If you feel like “déjà vu all over again,” to quote Yogi Berra, you’re not mistaken: US and international stocks rose during the 3rd quarter, bringing returns in the high teens over the past year, including dividends. Here at home, the stock market’s performance is underpinned by favorable fundamental factors: interest rates and inflation remain low, and growth in per-share earnings remains robust, at about 10% to 12%, year-over-year. Further growth is expected thanks to continued expansion of the global economy and optimism about potential US corporate tax cuts. For now, at least, the devastating impact of recent floods, hurricanes, and wildfires affecting large numbers of Americans has so far been shrugged off by consumers and investors’ alike.
This does not alter our cautiously optimistic stance from prior commentaries, and we continue to expect low single digits average returns from US stocks over the next 5 to 7 years. Pockets of value remain hard to find in US equity and bond markets. Now is not the time to let your allocation to risky assets drift above the target that was set to achieve your long-term goals, the so-called strategic asset mix. As John Templeton observed: “Bull markets are born on pessimism, grown on scepticism, mature on optimism, and die on euphoria.” At this stage in the bull market, maintaining the discipline to periodically rebalance into safer and less volatile asset classes is key, even if doing so appears to sacrifice potential short-term returns.
How Did The Portfolio Do?
Our average client’s balanced portfolio (i.e. made up of stocks and bonds) posted broad-based positive returns once again during the quarter, with all 12 asset classes gaining (your own portfolio results may differ – please refer to your Quarterly Portfolio Review Report). The table below shows how a model 60/40 portfolio is allocated, and for each asset category, the benchmarks’ returns through September 30, 2017:
Our investment selection outperformed on average in 8 out of these 12 categories during the quarter, and 11 out of 12 during the last 12 months. Such good fortune should not lull our investors in any sort of complacency: as recently as 2015, we lamented underperforming in most categories. Within equities, international markets, particularly those in emerging economies (China and Latin America) led the pack, while US Real Estate lagged. Natural Resources stocks rebounded sharply thanks to a recovery in energy stocks’ prices. US Growth funds once again outperformed their value counterparts. Bonds were modestly positive, led by international credit markets, which received a tailwind from a weakening US dollar.
Earlier in the year, when we decided to increase our clients’ allocation to foreign stocks, we introduced a new fund to the mix: Pear Tree Polaris Foreign Value Small Cap (ticker: QUSIX). Some of you asked us how we pick new funds, and we thought we would share the answer with all our clients.
The first steps in our screening process involves purely quantitative factors such as the expenses of the fund in relation to similar funds (the cheaper, the better), the length of the track record (the longer the better), the current manager’s tenure, and how much he or she is invested in the fund. The next step of our due diligence is to read interviews of or letters from the manager: this gives us a valuable insight into his or her process for selecting investments and managing the portfolio. We also like managers who are candid in admitting mistakes, and are modest when discussing success, since we believe that hubris is dangerous when managing money.
Finally, we analyze returns, but not in the way that you might expect. As we’ve discussed in the past, we discount the value of track records shorter than 10 years. This is due to the fact that, statistically, there is very limited explanatory power in a dataset limited to 3 to 5 years. If the past track record is particularly long and noteworthy (think Warren Buffett’s), it will definitely impact our opinion.
Should we ignore past performance the rest of the time? Certainly not. We want to look at all the information at our disposal, and track records remain part of the due diligence of any investment. But, with shorter ones, other factors than the absolute or relative numbers are our focus. After learning about a fund or manager, we should be able to anticipate consistent patterns in the historical set of data: are periods of under or outperformance consistent with the stated process or similar funds? Are portfolio holdings, buys and sales consistent with the investment philosophy? How did the portfolio perform during prior bull and bear markets? If the observed patterns are not what we expected, are we able to identify the reasons? Once we select an investment, our goal is to hold it for years. We review our original thesis regularly, but we understand that limiting turnover benefits our clients over the long-term.
Large Cap Value (LCV) Update
(Not all clients of Bristlecone are invested in our Large Cap Value Equity portfolio strategy depending on the size of the portfolio, and the client’s objectives and constraints)
Our average Large Cap Value stock portfolio slightly exceeded the S&P 500’s 4.5% return in Q3, and outperformed the index’s trailing 12 months return of 18.6% by a greater margin (Again, please refer to your Quarterly Portfolio Review Report for actual results).
