Equity markets have risen to new all-time highs in 2016 amid periodic bouts of sharp volatility, a soft global economy, falling corporate profits and troubling geopolitical issues. The current bull market in stocks is well into its seventh year. Since the prior market peak nearly nine years ago, the S&P 500* has only produced a negative return in one calendar year (2008). This remarkable escalation of asset prices, which has driven a 218% cumulative return in the S&P 500 since March of 2009, has dramatically outpaced the growth of corporate earnings over the same period, which simply means that equity investors collectively have been willing to pay far higher prices for the same dollar of profit.
One observation we have had over the last few years is that investors seem to have gravitated toward ‘popular trades’ in a rotating sequence, bidding up prices and then moving on to other areas. While this is not particularly unusual behavior for equity markets historically, we do believe an interesting difference in recent years has been that the popular trades have generally maintained robust valuation levels even when investors begin to rotate away, whereas a more typical pattern might have those areas becoming a ‘source of funds’ and selling off accordingly. After the financial crisis and market bottom of 2009, there were sharp initial rallies in the more cyclical and distressed parts of the market, which then gave way to a period in which investors showed a preference for ‘quality’ businesses. As valuation multiples expanded and capital gains broadly slowed, investors’ attention turned to narrowing pockets of fashionable growth businesses in areas such as social media, cloud software, e-commerce and biotech. More recently, income-oriented and so-called ‘minimum volatility’ stocks have been the favored plays, with industry groups such as utilities, Real Estate Investment Trusts (REITs), telecom services and consumer staples trading to very high multiples (and low yields), contributing meaningfully to the market’s continued rise.
Reflecting on the phenomena discussed above – multiple expansions and investors’ rotation through popular trades – we believe there are two key underlying drivers that have played major roles. The first is the unprecedented level of monetary expansion by central banks around the world as they have maintained crisis-era low-rate policies, introduced multiple liquidity mechanisms and made massive outright purchases of sovereign and corporate securities. These contemporaneous stimulative efforts have created vast excess bank reserves, hyper-easy credit conditions and a grasp for yield among investors. Evidence would suggest that the flow-through effect on the real economy has come up short, as global Gross Domestic Product (GDP) growth remains lackluster and productivity has slowed alarmingly. We are concerned that investors may be overlooking some very plausible negative ramifications of these interventions, including credit misallocation, excess capacity, degraded balance sheets and a significantly higher likelihood of higher inflation. Moreover, the sheer magnitude of the interventions and the degree to which interest rates have been suppressed have actually attached higher levels of systemic risk to the inevitable unwinding of these policies in our view. The emerging consensus among many investors that low (or negative) interest rates and easy credit are ‘generational’ phenomena that can be sustained and should be embraced has all appearances of a popular delusion to our eyes. The U.S. Federal Reserve’s evident reluctance to make normative policy actions in the face of steadying economic conditions is an example of how central banks may simply be trapped by the highly irregular and ultimately unsustainable conditions they themselves have created.
A second key driver that we believe has been critical to the market’s upward march has been the growing movement toward passive and factor-driven investment approaches among capital allocators. We certainly understand the appeal of these products in a rising market, as they can lower investors’ fees while also guaranteeing low tracking error vis-à-vis the indexes, factors or variables they are designed to replicate. The downside, however, is that these products in general lack mechanisms to identify and avoid valuation excesses that may be building in the underlying securities they hold. Lacking a subjective or judgment-driven layer in their investment process, passive products’ purchasing decisions are reflexive in nature. We would argue that this issue becomes even more problematic when the products are replicating capitalization-weighted indexes or focusing on narrow areas of the market such as REITs and ‘low volatility’ stocks. Equities trade in secondary markets, and therefore the movement of prices reflects the relative eagerness of the buyers and sellers in each transaction. As such, we believe there are clear dangers to having large pools of passive money indiscriminately and mechanistically purchasing shares in the open market based solely on money flows. As passive products have attracted trillions of dollars of inflows in recent years from both institutional and retail investors, we believe that security-specific valuation levels have been increasingly influenced by non-fundamental factors.
So what can we take away from the points noted above? First, we are living in very unusual times. Nearly $13 trillion in global debt is trading at negative nominal yields. Central banks appear to be locked into easy-money policies and a soft currency war. Economic weakness is suppressing the advancement of consumers at the lower end of the demographic spectrum, while wealthier cohorts enjoy the benefits of asset inflation. Corporate capital spending trends are scraping along the bottom, hurting productivity growth just as labor markets appear to be tightening. Meanwhile in the capital markets, valuation levels continue to rise as investors clamor for scarce yield and bid against each other to gain desired exposures to fashionable stocks and popular trades. Passive investment vehicles continue to pull assets away from active managers, resulting in continued overweighting of recent winners and overcrowding in certain themes and styles, with little apparent regard for the excesses that such a self-referencing feedback loop could be creating.
