Paul Winkler: Welcome. This is The Investor Coaching Show.
On to the news of today because that’s what I should talk about. “Here are a Few Stock Fund Managers Who Managed to Post Gains Over the Past Year” was the title of an article in The Wall Street Journal.
Economic and Market Transformation
It read, “Here are a few stock fund managers who managed to post gains over the past year.” They have a picture of this winning manager. He believes that we’re in the midst of a massive economic and market transformation and is saying that, “Perhaps this comes as some surprise that there’s a couple people that actually okay did during this period of time.”
“The recent buffeting of stocks and bonds is part of a massive economic and market transformation that requires a different investment perspective. We’re transitioning from an era of abundance of labor, raw materials, capital to one of scarcity,” he says. You can look at that, and I’m not going to go too much into detail on what he’s thinking.
The reality of it is, no matter what kind of transformation we have ever been through in this country, we have always responded to it. Yes, you may have an era of lack of labor. Well, what are people going to do?
Robotics is what we’re starting to see. If you look at some of the news in robotics, it’s nothing short of staggering what humanity is coming up with.
If you’re going to have a lack of raw materials, you’re going to find either ways to get at it or you’re going to find ways to go, “Maybe we don’t really need this particular raw material.” People will find something different.
You’re not going to sit there and go, “Oh, let’s just pay out the wazoo for whatever it is that we think we need.” No, we’re not going to do that. That’s not how humanity works.
We’re going to be lacking capital in some way. I’m not exactly sure what that is supposed to mean because the amount of capital fluctuates quite frequently with what’s going on economically.
There will be periods of time when capital is abundant and periods of time when it’s not.
It comes back when it’s needed, and it comes back at the right times. It comes back when the economic cycles fluctuate. To basically say, “It’s always going to be this way,” is kind of dangerous in my mind.
Investors Are Easily Tempted by New Things
The person that is winning this prize of having been the best fund manager wasn’t somebody I’ve heard of. I don’t know this person’s name. I’ve never heard of him. He wasn’t the best fund manager last year or the year before that, and he’s not a teenager, so he’s been around for a while.
We put these people on a pedestal and say, “Wow, this person’s really got it. Ooh, they’ve got a new perspective.” It’s like the fish going, “Ooh, shiny lure,” and they go straight to it. That’s what happens with investors. They go straight to things that they think are new.
What’s the evidence that I’m right about this? Well, go to SPIVA. They have the data on fund managers, professional fund managers, and what percentage of them the various markets had higher returns.
These professionals are doing exactly what this fund manager being highlighted in the article is doing. They are trying to figure out what stocks and when we should be in the markets and when we should be getting out and when we should be transitioning between things.
Attempting to figure out what the market is going to do and act accordingly is never a good idea.
The most recent data on one year returns is 55% of them failed to match what the market did on its own. This isn’t a bad year for the market. If you held any cash at all, you should have done better than the market over the past year.
Go back 15 years and it’s 89.38%, almost 90%. Nine out of 10 professional managers didn’t get returns of the S&P 500 investing in large company stocks. If you look at small company stocks, the number is 92%. If you look at large growth fund managers, and you compare it against the S&P 500, 97% failed to match market returns.
That’s almost everybody for those of you that are not good with statistics. That is really, really bad.
Over the past 10 years, according to Morningstar, if you look at the average professional manager in the U.S. small value stocks market segment, which would be the area of the market that you would have the highest expected return, $10,000 grew to about $24,000.
Looking at Small Companies
That is better than a poke in the eye with a sharp stick, but you have to recognize what happens if you look at investor returns and look at studies on investor returns in these categories. Go look at the DALBAR research or go look at Morningstar’s own research. What they do is they actually look at cash flow in and cash flow out.
If you just actually pulled it off and captured the return of these funds, you didn’t underperform like most people did, your $10,000 grew to about $24,000 versus about $27,000 in an index. What I like to do is I like to hold funds that hold the bottom 20% in terms of price-to-book and then hold the bottom half of the market as far as small company stocks go.
Then if you look at value stocks for example. That’s the same criteria. If you look at the average professional fund manager, $10,000 grew to $26,000 versus about $31,000 for the asset class.
That can be a pretty significant difference when it really gets down to it. If you look at small companies, really small companies, I tend to hold microcaps in my portfolio. You sometimes want really, really small companies.