During the 3rd quarter, the biggest contributors to the portfolio’s performance were NRG Energy (NRG +49.4%), AGCO Corp. (AGCO +9.8%), Markel Corp. (MKL +9.4%), Potash (POT +17.9%), and Cisco Systems (CSCO +8.4%). NRG’s positive contribution during the quarter was due to the announcement of a reorganization plan that involves selling assets, thereby potentially reducing the gap between the company’s stock price and the market value of its assets (as indicated by recent private market transactions). We reduced our investment but continue to hold NRG shares and view them as moderately undervalued. Investments that detracted the most were Medtronic (MDT -12.0%), New York REIT (NYRT -9.2%), QVC Holdings (QVCA -4.2%), Cemex (CX -3.6%), and Johnson Controls (JCI -7.1%). The decline in Medtronic shares was due to a recall of one of its products and the impact of hurricane Maria on its manufacturing facilities in Puerto Rico. In both cases, we view these issues as temporary and continue to like the company’s long-term prospects.
Besides NRG, we also reduced our investments in AGCO Corp. (AGCO), QVC (QVCA) and sold our entire position in HP Inc. (HPQ). In all cases, the reason was valuation as we felt that the rising share price was either close to or fully reflecting our assessment of the value of these companies. The only purchase that we made was to increase our investment in Johnson Controls (JCI) as the company’s shares declined during the quarter. JCI is the company that acquired the remains of Tyco Intl. and it has experienced weak sales growth recently. We continue to believe that our patience will eventually be rewarded. Cash was up to 15% in our model portfolio at the end of the quarter.
Behavioral Economics Rewarded
We were very pleased to learn that the economist Richard Thaler was awarded the Nobel Memorial Prize in Economic Sciences for his work showing that individuals frequently behave in ways that defy the assumption of rationality. In one example, setting out to explore why people feel losses more keenly than gains, he helped uncover the endowment effect: a tendency to value something more highly just because you own it. In another instance, he showed that, when thinking about money, people tend to group certain types of spending or income together, and view each group separately. This behavior, called mental accounting, explains why some people keep rolling a high interest credit card balance, while they have enough money to pay it off earning far less in a savings account. Previously, economic theory did not recognize that, in this situation, many people would not act rationally.
Daniel Kahneman and Amos Tversky, two Israeli psychologists, had already identified many of the biases that behavioral economics became famous for. These included anchoring (the tendency to rely too heavily on initial information); confirmation bias (the tendency to interpret evidence as supporting preexisting beliefs); and loss aversion (feeling the pain of losing ten dollars more intensely than the joy of winning ten dollars).
We are grateful for these insights in helping us understand better our own behavioral short-comings, but also those of our clients, particularly when helping them make better financial decisions. If you are so inclined, we encourage you to read “Nudge: Improving Decisions About Health, Wealth, and Happiness”, the book Thaler co-wrote with Cass Sunstein. It is surprisingly easy to read, amusing at times, and was a bestseller when it came out, a rare feat for a book written by an economist.
A Raise for Retirees
The Social security administration just announced that recipients and other retirees will get a 2% increase in benefits next year, the largest since 2012. Although some will credit the current administration for this small boost after years of no or modest increases, we note that it is automatic and based on a measure of consumer prices published by the Bureau of Labor Statistics. Congress has sole power to change this law.
As always, feel free to call us with questions about your portfolio. We appreciate your trust in our services.
One of Bristlecone Value Partners’ principles is to communicate frequently, openly and honestly. We believe that our clients benefit from understanding our investment philosophy and process. Our views and opinions regarding investment prospects are "forward looking statements," which may or may not be accurate over the long term. While we believe we have a reasonable basis for our appraisals, and we have confidence in our opinions, actual results may differ materially from those we anticipate. Information provided in this blog should not be considered as a recommendation to purchase or sell any particular security. You can identify forward looking statements by words like "believe," "expect," "anticipate," or similar expressions when discussing particular portfolio holdings. We cannot assure future results and achievements. You should not place undue reliance on forward looking statements, which speak only as of the date of the blog entry. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. Our comments are intended to reflect trading activity in a mature, unrestricted portfolio and might not be representative of actual activity in all portfolios. Portfolio holdings are subject to change without notice. Current and future performance may be lower or higher than the performance quoted in this blog.
References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and returns do not reflect the deduction of advisory fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase.
Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there can be no assurance that a portfolio will match or outperform any particular index or benchmark. Past Performance is not indicative of future results. All investment strategies have the potential for profit or loss; changes in investment strategies, contributions or withdrawals may materially alter the performance and results of a portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client's investment portfolio.