The best of times…the worst of times
October 23, 2015
Market Summary – 3rd Quarter, 2015
Following the pain of September’s sell off – with all indices down sharply – investors realized they had nowhere to hide. This sell off reintroduced the importance of understanding risk in any investment equation. Stocks, commodities and currency funds are nearly all in the red for 2015 (as of September 30). During the market’s best times, a sense of complacency can set in, and investors tend to downplay risk. A widespread correction, like what occurred in late August and September, is a painful reminder that risk matters.
It is during these times, when confidence is low and fear is high, that shrewd investors are eager to buy interests in great businesses at discounted prices from fearful sellers. This is how the foundation for wealth creation is established. Given the sharp declines in the market in August and September, we feel that this is an appropriate time to talk about risk and the two major investing styles – value and growth – being offered to the individual investor.
The “value” proposition
Growth and value stocks tend to move through cycles of performance leadership, with meaningful differentiation between the two styles over time. Growth investing is a strategy focused on buying stocks where projected growth in earnings of a specific company is expected to drive capital appreciation going forward. The primary focus for a growth investor is not the current price of a stock, but a belief in its potential. These stocks often trade at lofty valuations based upon the expectation that future earnings will justify the current price. Growth stocks also tend to be driven by momentum: investors are speculating that the price of the stock will rise not merely because of the underlying business fundamentals, but also because they believe that a future buyer will be found who is willing to pay a higher price for the stock.
Value investors (like MPMG) seek to identify misunderstood and inexpensive businesses with solid foundations and little or no debt. These are typically staid businesses that lack the glitzy “stories” of growth investments. These companies are supported by the fundamentals of strong earnings and often generate excess cash flow that is returned to shareholders through dividends and stock buybacks. Their businesses provide needed products and services to the world that are not easily duplicated. The value style is focused on risk mitigation, investing when the market price of the business has been discounted sufficiently; and thereby, limiting further significant downside risk.
In any given year, it is difficult to predict which style, value or growth, will be in favor. However, history shows that value stocks have proven to be a much more profitable investment over time. This is based on the performance of key benchmark measures of all-cap value and growth investing, the Russell 3000 Value and Growth Indices. These indices divide the Russell 3000 Index1 based on stocks with lower price-to-book ratios and lower forecasted growth values (for the Value Index) and those with higher price-to-book ratios and higher forecasted growth values (the Growth Index).
From 1979 (when data was first collected) to 2014, an individual who invested $100,000 in the Russell 3000 Value Index saw it grow to approximately $7.2 million by the end of 2014, while the same investment in the Russell 3000 Growth Index increased to only about $4.4 million during that span. This represents 64% more wealth for the value investor over the 36-year investment period. The difference can be attributed primarily to how each style weathers the market’s most challenging periods.
By paying a discounted price for a business, value investors are better positioned to withstand the impact of market downturns. Investors buying growth businesses with little regard to the current price of their stock are more vulnerable to the wrath of the market if the lofty expectations of these companies are not realized. Growth stocks may experience “higher highs” than value stocks; however, the growth stocks have been much more susceptible to wealth destruction via more dramatic losses. The main disadvantage (if you can call it that) for value stocks when they are out of favor is that they may not go up as much as growth stocks during those periods. If investors are caught on the wrong end of the market when growth stocks fall out of favor, they risk permanent losses of capital that are difficult to recoup. On the other hand, history shows that value investors generally limit their downside exposure by paying a lower price for a stock. Ultimately, the ability to limit losses amidst market downturns while producing steady – if not jaw dropping – returns during market manias has proven to be the superior path to wealth creation.
The value/growth relationship today
Since the financial crisis of 2008, the environment has been friendlier for growth stocks. The Federal Reserve opened the spigots on the liquidity fire hydrant through an unprecedented quantitative easing program and a near zero interest rate policy. This resulted in a mostly indiscriminate increase in asset prices. In an environment like this, fewer investments fail. The amount of liquidity being pumped into the market served to reduce the focus on risk and fueled speculative investment behavior. Now that the Fed has discontinued its quantitative easing program and rates are assuredly set to rise from today’s artificially low levels, the safety net is being pulled out from under speculative investors. Going forward, stock prices are more likely to reflect the actual value of businesses. The potential result is that many growth stocks are at risk of being severely punished, while quality value stocks stand to be rewarded.
At MPMG, our methodology hasn’t changed. We continue to do what we’ve always done, invest in attractively priced businesses that carry low levels of debt and create meaningful products and services that will allow them to thrive for years to come. It is not a guarantee of protection against short-term market declines. However, we believe that the record shows that MPMG’s unique value approach is a particularly effective way to offset risk in a volatile investment marketplace, like what we’ve experienced in late summer and early fall, while ultimately building long-term wealth.
The key to success – avoid emotional, knee-jerk reactions
Nobody can predict the market’s direction on a week-to-week or month-to-month basis. The key is to remember that any recovery in stocks comes with little warning, even a sustained recovery.
