Why Isn’t My Portfolio Keeping Up This Year?
Long-Term Diversification & Asset Allocation
The S&P 500, the most widely followed stock index, is up 10.56% through the end of the third quarter of 2018. This is a good return for stocks, especially over nine months. It’s natural to conclude: the stock market is having a good year—my portfolio should also be having a good year. However, outside of the U.S. stock market, most asset classes are down this year.
Investors with a diversified asset allocation in 2018 have trailed the U.S. stock market. We believe over time it’s important to have a well-diversified portfolio. All asset classes have periods of strong and weak performance, but in the long term tend to produce returns commensurate with their respective risks.
Over the past 20 years, it’s clear that owning a diversified portfolio has worked very well. In fact, you only have to look back to 2017 to see the merits of a globally diversified portfolio.
Heritage differs from most U.S. stock-bond portfolios in a few important ways. The leading reasons Heritage’s performance is under U.S. stock-bond portfolios this year are as follows:
1. Heritage takes a global approach to investing and has as much money in international stocks as in U.S. stocks—and international stocks are down year-to-date.
2. Heritage tilts its international stock exposure to emerging markets—and emerging markets are underperforming developed international markets year-to-date.
3. Heritage complements its allocations to traditional stock and bond asset classes with alternative investments—and Heritage’s alternatives allocation is down year-to-date.
4. Heritage believes in a value-investing approach for the long run—and value stocks have underperformed growth stocks year-to-date.
Despite the headwinds with recent performance, we strongly believe in the merits of our long-term investment philosophy. We have positioned clients to generate strong risk-adjusted returns over time, although this will not play out every year.
Am I Positioned Intelligently Today?
From a broad, simplified perspective, we view prospective stock returns as a function of two components: the current earnings yield (E/P) and the growth rate of earnings.
The Earnings Yield
Most market participants are accustomed to viewing the earnings yield as its inverse (P/E) or what’s commonly called the PE ratio or multiple. It’s analogous to a $100 bond with a $5 coupon selling at a 5% yield or, alternatively, 20 times cash flow. There is at least one important adjustment that makes this measure more stable and meaningful.
One issue with an earnings-focused framework is that short-term measures of earnings are noisy and earnings are cyclical. Robert Shiller of Yale earned a Nobel Prize in Economics for his adjustment to this measure, in what’s termed the cyclically adjusted price-to-earnings (CAPE) ratio. Taking a rolling 10-year average of inflation-adjusted earnings and comparing it to current prices stabilizes the measure through temporarily strong or weak earnings and the business cycle.
When we look at this measure through time and across U.S., developed international, and emerging markets stocks, it’s clear that the U.S. stock market has become expensive, while developed international stocks are moderately priced and emerging markets stocks are inexpensive.
Buying a basket of emerging markets stocks at a CAPE ratio of 8 means buying companies’ current earnings at a yield of 12.5%–quite good. Buying a basket of developed international stocks at a CAPE ratio of 20 means buying companies’ current earnings at a yield of 5%—add a few points for growth and compare it to low government bond rates and the opportunity looks reasonable. Buying a basket of U.S. stocks at a CAPE ratio of 32 means buying companies’ earnings at a 3.13% yield—compared to a 10-year Treasury bond yield of 3.05%, one must rely completely on earnings growth for a return above a Treasury bond.
Earnings Growth Rates
There are studies by the World Bank and the International Monetary Fund that show emerging markets economies with gross domestic product (GDP) growth rates far exceeding the United States. High-growth local economies provide a fertile landscape for emerging markets public companies to increase their earnings. There are also strong arguments concerning “catch up” potential for emerging markets companies by implementing known technologies from developed nations without the need for major research and development expenses.
Within stocks, we believe it’s intelligent to invest globally, not just in the U.S., and to overweight emerging markets due to their yield premium and their more-likely-than-not superior growth prospects. On average, emerging markets have traded at a yield premium which has been realized in returns.
Should My Portfolio Include Alternative Investments?
Heritage complements its allocations to traditional stocks and bonds with alternative investments. When we consider an alternative investment we also have to determine how to build it into a portfolio—the opportunity cost is a reduction in some mix of stocks and bonds. Whatever traditional asset mix we replace with an alternative investment, we structure it to provide a higher overall expected return for the portfolio.
One of the criteria for an alternative investment’s inclusion in portfolios is differentiated risk-and-return drivers. Alternative investments are more expensive than traditional market exposures; if they’re predominantly producing a return that moves closely in tandem with the stock market, the bond market, or a combination of the two, then we’d rather hold the traditional asset class mix at a lower expense. However, if their returns exhibit low correlation or are effectively uncorrelated with stocks and bonds, there is an opportunity to add to return without a commensurate increase in portfolio risk (or even with a reduction in portfolio risk).
A consequence of investing in uncorrelated alternative strategies—which is the goal—is that they act differently than stocks and bonds and could as a group be down when stocks are up. The offset is, when stocks are down the base case scenario is that alternative investments are up. Therefore, it’s worth looking back at the last significant drawdown in the global stock market.
During the -18.41% drawdown in global stocks from June 2015 to February 2016, Heritage’s alternatives allocation produced a return of +8.87%. The return differential of +27.28% not only softened the decline in portfolios’ market values, but provided capital to move into stocks at excellent prices. Near the bottom of the stock market drawdown, we shifted capital from alternative investments into stocks, which turned out to be excellent trades. When looking at our clients’ overall portfolio returns, our alternative investments’ strong performance made it hard to tell global stocks had fallen by close to 20%.
Is Value Investing Still the Right Strategy?
Value stocks have underperformed growth stocks in the U.S. over the past decade. We talk with clients about expectations for the “long-term,” over which we expect a premium from value stocks. We’re often asked, “Well, what’s the long term?” The question is practical. After all, isn’t a decade the “long-term?”
The truth of the matter is the answer isn’t straight forward nor is it simple. When we make estimations in finance, there’s always the possibility the underlying population’s statistical characteristics are different than our parameter estimates.
However, assuming for the moment our parameter estimates are accurate, we are able to speak to statistical probabilities as a function of time.
Kenneth French of Dartmouth calculated the monthly expected value premium from July 1963 to December 2016 (642 months) to be 0.29% per month with a standard deviation of 2.19% (also monthly). When one assumes those historical parameters accurately describe the population, the following conclusions may be stated:
1. There’s a ~33% probability of value underperforming in any given year.
2. There’s a ~20% probability of value underperforming over any given 5-year period.
3. There’s a ~10% probability of value underperforming over any given decade.
4. There’s less than a 1% probability of value underperforming over any given 30-year period.
History could be an unreliable guide in informing estimations of return premia—but it’s a big leap to abandon the prediction of a compelling, intuitive model.
Even if an expected premium is actually large and positive, the likelihood of a negative realized premium over 3, 5 or even 10 years is not immaterial. As far as we can unemotionally see, value investing is still a compelling strategy with strong empirical evidence in its support; and rough patches are to be expected.
We thank you for your continued trust in Heritage as a diligent and prudent steward of your wealth; it is genuinely an honor to be entrusted with such a great responsibility.
It’s in these times, when our strategy is not producing immediate benefits, that your willingness to hear our perspective and your patience with our process and philosophy are particularly gratifying. You allow us to run an investment strategy set up to win over the long term; sometimes your returns will lag your neighbor’s U.S.-biased portfolio, but we firmly believe you’re positioned more intelligently for a successful lifelong journey of investing.