Because you would have wanted Microsoft when Bill Gates was running it out of a garage. That would be the cool thing. Not after it’s already become a behemoth, and it’s already run its course.
You want to own it when it’s a little bit smaller when it’s a microcap. That would be the bottom 20%, so I’m typically looking for funds with market caps, or market capitalization, that’s going to be a little bit smaller. When I say a little bit smaller, you’re looking for companies that are somewhere in the neighborhood of about a billion dollars.
We’re looking at companies that aren’t too big yet. That’s pretty small when it comes down to it, especially when you have a hundred billion dollar plus companies in the market that you can invest in when you’re dealing with large caps.
American investors tend to only invest in companies they recognize the name of.
You’re dealing with really, really small companies when you’re dealing with that 1 billion range. It’s a lot of companies’ names you wouldn’t even recognize, so it doesn’t make it popular with American investors because American investors tend to like companies they recognize.
Markets Right Now
You wouldn’t even think of owning a small company because you don’t even know their names. It wouldn’t be something that would hit your radar. “I want to own CorVel Corp.” “Yeah, what’s that?”
All kidding aside, you look at these little teeny companies like, “Who’s that?” You look at a portfolio like that, and $10,000 in that category of small blend grew to about $24,000. The index is $27,000, but it’s almost $30,000 for microcaps over the last 10 years.
That is why you often hear me say, “Ah, don’t get too excited about indexing.” The reality of it is that they hold companies in a proportion and in a manner that I would not get too terribly excited about simply because they’re holding bigger companies.
Why do fund companies do that? You’ve heard me say this before if you listen to the show. They do it because it is a popularity contest. It’s cheap, and it’s an easy way to do things for the fund company. But I think it’s quite frankly very lazy.
Now, if you look at what’s going on in markets right now, why is any of this stuff important? What’s fascinating right now is I’m always looking at what price stocks are selling for compared to earnings.
For the first time in quite a while, even the S&P 500 is selling for less than its historic price-to-earnings ratio.
Right now, as we speak, I ran the data at the end of this last week, it’s actually selling for less than what it has historically.
That doesn’t mean it’s poised for a rally. I’m not saying that. But I think it’s just worthy to note that normally those stocks sell for about $16 times earnings, and they’re selling for just over $15 earnings right now. The S&P 500 is a little bit over $15.05. I can’t remember the last time it was under $20, so that is pretty significant to me.
Now there are some market segments right now selling for six times earnings. These are companies emerging in countries that you wouldn’t think of as established international companies, like Germany and France and Japan and Australia.
A Response Is Inevitable
So think of it this way. If earnings come through as we expect to come through, you literally have your money back in six years. That just shows you what a big deal things are right now. Then if you look at international small companies, value companies, they’re about seven times earnings, not much more. International value is seven times earnings right now.
Now, why is any of this important? It’s really important. It comes down to, especially when you’re an investor, more than just the obvious because the obvious is what we want to do as investors, which is to buy low, sell high.
I’m not saying it’s poised for a rally next… I don’t know when it’s going to do that because that would make me an active manager to tell you that I knew exactly when it was going to take off. What did I just tell you about these active managers? 90 to 97% of them, 98% of them, aren’t matching market returns. I’m not jumping in that category, but it does mean something really important for the investor, especially for somebody that is taking income from their investment portfolio.
As I often say, “I can’t predict market downturns, but what I can predict is that people will respond to them because people respond to everything.”
People respond to everything.
They’re going to either run from the market or they’re going to invest more. Maybe some people will sit tight, but I’m talking about the people that are at the companies themselves.
They’re sitting there going, “Oh no, the market’s down. Our stock price is down. What are we going to do?” “Well, sir, we need to sell more stuff.” “Yeah, no kidding. Okay, what else can we do? Because we can’t sell anything more because people aren’t necessarily buying our product. Well, we can reduce expenses.” “Well, sir, we can’t reduce expenses right now. Or ma’am. We can’t reduce…” That was sexist. “We can’t reduce expenses right now. The reason we can’t do that is because we’re still fulfilling orders from our back orders from the previous period of time, so we’re going to have to wait a little bit.” “Okay, we’ll wait a little bit, and then we’ll reduce expenses.”
The Strength of the U.S. Dollar
But they’re going to reduce expenses by laying off people, and they’re going to reduce expenses by… and then eventually what’s going to happen is the energy costs that are so high right now that’ll eventually come down as new sources come online and as they find new ways to economize or whatever on whatever expenses that they’re dealing with.
