has been slow progress has been made. Various metrics, such as NPLs and risk-weighted capital, suggest banks are much healthier and in general pose a lot less risk to the economy than around the GFC. Private-sector deleveraging has also progressed in the right direction. As can be expected, austerity and poor growth is leading some countries to adopt reforms and become more competitive. Companies are restructuring and getting learner and are relatively more positively geared towards global growth. We can expect some pent-up demand post a long cycle of financial and private-sector deleveraging that may at least make up part of the time-value lost.
ECB’s president, Mario Draghi, has time and again stressed the need for coordinated fiscal easing rather than austerity to help reflate the eurozone. That may happen in a substantive way (now that some countries have adopted some reforms), although it’s hard to know with confidence what is substantive, except in hindsight, again because many variables impact economies, not just one.
A number of catalysts could start to work in favor of global growth and Europe reflation—Brexit resolution, end of trade wars, China’s growth outlook etc. Our case rests on Europe earnings normalizing from here. They don’t have to normalize to the old-normal level, such is the wide discrepancy we see [refer to the BCA chart again].
With Europe, our model is relative to the US. Historically, when excess return has been at least five pp, overweighting Europe has had a very high likelihood of success. Once you subtract this five pp from the mid-teens return you see on the return sheet, our high-conviction nominal return expectation from Europe as of the end of 12/31 was low double digits. This return is reasonable when you consider Europe has underperformed the US by nearly eight pp, annualized, since April 2015 and by about seven pp, annually since the GFC (over nearly ten years, this is a cumulative performance gap of nearly 200%). Historically, it doesn’t always take a long time for valuations to normalize as implied by our current relative return expectations between Europe and the US. In the mid-1980s, it took about seven months, in the mid- to late-70s, a bit more than a year, and in the 2000s four years. This cycle has admittedly been long, but the point is relative price movements can occur quite fast so waiting for a catalyst or better news may very well mean missing the relative opportunity.
We will be doing further analysis in the coming months to assess whether Europe warrants a further haircut given their structural issues we just discussed and the possibility their deleveraging may not yet be complete. At the same time, we will remain open-minded to adding to our overweight, especially if returns become meaningfully more attractive than they are today. We also realize that our additional caution, or maintaining a relatively high hurdle, may result in us missing an opportunity to add to Europe at more attractive normalized valuations than observed historically.”
Thanks, Rajat. We look forward to hearing more about the continued analysis, and how it may impact our portfolio positioning. A potential topic for a future webinar.
Our next question is a manager-specific question. It reads:
My primary model concern is the baffling performance of Oakmark Select and Oakmark Global Select. Stock picking misses of this magnitude call into question the premise for these positions in the portfolio. If you were assessing these positions for potential new inclusion in the model, would you reach the same conclusion to add them? Is this how you approach underperformance, or do you assess the probability that they "bounce back" in an oversold market? Are you advising clients to buy more at this time if they are underweight that particular asset class?
Kiko, will you please address this?
We talked in detail about Oakmark Select’s underperformance on the last call. Unfortunately, the fourth quarter wasn’t any better for the Oakmark team. Last call we talked about many of the stocks in the portfolio being flat to slightly down in a strong up market. But during the fourth quarter, as market volatility picked up, many stocks in the portfolio had sharp price declines. The nature of the sell-off in the fourth quarter was such that many investors became concerned about slowing economic growth and rising recession fears. Obviously, this hurt pro-cyclical stocks, which currently make up a good chunk of the funds exposure. The fund has meaningful exposures to financials, industrials, materials and energy stocks – all of which have a pro-cyclical element to them and so were hurt when fears of a recession increased.
While we never like seeing it, the Select fund has experienced 12-month periods of similar levels of underperformance. And the fund has bounced back and performed well in the subsequent periods. We don’t know what the future holds, but we are confident that the process and philosophy underpinning the strong long-term track record remains in place. As a quick show of how quickly performance can turn, since Christmas the market has become less worried about a recession being on the near-term horizon – and since then, the Select fund is already up more than 16% while the market is up roughly 12%.
Thanks, Kiko. Rajat, did you have something you wanted to add?
Kiko’s comments and drivers of underperformance apply in large part to Oakmark Global too, and we have written about these drivers in more detail recently (please ask and we shall forward it to you). So, I will briefly touch upon our discipline when a fund or manager is going through a tough period like 2018.
In the past several months, we have spoken at length with three of the four portfolio managers of Oakmark Global—David Herro, Jason Long (who is also the lead analyst on many of the European banks that have hurt performance), and Clyde McGregor.