Few successfully predicted that March 2009 would be the bottom of the financial crisis bear market. As a result, many investors remained on the sidelines and missed a seminal investment opportunity. Investors sometimes spend an inordinate amount of time trying to figure out the short-term direction of the market. The fact is that it is impossible to predict with any degree of accuracy what the market will do over the coming weeks or months. What we do know is that you have to invest in reasonably priced businesses that offer a margin of safety, and then remain committed to your investment (unless the fundamentals change). One must do this amidst market volatility and uncertainty, without regard to what will happen in the subsequent weeks and months, in order to profit over the long run.
Consider what happens by remaining committed to investing, even if your timing is awful. CNBC recently published the hypothetical outcome of the world’s “worst market timer”3. This person made lump sum investments into the market right before significant market corrections:
- In 1973, just prior to the market losing 48%, he invested $6,000
- In 1987, just before the 34% market crash, he invested $46,000
- In 2000, just before the 41% dot-com crash, he invested $68,000
- And in 2007, just before the financial crisis, he invested $64,000.
In total, this investor put $184,000 to work at various times. Earning merely market-like returns, this series of poorly timed investments grew in value to $1.16 million, a profit that represents about a 9% annualized return based on a money-weighted basis. The investor generated significant wealth by avoiding the temptation to sell when an emotionally charged market might have convinced him to do so. He kept faith in the equity market, which has been the greatest wealth creation mechanism in history, and profited from it.
A value investor’s credo – don’t believe everything you read
Negative sentiment among investors today is, by some measures, stronger than it was even at the end of 2008, in the depths of the Great Recession and financial crisis4. According to a survey of those who write investment newsletters (conducted by Investors Intelligence), the level of skepticism of these professionals is soaring by some measures at the fastest pace since the early 1980s when interest rates were in double digits and inflation and unemployment were high. What may surprise you is that we see this as good news!
Interestingly, in the year following such elevated levels of pessimism amongst these newsletter writers, the S&P 500 Index has risen by an average of 11% (as compared with an annualized return of 8.3%). The sentiment expressed by the so-called “experts” is indicative of what has been one of the least celebrated bull markets of the past 50 years.
Investors have been particularly skittish since the financial crisis. Subsequent events such as the euro crisis of 2011, the Ebola scare of 2014, or more recently, the specter of a Greek bond default and the dramatic sell off in China’s stock market have sent investors scurrying to the exits. The fact that sentiment remains so negative may be a contrary indicator, and any run of good news could potentially catch investors by surprise, and lead to another great rally in stocks.
There will always be pockets of bad news. What’s more important is the overall direction of the economy. There are a number of positive signs that are worth noting. U.S. unemployment has fallen to its lowest level in seven years. Housing and auto sales are booming and rising retail sales signal that consumers may be looking past recent volatility in financial markets and be ready to spend on a more prodigious level. Our economy remains resilient in the face of various global challenges. If Congress ever enacts pro-growth fiscal policy, the future growth could be tremendous.
In the current favorable economic environment, many stocks of quality companies are available at deeply discounted prices. The market may be volatile and the media will be certain to play up any negative headlines. Investors who stay focused on long-term results realize that this is a time to take advantage of the significant value opportunities that are present today, and lay the foundation for additional wealth creation. Patience and persistence will be rewarded.
In House News – MPMG is pleased to announce:
Portfolio Manager Robert Britton has earned the Chartered Financial Analyst (CFA®) designation. The CFA credential has become the most respected and recognized investment designation in the world. The CFA Program curriculum connects academic theory with current practice, ethical, and professional standards to provide a strong foundation of advanced investment analysis and real-world portfolio management skills. Please join us in congratulating Rob.
Managing Director Herbert Schechter recently received the Lifetime Award from the Minnesota Society of Certified Public Accountants. Herb received this award in recognition of his service and contributions to the profession. Before joining MPMG in 2005, Herb was a founding shareholder of the CPA firm Schechter, Dokken, Kanter. He has taught numerous professional continuing professional education courses, including “Estate Planning: A guide for the financial planner”. Further, Herb has served on many national and regional committees and task forces, including the national body that sets and interprets the standards of practice for the CPA profession. Please join us in congratulating Herb on this recognition, a testament to his service to the accounting profession and the business community.
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted. Market returns discussed in this letter are total returns (including reinvestment of dividends) unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.
1The Russell 3000 Index measures the performance of the largest 3,000 U.S. companies representing approximately 98% of the investable U.S. equity market.
2Tom Lee, CNBC, Sep. 8, 2015
3Alex Rosenberg, “The Inspiring Story of the Worst Market Timer Ever,” CNBC, Aug. 27, 2015.
4Lu Wang, “Who’s Left to Sell U.S. Stocks? Mood Darkens Most Since Volcker,” BloombergBusiness, Sep. 20, 2015.