Maybe they start to get the supply chains… They start to get caught up in that particular area and then that becomes not as big of an issue. You don’t have the supply demand issue, which you don’t have a lot of supply and you got a lot of demand that drives prices up. Eventually that will come out.
People aren’t hearing about the devaluation of foreign goods due to the current strength of the U.S. dollar.
Matter of fact, it’s interesting if you look at right now what’s going on with the U.S. dollar. The U.S. dollar is extremely strong, and it is actually driving down the prices of foreign goods. You have deflation in foreign goods because of the strength of the U.S. dollar. Are you hearing that anywhere? No, you’re not.
Stewart McKee: I bought something from the UK this week. I think it might have actually been cheaper in U.S. dollars than it was in Euro or whatever I purchased it.
PW: Yes, that is true.
SM: I thought it was going to be, let’s say, $150 and it was less.
PW: Yeah. No, you’re exactly right. We haven’t seen this in quite a while where there’s been that parity that has been so messed up. What is predictable to me is that somehow some way companies are going to respond, and they’re going to do whatever they have to get their stock prices to go back up because they get fired otherwise.
Stock Prices Compared to Earnings
Now back to my point about the prices of stocks compared to the earnings and why that’s important. We’re going to look back historically and take a distribution from an investment portfolio.
I did a workshop a while back where I took a 4% distribution, and I increased it. It’s on my website for anybody who wants to go look at it.
I increased it from inflation each year. I said, “I’m at a million dollars,” and I took a 4% distribution, which would be $40,000. With the next year’s inflation, you might have to take $41,000 to live at the same level.
I increased it each year from the year 2000, so now the income is well over $60,000 just to keep pace with inflation over the past 22 years.
We have a 4% rule. If you’re increasing the distribution each year, regardless of what the market’s doing, then there are going to be years where that distribution is not going to be 4% anymore of the portfolio value.
Let’s just say for the fun of it that your distribution year one was $40,000 and that your portfolio value was a million dollars—$40,000 is 4%, right? But what if the very next year your portfolio value dropped, and it wasn’t a million dollars anymore because the market fell. Let’s just say for the fun of it, it went down 5%.
Flexibility and patience are valuable assets for investors.
Now your portfolio distribution is going to be 4.3%. It’s going to be higher because you’re taking out a little bit more money, but the portfolio value is lower. In the third year, let’s say if your portfolio dropped, and it went down to $900,000, but you’re taking out like $42,000. Now you’re up to 4.7% of your portfolio.
I had a sneaking suspicion that a lot of distributions would be well over 5%. In essence, you’ll have some years where it’s maybe 3%. After a really good move in the market, you may only be pulling out 3% of your portfolio value. Some years it’s going to be above 4%.
So 4% is only the starting percentage, at least that was all designed to be. Now, why is that number significant, and why are some of these numbers I said earlier significant?
Earnings Yield and Returns
If you have an earnings yield that doesn’t change, that’s not great. Companies hope that they’re going to go up, right? We don’t want earnings to go down, and we get fired if earnings stay the same forever.
Where do returns come from? A big part of it is that earnings yield. It’s too hazardous to your wealth to go and stick all your money in any one asset category.
When you’re taking an income, how do you take it? I’m always taking it from the asset categories that are overrepresented. When you have market downturns, the earnings yield tends to get fairly high when you look back through history.
If you look at all the market downturns, that’s when you see that distribution being more than the 4% rule that I’m talking about. Why did it work out okay? Well, because that’s what typically happens in markets. After downturns, you have upturns.
Without market downturns, there would be no market upturns.
Now, I don’t know what’s going to happen, but 100% of market downturns is how many we’ve recovered from. We have recovered from every one of them.
Now to say that this is the one we’re not going to recover from, you could say that. I think that’s a far-fetched bet to say that. If we don’t recover from it, then we probably have bigger problems on our hands.
These are the times you need to hear a voice like this. You really do. Because there is so much pessimism and talk about how the markets are down. I’m like, “Yeah. So? That’s what it does.”
Be thankful for it. As odd as it is, if it weren’t for the downturns, we wouldn’t have the upturns. We wouldn’t have the higher returns of markets that historically markets have given us if it weren’t for these downturns, so be thankful for them.
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