Vanguard did a good job of convincing people to buy into their S&P 500 index fund, but was that advice wise? Jack Bogle, the company's founder and most outspoken advocate, seems to make a decent case for Vanguard.
After getting crushed by their technology stock centric portfolios from 2000 through 2002 (The Nasdaq fell 80%), investors should just move what's left of their nest egg into index funds. After all, few actively mutual managed funds can consistently beat the overall market indices. Why pay 1.5% per year for a lackluster managed fund when you get pay 90% less for Vanguard Index 500?
Not only do we hear this logic all the time, but millions of people have adopted the strategy. What do they have to show for it? Not much, according to Lipper, a leading tracker of mutual fund perfomance. For the 7th straight year actively managed U.S. stock mutual funds beat the S&P 500 index funds that have been marketed so heavily since the bubble burst.
So far this decade the S&P 500 has averaged a return of 0.2 percent per year. Actively managed frunds have returned 3.5% annually for their investors during the same time period. Some people may be surprised to learn this, but is it really that shocking? If active managers can't beat a 0.2% return, that would be pretty pathetic. Still, annual gains that barely outpace inflation are certainly nothing that active mutual fund owners should feel all that happy with, so don't think these funds are all of the sudden your best way to make good money.
The index fund argument completely ignores the entire point of investing; to buy low and sell high. To do so, investors must purchase attractively priced stocks, wait until they trade closer to fair value, and sell them. Then the process repeats itself. How does owning every stock in the country via an index fund accomplish this feat? By definition, it won't. You'll own undervalued stocks, fairly valued stocks, and overvalued stocks. Basically, you're just crossing your fingers and hoping the stock market goes up. Too bad the bull market ended six years ago.
I don't know about all of you, but banking your retirement on the hope that the market will go up is a risky proposition. Getting superior returns from index funds will solely depend on whether or not you happen to own them during bull markets or not. Unfortunately for investors, the greatest bull market in history ended in 1999. Pretty ironic considering that actively managed funds have outperformed the S&P 500 each and every year since, you guessed it, 1999.
Closing the Books on 2005
PERIDOT'S PERFORMANCE
I would like to take a moment and thank all of Peridot Capital's clients for their business in 2005. This past year was a very successful one despite the fact that the S&P 500 index only returned 3.0% for the year. Peridot was able to book average gains of 10.7% for our equity+fixed income accounts and we look forward to another profitable year in 2006. Shortly I will be mailing out our Annual Letter and will be posting a copy here online as well.
THE BLOG'S FIRST 15 MONTHS
This blog has now been in operation for 15 months and I would like to thank all of our readers for your support in this endeavor. I recently completed an analysis of my investment opinions that have been posted here since late 2004. I was curious to see how they have performed compared with the market as a whole.
Although actively managed accounts should exceed the investment advice given here (mainly because most of my picks on this blog are never updated when an outlook has shifted, whereas active portfolio managers take immediate action as news develops) I was still hoping to find that the analysis provides some value to our readers. Sure enough, it did.
From November 2004 through December 2005, investment recommendations from this site have averaged an 11% gain. The S&P 500, meanwhile, has risen only 7% during that time. The spreadsheet I created for the analysis can be found here. Since many stocks have been mentioned multiple times on this site, I only used the initial mention to calculate performance figures. While it would have boosted the numbers to count every positive mention of Google shares throughout the time period, I don't feel like that is an accurate measure of how well our "average" pick (or pan) performed.
PERIDOT'S 2006 SELECT LIST
As mentioned late last year, I will be publishing a 2006 Select list shortly (hopefully it will be ready on Tuesday). The list will comprise 10 stocks Peridot feels will outperform in 2006. To maintain a fully diversified group, one company will be chosen from each of the 10 major sectors of the S&P 500; technology, telecommunications, financial services, consumer discretionary, consumer staples, healthcare products, energy, materials, industrials, and utilities.
The list, to be made available for purchase online via PayPal, will cost $20.06 and will be emailed to you directly in Adobe Acrobat format after payment has been received. I will make a blog entry with a link for those of you who are interested when the list is completed.
*****
Thanks again to both clients and readers of this blog for your support of Peridot Capital Management and have a very prosperous 2006.
Regards,
Chad
Does Size Really Matter?
Over the last week or two, CNBC coverage has focused a lot of its time on the large cap versus small cap debate. Dozens of professionals have been dragged on air to give the arguments for why they think large caps will outperform in 2006, and an equal number to make the opposite case for small caps.