When a fund goes through underperformance, and this is inevitable, the intensity of our due diligence increases, especially when the magnitude of underperformance is this significant, as you rightly point out. We review our old notes and transcripts of prior calls and meetings, shareholder letters and press interviews with these managers to remind ourselves (in greater detail) their investment discipline, including what they have said in the past about some of the holdings that have driven underperformance. This context and review work help us narrow down our questions: we try not to go over the same stuff we have before but aim to further our understanding of a fund manager’s investment discipline with every call and meeting. We ask these questions to help us assess whether a manager is sticking to their investment discipline; are they becoming stubborn by not factoring in new information; are they cutting corners in terms of their due diligence; do they remain engaged; are people who we expect to be involved in making decisions involved; does the manager have adequate coverage and resources; are they being intellectually honest when weighing various risks in terms of what they can and cannot know, how conservative are their assumptions and have they adequately factored downside risks, etc.
If no red flags are raised post this due diligence, we stick with the fund or manager and would advise clients to rebalance up to their target weighting. This is an important aspect of our investment discipline. It prevents us from getting whipsawed, i.e., selling at the worse point of a fund’s inevitable underperformance cycle and buying into something that might be at the top of its performance cycle (we count momentum-heavy indexes or ETFs among that list today).
Our patience is not always rewarded. Fund managers do not bat a 1000 and sometimes end up being wrong. That leads us to discussing a manager’s mistakes at length. We think about what we know about their investment discipline and what we want to really understand, what’s reasonable to expect from a fund manager in terms of what they can know/not know (past discussions help in this sifting), what could the fund manager have done better? Is there a weakness and to what extent is it an opposite reflection of their strengths that we regard highly? What are the right lessons to learn? Are they learning them and becoming better? If their mistakes raise a red flag (e.g. they didn’t really learn and repeat a mistake, although each situation is different and there are nuances we need to understand), then we would sell. Otherwise, we stay and advise clients the same. During all this work, there is constant debate among the research team, where each member is acting like a devil’s advocate, asking the lead analyst tough questions.
Over time, though, if mistakes occur again and again, and the underperformance period extends, we need to be honest with ourselves and ask whether we are missing something. We have made some mistakes. We try to learn the right lessons from them and apply them to other situations, while factoring in their respective uniqueness.
What we won’t do is sell a manager/fund just because they are underperforming. Oakmark Global’s performance has been really disappointing in 2018. McGregor has been managing this fund for 15 years and has had a highly successful track record of investing for over 30 years (same applies to David Herro). Such managers don’t lose their investment skill suddenly. In addition, he has served shareholders well by side-stepping previous excesses, such as financials and homebuilders prior to the GFC, and being tax-aware. He is confident that some cyclical stocks, such as GM, are pricing in a very severe economic outcome and are very cheap. We discussed at length this name in our recent conversation.
Oakmark Global, like Oakmark Select, is bouncing back so far this year, outperforming its index by over 400 bps and ranking among the top three percent of its comparable peers, according to Morningstar. The fund’s long-term track record remains solid. We remain holders.
Thanks for adding that additional detail on the global strategy and our own internal due diligence process, Rajat. Moving on, this next question is pulled from the headlines and I feel like we should address it as it could benefit our audience as they answer questions from their clients. It reads:
What are your thoughts on the government shutdown? Is it impacting your investment outlook?
Jeremy, can you speak to this question, please?
The government shutdown falls into the category of things and events that have no influence on our investment decisions or analysis -- except and unless they create a buying opportunity from a myopic market over-reaction. In other words, something like this government shutdown has absolutely no impact on our medium- or longer-term return expectations or assumptions for any asset class or the overall economy. We view it as immaterial from a longer-term fundamental investment perspective. One of the many such events that will be just tiny blips in the course of financial market history.
In terms of the potential short-term impacts, we have no expertise or edge versus the market in guessing or predicting when the shutdown will be resolved or what the short-term market impact will be. But we don't need to have an edge there. Nor do we need to have a high-conviction view or opinion on it one way or the other because we already manage our balanced portfolios to account for short term risks, shocks and unknowns. Our portfolio construction and management approach already incorporate potentially negative shorter-term market events, including a bear market.
I'd be surprised if the government shutdown caused a recession. But given an already slowing economy, if it lasts for several months, it might be a catalyst.
But if it does lead to a recession, we've already got that scenario covered. We are already expecting a recession and bear market to occur sometime during our tactical five-year time horizon – and probably sooner than later given where we are in the economic cycle. So, the potential impact of the shutdown doesn’t change anything from our portfolio management or asset allocation point of view.
Stepping back even bigger picture, we don't alter our investment approach in anticipation of or in response to election outcomes or political squabbles. As long as we assume the U.S.’s largely capitalist democracy – and the institutions and laws that support this system -- remain intact, all the political stuff just falls into the category of "noise" when it comes to how we invest.
Thanks for reiterating how we think about or factor in these types of political events within our process.
We’ve covered a lot of ground today and we’re up against our allotted time.
…With that, I’d like to conclude today’s event by thanking our audience for all the great questions and their continued support and thank Peter and the analyst team for sharing their perspective with us.
A replay of the webinar and a copy of the presentation slides will be available on AdvisorIntelligence.com later today.
For those advisors accessing our fully outsourced Portfolio Strategies via a TAMP, we’ll make a replay available to you as soon as possible.
Thank you all for joining us and have a great day.
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