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July 24, 2015
“The essence of investment management is the management of risk, not the management of returns.”
~ Benjamin Graham
Much has been written about the massive money-flow into index products in the last few months. Further, we are hearing (as most active managers are) some form of the following question repeat with some commonality: “Why should I pay for active management when indexing is cheaper and is getting great results?” While this topic was addressed in our Investor Update earlier this year, given the importance and timeliness of the subject, we thought it would be beneficial to further expound on the subject.
Recall from our Investor Update letter: “Presently, investors seem enamored with passive or index investing. According to the Wall Street Journal, in 2014 $12.7 billion was pulled from active managers and $244 billion was poured into passively managed funds. Remember, if investors want to achieve index-like returns, they have to accept the downside with the upside. Investors in the S&P 500 index on December 31, 2007 didn’t recapture their losses on a price level until around mid-September of 2012. Notable as well, that while the market cap weighted S&P 500 was up 11.4% (price change only with no dividends) in 2014, the Value Line Geometric Index, which is more representative of the average stock, finished up 2.7% (price change only with no dividends).”
To shed more light on where the returns were generated, we examined the make-up of the 2014 returns for the well-followed S&P 500. What we learned was that there were only a handful of companies that provided much of the return of the S&P 500 in 2014. Specifically, the top ten performing companies alone provided over one-third of the S&P 500’s return.
Leon Cooperman of Omega Advisors addresses another nuance of the general stock market in his firm’s year-end letter: “Dispersion was particularly tight in 2014. For example, over a time frame dating all the way back to the 1920’s, the trailing six-month spread between the returns in the top and bottom-performing sectors approached trough levels last year. The good news is that, following a year like this, dispersion typically rebounds sharply in the subsequent year, nearing average long-term levels, a benefit to active stock-pickers.”
Although we don’t spend significant time or effort trying to value the general stock market as a whole, it is evident to us there are certainly times when the market is either inexpensive or expensive relative to its historic fair value. Warren Buffett suggested a metric in this regard. The “Buffett Indicator” measures the market capitalization of US equities and compares it to US GDP. To utilize this metric one has to believe that the value of a large swath of publicly traded US companies should, over time, trend towards its mean, which is approximately 70% of US GDP when using the Wilshire 5000 Index for market capitalization. Distortions above and below this level should indicate when US equities are over or under-valued relative to historic norms.
At very low ratios of market-cap to GDP, the US equity market as a whole proved to be a great buying opportunity. The most recent example would be in 2008 when this ratio fell to 56% or 22% below its mean. On the flip side, higher ratios can be warning signs. In 2007, this ratio peaked at 105% or 46% above its mean.
Today this ratio is over 115%. In essence, in today’s environment, indexers of the broad U.S. stock market are buying-in at a ratio of 115%+ versus the historic norm of 72%. In other words, these indexers are effectively paying a 60% premium. Historically this has proved to be a very poor risk/reward endeavor.
In stark contrast and for reference, we value our core strategy’s portfolio as trading around a 30% discount to our calculation of its intrinsic value.
In another excerpt from our Investor Update letter:
“To index now is truly following the herd. At times like this I’m reminded of the saying parents have repeated to their children for generations, ‘If Johnny jumped off a bridge, would you do it too?’ We are disciplined investors and adhere to a process that has worked over long periods of time. The fact that we may trail the S&P 500 from time to time is not a signal to us that we should change our stripes to mimic an index in order to achieve its returns.”
This investor mindset is cyclical and predictable. It is something we have seen before, most recently in 1998-1999 and 2006-2007. A repeat of this behavior was anticipated and discussed internally at VNB Wealth Management going back to late 2013. We are also convinced that this action on the part of passive investors will end poorly as history will repeat.
A lengthy bull market often leads investors to ask, “Why should I pay for active management? This is easy and I’ve done better lately than my manager.” Well, time may heal all wounds but time also makes people forget. Markets don’t always go up. As Benjamin Graham so wisely understood, the management of risk is more important than the management of returns. Investors have, by and large with time, forgotten the painful lessons of owning the general stock market in 2000 through 2002 and in 2008 through early 2009. We will be reminded of these lessons and, unfortunately for many, painfully so, as we progress through this market cycle.
We are focused intently on “what could go wrong” in all of our investments. We strive to buy $1 of value for significantly less than the price of $1. We believe that overpaying for an investment significantly reduces an investor’s chance of earning an acceptable return on capital and serves to increase the risk of a permanent loss on that capital.
We are confident that the diligence we exercise in making investments on behalf of our clients will provide a favorable outcome over a full market cycle.
Respectfully submitted on behalf of the investment team at VNB Wealth Management,
Mark A. Meulenberg, CFA
Chief Investment Officer
Disclosures and Definitions
This Investment Review is furnished for general information purposes in order to provide some insight into the investment management process and techniques that VNB Wealth Management uses to make investment decisions. It is provided for illustrative purposes only. Opinions and information provided are as of the date indicated. This material is not intended to be a formal research report, and as such, it should not be construed as an offer or recommendation to buy or sell any security, nor should information contained herein be relied upon as investment advice. Opinions and information provided are as of the dates indicated. VNB Wealth Management does not undertake to advise you of any change in its opinions or the information contained in this report. The statistics in the article were obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed.
