With so many differing investment approaches being promoted today, a couple of lessons from professional sports may be helpful for us to keep the right perspective in the decisions we make. It was in July 1961 when Vince Lombardi spoke to the disconsolate Green Bay Packers with his famous line that pointed to the essential nature of the fundamentals of the game.
“Gentlemen, this is a football”
And a quote from the great hockey star Wayne Gretzky highlights the importance of focusing on expectations.
“I skate to where the puck is going to be –
not to where it has been.”
Using his skills and experience he concentrated on getting himself into a position that gave him increased opportunities for success.
The Investor’s Enigma: While most investment trends are cyclical, there is a tendency for investors to follow the crowd and do what is currently most popular. And, even though experience tells us that it’s not possible to predict the direction of the market consistently, many investors still focus on trying to do so. One trend that has had an extended period of outperformance is passive vs. active management. Morningstar estimates that during the first half of 2018 there was a shift of more than $100 billion out of actively managed equity funds and $80 billion going into index funds and ETFs. Another trend has been a continuing shift out of stocks into bonds, even though the return prospects for bonds are unattractive, in our view.
The idea of passive investing dates back to the 1950’s when Jack Bogle wrote his senior thesis at Princeton about the difficulty many mutual funds had in outperforming the market. In 1976 he introduced one of the first index funds and began promoting indexed investing through the Vanguard funds. The popularity of indexed investing didn’t catch on immediately, but has become very popular in recent years. Many investment advisors, mutual fund managers, institutional and individual investors have exited actively managed equity funds to shift into passive or rules-based products that mirror an index. It is estimated that 40% of all stocks are now held by index funds.
Another distinction that has received much attention is so-called value or growth styles. Value oriented managers typically invest in stocks that are deemed to be selling at a discount to their long term investment value. The problem is it is impossible to determine the value of an investment without taking into account its growth potential. At times growth stocks are the best value.
In the current cycle growth stocks have outperformed value by a wide margin and for an extended period of time.
As such, several of these growth stocks have grown to be some of the largest companies in the indices and as more money is allocated to passive strategies, a large portion of the dollars goes to purchase more of these large cap growth stocks, pushing their prices higher. This momentum effect, as more money flows into index funds, may partially explain why this cycle is so strong, but also raises the question as to what will happen to these stocks when money flows out.
The market price of a security reflects the collective best guess of what may happen next, but sometimes the market is wrong. When Benjamin Graham spoke about investing he emphasized the importance of analysis and understanding the fundamentals of a security. He advocated having goals of safety of principal and achieving a satisfactory return, and contrasted this with speculative operations that focus primarily on price. In some cases the emphasis is on price changes alone, and in other cases the emphasis is on changes in value which are expected to give rise to changes in price. In regard to passive strategies we wonder if they are focused only on price or also on fundamentals.
After a shaky start to the year, the U.S. equity market resumed its movement to new highs in the third quarter, as profit growth continued to exceed expectations. Numerous risk factors remain such as Fed policy and rising rates, geopolitical tensions, the strengthening of the dollar, and trade wars. Following a period of unusually low volatility we know there will also be periodic times of turbulence in the market. While nobody knows what the market will do next we believe there are still many attractive opportunities.
Contrary to popular thinking, a study of history shows that there are both actively managed and value oriented strategies that have outperformed over long periods of time. Markets will likely be more volatile in the future and we strongly believe that investors will continue to be rewarded by maintaining long-term investments in securities with strong fundamentals with an eye to the future.
Note: We have gathered the information contained in this report from sources we believe reliable; however, we do not guarantee the accuracy or completeness of such information. You should not assume that any discussion or information contained in this market commentary serves as the receipt of or as a substitute for personalized investment advice from Whitnell & Co. No part of this publication may be reproduced in any form or referred to in any other publication, without express written permission.