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Stefan D. Abrams, CFA Mr. Abrams is currently a Senior Advisor to the Trust Co. of the West. From 1986 until 2006, Mr. Abrams served as Managing Director, Chief Investment Officer for Asset Allocation of Trust Company of the West. He co-managed a multi-billion dollar global asset allocation... More
  • Can We Review The Bidding?

    I don't play bridge, and I confess that I know precious little about the game, but I am told that in friendly games at least, during the play of a specific hand a player can always ask for a review of the bidding up to that point. Presumably, the information gained helps to plan strategy going forward. With the Standard & Poors 500 Stock Index at an all-time high and after a four year run now approaching 1600, it might be productive to do the same as part of an effort to plot an investment game plan from this point on. Looking back a few years at the various factors that have impacted stock prices might offer some insight into how stocks might respond to future developments.

    Ever since the financial crisis and the many scandals in 2008-9 investor fears and lack of conviction have been as bad as at any time since the 1930s. In this environment the cacophony of extraneous "noise" has often drowned out the "signals" from an improving US economy with steadily rising corporate earnings. There is always a "wall of worry" that stock prices have to climb, but in recent years the bricks in this wall have been so numerous and often so frightening that it has been all too easy for individual and institutional investors to be scared out of their equity positions or to refrain from participating in the first place. The 24-hour news cycle, especially the financial news media, has trumpeted various macro worries, including recessions and financial crises abroad, fiscal deficits and political dysfunction at home and geopolitical fears of all sorts, so loudly that even seasoned investors lose sight of the most fundamental principle that governs equity values, namely the trend of corporate profits. The focus of the media with its instant (and often wrong) analysis seems to be aimed only at day traders, not investors, and as a result the hysteria surrounding short-term economic reports allows them to be blown way out of proportion to their actual impact on long-term corporate profitability.

    In recent months investors have panicked over our unsustainable fiscal deficit, the dysfunction in Washington, the payroll tax restoration, higher tax rates and Obamacare issues, the much exaggerated impact of the fiscal sequestration, the many ups and downs in the European economies, financial and currency markets, and banking system, whether or not China is growing, as well as any little wobble in the high frequency economic data. Through all of this, the S&P 500 Index has more or less steadily recovered from the bear market low of March 2009 and now stands roughly 140% higher, with many individual shares having substantially outpaced the Index itself.

    There is no doubt that the extremely accommodative monetary policies of the world's central banks have played the major role in supporting the current bull market, not only driving interest rates to record lows but also through various transmission mechanisms which have stimulated at least modest economic growth in the face of continuing fiscal drag. Bear in mind that the private sector in the US has been growing at better than a 3% rate for quite some time. Corporations have rationalized their cost structures, strengthened their balance sheets, entered new markets and are deploying their increasing cash flows to buy back stock and to boost dividends, yet the overall payout ratio is still at a near record low of just over 30%. Brisk merger and acquisition activity tells much more about management's confidence than the latest macroeconomic figures, though admittedly, many acquisitions are motivated by a desire to increase revenues in a slow growth environment. Throughout all of this, the majority of investors, still paralyzed by memories of the credit collapse and the scandals, as well as the unprecedented volatility of the equity markets, continue to accept negative real returns in the bond market, which is still regarded as a safe haven. In that regard, the minutes of the FOMC's mid-March meeting should give bond holders fair warning that the current ultra-easy monetary policy is likely to end sooner than most expect. There is no doubt that even a modest change in the Fed's stance will prompt a significant short term correction in stock prices, but as long as the economy is in a self-sustaining expansion, this should provide an entry point for the vast amount of cash still sitting on the sidelines.

    Assuming S&P earnings of $110 this year, equities in the aggregate are valued at about 14.5 times these results and offer a 6.9% earnings yield, no longer deeply undervalued but certainly no worse than fairly priced, particularly when measured against BBB bond yields of about 5.0%. Nonetheless, committing new cash or refocusing the portfolio of a new client has become a more difficult task. It is no longer possible to simply throw darts at name brand companies selling at cheap valuations in the hopes for a profit recovery and some P/E expansion. In order to achieve worthwhile investment returns from this point forward one must apply stricter criteria to individual stock selection. We believe strongly that the US economy is in the early stages of a multiyear expansion powered by favorable demographics, lower cost energy leading to more competitive manufacturing, and the approach of energy self-sufficiency. These factors all lead to increased employment and incomes and support higher demand for housing, automobiles, high-tech capital equipment and gradual rebuilding of the country's physical infrastructure.