This article contains commentary regarding several securities that have been purchased by VNB Wealth Management on behalf of our clients. Individual account holdings may vary, and the views expressed herein may change at any time subsequent to the date of this article. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of securities referenced in this article. The price and value of securities referenced in this article will fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed and a loss of all of the original capital invested in a security discussed in this article may occur.
Past performance is not indicative of future results.
Performance results are not GIPS compliant.
Investments and Accounts at VNB Wealth Management:
Are NOT insured or guaranteed by the FDIC or any other federal government agency
Are NOT deposits of, or guaranteed by, a Bank or any Bank affiliate
May lose value
Indexes represent securities widely held by investors. You cannot invest in an index.
The S&P 500 Index is a capitalization-weighted index calculated on a total-return basis with dividends reinvested. The Index includes 500 of the top companies in leading industries in the U.S. market.
The Wilshire 5000 Index is a capitalization-weighted index composed of more than 6,700 publicly-traded companies which are headquartered in the United States and whose stocks are actively traded on an American stock exchange.
Source used for Buffet Indicator data and ratios: dshort.com – January 2015 – Q4 Advance Estimate.
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July 10, 2015
Freshman Finance 101
If you are the parent of a recent high school graduate, congratulations! According to the National Center for Education Statistics, 3.3 million students will graduate high school in the 2014-2015 school year. The majority of you parents are in the midst of preparing your child for the next phase of his or her educational journey, college. For many 18 and 19 year olds, college is a big transition. It could be the first time the student has lived on his own and had to apply self discipline around class attendance, assignment completion and, of course, financial management. Hopefully, the good study habits that got your child into college will help him through the next four years. Here are a few tips you might consider sharing with your child to help him manage his financial resources and eliminate financial problems as an unwanted distraction.
Budgeting and Transparency - Rather than just setting an “allowance” for your child while he’s at college, why not set a budget? You can share all of the sources of income (student loans, financial aid, income from his job, any amount you are contributing) and all of the expenses, emphasizing those sources and expenses he is responsible for managing. If student loans or financial aid are involved, your child will understand that those resources need to go toward tuition and books, not pizzas and road trips. If you are helping to pay for your child’s education, he will have a better appreciation for your financial commitment.
Track Spending - As they say, “There’s an App for that.” There are actually a number of very good mobile applications that help track and categorize spending. You and your child could review a few and see which makes the most sense to him. Apps that have been recommended for college students include; Mint, Left to Spend, Check and Toshl Finance. Getting into a spend tracking habit will help your child long after college.
Look for Deals and Discounts - College towns are loaded with lots of local merchants offering discounts to students. Ask about this at orientation and see if there is a guide to “student friendly” businesses and restaurants. Colleges also offer lots of “free” amenities like gyms and other recreational facilities. Text books are a huge cost hog in the college budget. Get your student to consider purchasing used books and looking online for used books. They can sell text books at the end of the semester.
Manage Debt Wisely - Freshmen are typically bombarded with offers for student credit cards, student loans and checking accounts that may have hefty overdraft fees. Make sure you help your student evaluate any financial obligation he may consider. If your child gets a job while in college, encourage him to use extra money to reduce his consumer and student debt.
Gotta Have vs. Nice to Have - Does your child really need a car and all the associated expenses at college? Most colleges have a free transportation system and readily available taxis or Uber cars. Bicycles offer a low cost alternative for traveling across campus. Besides the expense of the car, your student will save money on parking, gas, repairs and maintenance. Other areas to consider include travel, entertainment, clothing, and eating out.
Identity Theft Starts Here - 18 to 24 year olds have a high incidence of identity theft. They tend to be more trusting and share passwords with friends. They also are more likely to give out personal information, including a social security number, when asked for it. Be sure to have a talk with your student about protecting his identity. Remind him not to leave personal documents out in the open in his dorm room, when he’s not there. He may also want to consider getting a free annual credit report to make sure his identity has not been compromised. It will reflect any “forgotten” bill payments that may need to be cleaned up.
Banking - You may decide to set up a joint checking account with your student so that you can easily deposit money, when required. Be sure to ask about overdraft protection and simple warning systems like text notifications when balances are low or spending exceeds a certain dollar amount. Find out what the fees are for ATM withdrawals at your bank and other, alternative cash withdrawal locations. Teach your student about online banking for bill pay and transaction review. You may want to consider giving your child a credit card to have, in case of emergency and be clear about what constitutes “emergency.”
Random Acts of Kindness - Don’t forget to surprise your college student every once in a while with a nice care package to reward him for good financial management. A prepaid Visa card, his favorite home baked cookies, a Starbucks card or prepaid gas card all will bring a smile to his face.
Good financial mentoring can set your child up for life. If you need help getting your new college student on the right track, stop by and see one of our bankers. We are here to help.
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