2015 – 1st Quarter Letter – Harold Kuyper & ERP
April 15, 2015
Into every life a little rain must fall, and I guess my time came a few weeks ago. I found myself trapped in a meeting that featured Harold Kuyper, an investment advisor, who claimed enough skill to predict the near term direction of the market. He told his audience that large cap stocks were extremely over extended and hadn’t had a meaningful correction for almost seven years! He held an opinion that we have heard from others; the S&P has enjoyed an unabated rally since its -37.03% performance in 2008, and would soon collapse under its own weight. Everyone is entitled to their own opinion so I passed on most of the Q&A, but erred by asking a couple of questions about the performance of two large cap managers currently employed by the portfolio being discussed. I should have kept still. Harold told me that his short term predictions of a correction would actually favor the managers in question and allow them to outperform once the market heeded his call. At P&A, this would be the equivalent of a triple twisting double back flip off the high board with a perfect entry…. a move you just don’t attempt.
He might be right….
No change since our last letter; we continue to “Like” the market. However, our opinions need to be constantly challenged. Like a tent pole, there is need for tension from all sides. If we insist on soliciting opinions that agree with our own, the world will become a pretty a small place with a very steep learning curve. We always try to remind ourselves that the other guy might be right….in this case, Harold. Could there be a correction at hand? Could it cause today’s preferred holdings to flip flop with the unloved? What is the price of reducing our equity exposure? How good is the other guy? How good are we?
An unflinching equity investor would have earned about 8.50% annually over the last 10 years. Considering the -37.03% financial collapse in 2008, that’s a pretty good wage. One of the keys to successful investing is to employ the fullness of time, staying put when others rabbit. We’ll admit, it’s hard not to get bucked off when the media insists on fighting the last battle over and over. Too often, that approach sponsors short term thinking and the kind of financial gymnastics recommended by Harold. Let’s start with a shorter time frame and take a look at what would have happened to investors who have stayed the course over the last three years:
Ok……that was easy. All you have to do is learn to buy stocks instead of a money market fund. If you bought the market in January 2012, the value of your assets increased by 49.88% over the next 3 years, an arithmetic average of 16.63%. Who wouldn’t be happy about that? The dissatisfied like to make things a little more difficult and hide behind the concept of “they.” It’s a pronoun which refers to a powerful but unspecified group of people, often sinister in their authority. For instance, the 28.83% return in 2013 will surely be followed by a loss because “they” won’t let you get away with that. In order to avoid that risk, success is often followed by retreat. Harold, no doubt, is a firm believer in “them” and wants to see the market correct before it goes higher. Let’s widen the lense on our camera just a bit:
This brings a few more stumbling blocks into view. The arithmetic rate of return for a Money Market account is now fractional….. not exactly a wow! Over the same comparison period the P&A Blend averaged 12.75%….a rate superior to the historic 10.75% for equities. In addition, something funky happened back in 2011. The Dow shed about 17%, while the S&P dropped 19%, both qualifying as a primary correction (don’t tell Harold). However, that negative price action was contained by the seasonally weakest months of the year (April through October). Once year end rolled around the market was just about back where it started….. the S&P actually closed 2.14% higher. The calendar masked this market action for “annual” observers. Events like this fit the description of being out of sight and out of mind… if the market ends up positive for the year investors don’t mind. As it turns out, this was a very good five year period, and investors should not have been scared to the sidelines. The P&A Blend beat the money market fund by $388,472, an historically high equity risk premium…..more on that later.
In retrospect, we were dead wrong for being in the “Really Like” mode in January of 2011. However, by the 4th quarter we saw the error in our ways. We actively harvested losses and in true contrarian fashion, dialed our equity affection up to “Love”… this time we were right. Our “Love” was warmly received in 2012 and we retreated to “Really Like” in the first quarter of 2013. Wrong again, 2013 was dynamite. Hopefully my point is getting through. We make small corrections in our affection for equities and never drop below “Like.” The short term is very difficult to predict and we dislike being un-invested in an asset class that appreciates 67% of the time. Every now and then we are right, and we are never really wrong. Our “Love” is usually generated by a catharsis; these changes should not be used as short term market calls. This system keeps us in the game and was developed to provide answers to clients and prospects that are entitled to an opinion. By the end of 2013 we fell back to “Like” and remain there as of this writing.
This might be an appropriate place for an aside…we are often asked “whose research do we use?” Whenever we can, we use our own. About 10 years ago we compiled a database which tracks the annual performance of large cap equities since 1896…. a reasonably long period of time. In order to measure reversion to the mean we track nine multi-year moving averages. We don’t consider this work terribly unique, but we don’t know anyone else that does it. At the current time we pay “hard dollars” for fundamental and technical research generated by a handful of third party providers. Most of this research is offered by boutique-ish sources and used to validate the proprietary research generated by P&A. The lack of consistency offered by sell-side broker dealers and high profile vendors has betrayed us too often. If we can’t assemble and disassemble the research we use in-house, we generally don’t use it.
Readers of this letter know that we believe that the long term is the only term. With that in mind, let’s increase our field of vision one more time and learn a little more:
How about that money market rate? The average over this 10 year period of time now comes to 1.99%, a reminder of the rates paid seven to ten years ago. The excess return generated by stocks is called the equity risk premium (ERP). It is the incentive required by investors for taking the relatively higher risk of owning stocks. By now you should have figured out that the second column from the right calculates the ERP for the P&A Blend, a benchmark for how we manage equities, vs Money Market rates. In percentage terms it comes to 6.89%. In dollars it comes to $200,423. There a lot of different ways to calculate ERP, this example is historic. Future or anticipated ERP is historically in the four to five percent range. We have included 2008 in our work, although many would suggest this year was an outlier. All that being said, the last 10 years has been a wild ride for equity owners. Volatility creates a lot of opportunity. Take another look at the value added by the ERP and ask yourself if it has been worth it?
Harold Kuyper might be right but we doubt it (he was a better church league basketball coach than investor anyway). One of our pals in the business used to say “that guy’s got more moves than Jell-O.” Harold isn’t that guy and a fully diversified/balanced portfolio moves like a bus, not a go kart. Trying to make it something it’s not often creates foregone income…..the true cost of behaving this way. We like our high quality, low turnover approach to managing money; it seems to deliver a lot of beauty rest to our clients.
Thousands of investors continue to be flushed out of savings accounts, CDs, money market funds and short term bonds. These short term investment vehicles became as popular as self-cleaning ovens during the high interest rate 70’s and 80’s. Unfortunately they transitioned from a saving grace to a Chinese water torture as rates began their decent. Our current stock market is not as oversold as it was in 2008 so there will be corrections and lumpy returns. Fractional short term rates will continue to make equity investors out of CD buyers. Some will head back to the bank when rates work higher but increasing dividends and capital gains purloin a fair share. “How you gonna keep ‘em down on the farm after they’ve seen Paree?”
Volatility by itself should not be defined as risk. It becomes risk when combined with liquidity needs. Without liquidity needs volatility represents opportunity. We like balanced portfolios, they are good at delivering liquidity and represent our most popular discipline by a wide margin. In the end, when properly managed, stocks can do anything bonds can do better.
We continue to “Like” equities.
James S. Pittenger, Jr,