    At this point, we are particularly attracted to those companies that in the past have not only demonstrated an ability to consistently execute a growth strategy, but in addition, have recently outlined a path for higher revenues, profit margins and per share earnings over the next several years. These companies articulate a growing addressable market as well as a strategy for gaining a profitable market share. Most large companies give guidance in their quarterly reports and conference calls for only one quarter ahead or, at best, for the remainder of their current fiscal year. The game they play is to lower investor expectations for the next quarter in order to beat the consensus and in doing so give their stock prices (and their options) a boost. Beating the consensus for quarterly earnings per share by one or two cents is hardly a strategy for consistent extended term growth. At this stage of the cycle the biggest risk to equity valuations generally, or in any specific company, is a compression of profit margins. Companies that are planning mainly for short term results are the most vulnerable. Companies that are not only reasonably valued but are willing and able to articulate a growth strategy for several years ahead, not merely the next quarter, are harder to find, but fortunately our persistence has been rewarded and should enable our clients to withstand the next market setback without panicking at just the wrong time.

    Apr 12 1:56 PM | Link | Comment!
  • The Hardest Job

    It is a well-known axiom on Wall Street that "the money follows the performance." Invariably, after equities have enjoyed a prolonged uptrend, there are those investors, both institutional and individual, that decide it is time to change investment managers, to increase equity exposure or even to reenter the equity market itself. Ever since the cycle low in March of 2009, investors of all classes have been fleeing equities for the perceived safety of bonds. Throughout virtually all of this period, bonds have been "certificates of confiscation," as the pre-tax yield on US Treasuries and cash instruments has been negative. Anyone holding Treasury bonds at this time must be convinced that outright deflation is just around the corner. If that were the case, then those who own the higher yielding credit bonds would likely face large losses. Given the determination of central banks worldwide to support asset prices and stimulate economic activity, the risk of outright deflation is exceedingly remote, especially in this country.

    Indeed, the US, above all developed economies, enjoys the best demographic profile, the strongest position in advanced technologies, a growing advantage in traded goods, as its reliance on imported energy declines and as it benefits from an improving relative cost position, since wages here have been essentially stagnant, while those in many emerging economies are rising rapidly. A modestly weaker trade-weighted dollar, some transportation cost advantages and local incentives are helping as well. Moreover, US households have deleveraged significantly since the onset of the financial crisis. Lower debt levels and low interest rates have greatly reduced the household debt service burden. Moreover, there is enormous pent-up demand, not only for new automobiles and new housing units, but even for corporate capital equipment, particularly for next generation technology. The US economy may be growing at only a 2% pace, but a major industrial renaissance is underway which will improve the growth rate and support an extended period of rising corporate profits.

    "So what's the problem?" you ask. Simple. As always, the stock market has long recognized all of these positive fundamentals, and even as many have been selling stocks to hide in cash instruments and bonds, knowledgeable investors, including corporate managements themselves, have been steadily accumulating equities and have driven the S&P 500 Index 130% higher off its 2009 low. Now along comes a prospective new client who says, "I hear you've been performing well. Take over the management of my account and let me share in your success." No businessman turns away a chance for incremental revenues, but the task of overhauling a portfolio constructed by another party is extremely difficult. First of all, the new manager doesn't have high conviction regarding many of the existing holdings, so it becomes a guessing game to know which ones to sell immediately and which to hold on to at least for the time being. Secondly, since the valuation of equities has already increased from a single digit P/E to approximately 14X this year's estimated S&P 500 earnings of $110, it is obvious that the easy money has been made, though, of course, it didn't seem so easy at the time. Those who note that the S&P's P/E has averaged about 15X for a long time must also realize that number is merely an average, and in view of all the macro volatility in today's world, it may prove to be a difficult target to reach in the near term. A newcomer to equities today must now rely mainly on profit growth for the bulk of his future returns. We believe this is a good bet, but earnings growth comes about only gradually, while P/E multiple expansion occurs much more rapidly. Finally, and perhaps the most difficult task for an investment manager, is to select which of his favorite holdings is still attractive for new money purchases. With the popular market averages at or near their all-time highs, no responsible manager can simply fill up a portfolio with the names his existing clients have already owned for some time and which presumably have appreciated significantly since their original purchase cost. This is, of course, the fundamental fallacy of investing in a mutual fund (whether actively managed or passive) because in those vehicles the new cash inflow is simply spread over the existing holdings. To us, this makes no sense. A prudent investment manager needs to find new opportunities, or he must wait patiently and allow the market's inherent volatility to bring some of his favorites back to prices which offer a favorable risk/reward potential. Likewise, the client needs to have patience, which is unlikely since he/she now regrets not having participated during the bull run up to this point and tends to want instant gratification.

    It is at this point in a market cycle when it becomes all too easy for equity investors to fall into "value traps," buying shares of companies that are statistically cheap but, upon careful analysis, deserve to be. Conversely, one must be alert to the natural erosion of P/E ratios, as great growth companies begin to confront either increased competition or simply the law of large numbers. Finally, investment managers must resist the temptation to sacrifice quality or to venture outside their traditional investment style in search of outperformance. There are always some special situations which arise, such as companies with disruptive, "game changing" new products, new management teams, companies exiting non-core businesses, companies emerging from bankruptcy, etc. These usually offer attractive opportunities, no matter at what level the market averages are, but they rarely are found in sufficient quantities to build an entire portfolio.