We believe that equity markets have begun to embed very high levels of price risk. As value-oriented investors with a keen emphasis on capital preservation, we define price risk as simply the degree to which market prices for stocks exceed conservatively calculated estimates of their intrinsic worth. Generally speaking, high valuations imply some combination of bullish expectations for corporate earnings growth, lowered requirements for risk-adjusted returns (i.e. lower discount rates) or simply too much money chasing the same assets. Interestingly, quarterly earnings per share for the S&P 500 Index were down by more than 9% in 2Q16 as compared to the last cyclical peak in 3Q14, yet the Index itself has returned 15.1% from the end of 3Q14 to the present. We see this as being a clear illustration of heightened price risk. As these conditions escalate, we believe that the risk of a significant market correction accumulates. But just as price risk can periodically reach very high levels (early 2000 and the autumn of 2007 come to mind), there are also times when price risk becomes very low as investors adopt pessimistic assessments of corporate earnings prospects and demand higher levels of risk-adjusted compensation for owning equities. History has shown such times to be very attractive opportunities for investors who have a long-term framework and high conviction levels on durable, high-quality businesses that they stand ready to buy.
For our Core Select strategies, in addition to having a sharp focus on price risk, we also place great emphasis on the concept of business risk. With our demanding investment criteria, extensive due diligence and careful consideration of factors outside of companies’ control, our goal is to narrow the universe of investable large-cap stocks down to a subset of particularly exemplary businesses for which we believe the long-term likelihood of solid growth, robust cash flow generation and internal compounding of returns through shrewd reinvestment is well above average. We believe that companies of this caliber offer better visibility and a narrower range of potential long-term outcomes, and to the extent we can consistently identify and invest in such opportunities, we believe we can lower the business risk of the portfolio.
When the Core Select investment team came together nearly 11 years ago, we set forth a simple statement of our performance objectives. Our primary long-term goals were to achieve attractive absolute compounding of returns over full market cycles and seek to protect capital during market downturns. These aspirations remain unchanged today, and we are proud of the fact that we have built an investment track record that manifests our original objectives. We believe the most critical drivers of our differentiated long-term performance have been 1) the efficacy and consistency of our strict investment criteria and valuation discipline, 2) our high level of ‘active share’ (the degree to which our portfolio differs from market benchmarks) and 3) our long-term, low turnover ‘buy-and-own’ approach. With those tenets at the core of our investment philosophy, it naturally follows that we are not benchmark sensitive over short periods of time within market cycles – in fact, we fully expect that we will experience rolling one, three and even five-year periods during which our performance will differ materially from broad market indexes, both favorably and unfavorably.
Given today’s challenging valuation environment, tepid economic conditions and the longer-term risks posed by unprecedented levels of monetary policy intervention, we believe it is critical that investors not be lulled into a sense of complacency by the continued rise of asset prices. We also think it is important to consider scenarios in which the multi-year pattern of strong inflows into passive products could potentially reverse in response to higher rates, higher inflation, economic recession or a broad re-underwriting of risk in general, creating risks of disorderly selling. These are not top-down predictions per se, but instead are a reflection of our heightened awareness of price risk given the growing disconnect between company level fundamentals and corresponding equity valuations.
We remain very confident in the fundamentally driven, concentrated, long-term approach we use for Core Select. Over full cycles, we aspire to deliver attractive compounding of equity returns while seeking to protect capital during times of stress. Regardless of the state of markets or the appearances of our short-term relative performance, we simply will not alter our commitment to mitigating business risk and price risk by investing in high quality, resilient businesses at prices that give us a meaningful margin to safety relative to our estimates of intrinsic value**. It is certainly possible that today’s unusual circumstances could persist for a period of time, in which case our high active share portfolio could continue to behave differently from the broader market. Nevertheless, we will stay true to our core principals and full-cycle perspective.
We appreciate your continued support, and we welcome your questions and feedback.
Timothy E. Hartch
Michael E. Keller, CFA
*S&P 500 is an unmanaged, market capitalization weighted index of 500 stocks providing a broad indicator of stock price movements. The index is not available for direct investment.
**BBH’s estimate of the present value of the cash that a business can generate and distribute to shareholders over its remaining life.
Core Select Investment Objective: Our primary long-term goals were to achieve attractive absolute compounding of returns over full market cycles and to protect capital during market downturns.
Opinions, forecasts, and discussions about investment strategies represent the author’s views as of the date of this commentary and are subject to change without notice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations.
Purchase and sale information provided should not be considered as a recommendation to purchase or sell a particular security and that there is no assurance, as of the date of publication, that the securities purchased remain in a fund's portfolio or that securities sold have not been repurchased.
Investors in the Fund should be able to withstand short-term fluctuations in the equity markets and fixed income markets in return for potentially higher returns over the long term. The value of portfolios change every day and can be affected by changes in interest rates, general market conditions and other political, social and economic developments.
The Fund is ‘non-diversified’ and may assume large positions in a small number of issuers which can increase the potential for greater price fluctuation.
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Brown Brothers Harriman & Co. ("BBH"), a New York limited partnership, was founded in 1818 and provides investment advice to registered mutual funds through a separately identifiable department (the "SID"). The SID is registered with the U.S. Securities and Exchange Commission under the Investment Advisers Act of 1940. BBH acts as the Fund Administrator and is located at 140 Broadway, New York, NY 10005.
© Brown Brothers Harriman & Co. 2016. All rights reserved. 08/2016
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IM-2016-08-18-3144 BBH001710 Exp. Date 09/30/2016