    Accordingly, while we remain extremely optimistic about the non-inflationary growth prospects of the US economy over the next few years (notwithstanding our dysfunctional government), and we expect corporations to continue to garner an important share of that growth in the form of rising earnings, we are equally convinced that from this point forward, worthwhile investment rewards will require considerable patience. Also, as equity valuations rise further, stock market volatility may well increase, and stock prices will become more vulnerable to some exogenous news event, which will seem catastrophic at the time. Newcomers to equities must have the staying power not to be faked out by such an event and not to liquidate their holdings. As a general rule, we believe that even if one or more of the currently known worries should come to pass, the negative impact on equities will be temporary. In the financial crisis of 2008-9 the global financial system and economy came as close to ultimate catastrophe as one could imagine. Yet we all survived. That, in itself, is good news for all investors.

    Mar 07 3:08 PM | Link | Comment!
  • Through The Looking Glass

    At this writing the Standard & Poors 500 Stock Index is on its way to the best January performance since 1994. Daily stock exchange volume continues to be anemic because an entire generation of investors has abandoned equities for the perceived safety of bonds. Mutual fund redemptions approached $150 billion in 2012, although there has been some inflow into equities in January reflecting normal beginning-of-the-year reinvestment flows and perhaps a reaction to the move-up in the 10-Year Treasury yield, which is now approaching 2.0%. Nonetheless, a number of Wall Street pundits are predicting a disappointing 2013 with profits falling short of expectations and stocks expected to decline for the year. We don't pretend to forecast either the economy, corporate profits, interest rates or the stock market indexes. To the extent our clients entrust us to manage a portfolio of equities we try to find attractive situations on a bottom-up basis to gain exposure to what we perceive to be long-lasting, overarching investment themes, such as the pent up demand for new autos, a recovery in residential housing, the drive toward energy self-sufficiency, the renaissance of American manufacturing and export competitiveness; and, of course, many areas that benefit from the aging of the population.

    The current consensus expectations for S&P 500 profits are, in round numbers, $100 for 2012 and $110 for 2013. Whether or not these forecasts prove correct is not of great importance except to note that at today's 1500 on the S&P Index the forward P/E would be about 13.6 times forecast results, with an earnings yield of 7.3%, which is more than 250 basis points above BBB bond yields. On the other hand, it is worthwhile to note that equity valuations expanded by about two multiple points last year, and even if the optimists prove to be correct, the overhang of uncertainty stemming from a dysfunctional US government as well as various geopolitical risks around the world, is likely to limit further expansion of valuations. Stocks are no longer enjoying a sharp rebound from deeply undervalued levels brought about by the financial crisis and the ensuing recession. Moreover, interest rates appear to have bottomed after a 30-year bull market, and without doubt as the employment picture strengthens, the Fed is likely to begin gradually to withdraw its extraordinary provision of liquidity. For example, if the country were to begin creating 200,000 jobs per month in what appeared to be a sustainable trend, the current QE3 program, which purchases $85 billion per month of Treasuries and mortgage-backed securities, would likely taper off. The old saw, "The Federal Reserve Board always writes the market letter," would be acknowledged by at least a short correction in the market's uptrend. This would by no means be the end of a bull run, but even periods of consolidation can be painful.

    Given our view that stock prices are likely to do little more than track aggregate earnings this year we believe 2013 will be one in which significant investment outperformance will be achieved via ownership of a potpourri of "special situations." These come in many shapes and colors, to wit: companies developing a "new, new thing" that is truly disruptive; companies riding the crest of strong macro themes as mentioned above; companies undergoing a significant change in management; companies breaking up into more than one entity to maximize shareholder value; companies selling or spinning off non-core assets to enhance productivity, and companies exiting bankruptcy. For the most part, the managements of these entities are seriously interested in creating a higher shareholder value, including, of course, the worth of their own stock options. Many times these special situations are hiding in plain sight and are often rejected by investors due to lingering memories of a poor past record. But they are around, and many activist funds are constantly on the prowl for these opportunities.

    As long as the macroeconomic backdrop is favorable, indeed improving, as long as financial market liquidity remains abundant with forecast earnings yields well above bond returns, the trend of the market will likely remain up, and setbacks caused by exogenous factors will prove to be attractive entry points for latecomers.

    The biggest risk for the year ahead, in our judgment, would be a compression of profit margins. Recent results for many high quality companies highlight this concern, which will likely persist as long as domestic economic growth is below 3% in real terms. Thus, to the extent that there may be only limited headroom in terms of valuation expansion, the case for special situations, as opposed to companies whose success is driven largely by macro factors, is made even more compelling. That said, the remainder of this bull market will require longer holding periods for new investments to provide worthwhile returns.

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Feb 11 12:18 PM | Link | Comment!
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