Please ignore these conversations. Investing in equities should not focus on such a debate. The point of investing in public companies (or any company for that matter) is to get a good deal; to buy something that you feel is undervalued now and will ultimately be worth more in the future. Looking at company-specific issues is how you should go about doing this.
Focusing on how big a company is has nothing to do with the potential for it to be a good investment. Now I know many investors are of the "passive" type and only buy indexes. In determining how to allocate their funds, they will try and figure out which of the many asset classes they should overweight and underweight, small cap value, large cap growth, and the list goes on.
Passive investors will spend time looking at the valuation disparity between large cap and small cap stocks, compare their growth outlooks on the whole, and try to figure out which one is the relative bargain. Rather than simply guess how well a set of hundreds of companies are going to fare collectively, I think it's a much better use of one's time to get to know a handful of companies really well and determine if they represent good value.
Whether we're talking about micro caps, small caps, mid caps, or large caps, there are always going to be great investment opportunities in each segment of the market. Buying an entire asset class is really nothing more than speculating, given that you aren't really analyzing whether or not any of the companies in that large subset are actually good investments or not. I'd be willing to bet you'll be more accurate predicting relative value of individual companies than you will entire indexes based on company size.
H&R Block Financial Advisors' Top Picks for 2006
Thought maybe readers would find this list helpful. Not that I think H&R Block Financial Advisors are great stock pickers, but maybe some of these fit criteria that you look for in a stock.
Comcast (CMCSA) Consumer Disc.
Int'l Speedway (ISCA) Consumer Disc.
CVS Corp (CVS) Consumer Staples
Pepsi Bottling (PBG) Consumer Staples
United Natural Foods (UNFI) Consumer Staples
Global Santa Fe (GSF) Energy
Schlumberger (SLB) Energy
Capital One (COF) Financials
Wachovia (WB) Financials
Neurocrine (NBIX) Health Care
Stryker (SYK) Health Care
Teva (TEVA) Health Care
3M (MMM) Industrials
URS (URS) Industrials
Dell (DELL) Technology
Intel (INTC) Technology
Micron (MU) Technology
Verizon (VZ) Telecom
FPL Group (FPL) Utilities
Full disclosure: Peridot owns shares of Capital One
Performing A Tax Loss Selling Analysis
Since it is historically the weakest month of the year, I do my tax loss selling for taxable accounts during October. Prices tend to be weak, so you can maximize your capital loss offsets by selling any losers you have in your portfolio, and thereby minimize your capital gain tax bill the following April. This also frees up cash to put to work before the seasonally strongest six-month period for stocks (November through April).
Something else I do myself, and recommend for all of you, is to carefully analyze those stocks you sold at a loss. Don't simply try to purge them from your memory. Instead, study them and figure out what common themes those positions possessed. That way, you can learn from your mistakes. We're all going to make them, but it's great if you can figure out why they didn't work out the way you thought they would, and most importantly, use such knowledge to maximize your future investment performance.
An Uncanny Comparison
I've noted previously that the market action in 2005 fairly closely mimics the movement we saw in 1994, the last time the Federal Reserve engaged in an extended increase in the price of money. In fact, as we've gotten deeper into this year, the comparison has strengthened, as seen from the two charts above.
Market Action Feels Like 2001
Midway through the 8th day trading day of October, we have our 7th down day of the quarter. This market feels a lot like the painful one we experienced in late 2001. The culmination of the Nasdaq bubble bursting, the outbreak of SARS, and the 9/11 terrorist attacks led to an environment that felt as though it would go down every day and never end.
Today we have a similar scenario. Stock prices are indicating that 1) gasoline prices will remain at $3 per gallon even as refineries come back online in the coming weeks and months, 2) natural gas prices will remain high even after the winter season passes, 3) consumer spending will be poor during the holiday season and every season thereafter, and 4) the Fed will continue to raise interest rates forever. Add to it that we are in the historically poor performing month of October, and it feels like no end is in sight.
Like in 2001, today I wish I was a trader in these environments, not a long-term investor. As a trader you can just go with the trend and short this market. As a long-term value investor you need to buy stocks as they fall, knowing full well they will most likely fall further before they rebound.
However, I know that as a short-term trader I would not have been able to profit handsomely from some very contrarian bets. Shares of Royal Caribbean (RCL) fell from $30 to $8 in 2001 after leisure travel was halted in the United States. Four years later the stock closed 2004 at $54 per share, for a gain of 575 percent.
In the end, sacrificing the short-term for the good of the long-term can yield outstanding rewards. The key is stick to your convictions when it hurts the most. "No pain, no gain" rings true in the stock market as well.
Delving into the Conventional Wisdom
There are two reasons the market is down so far this year; energy and interest rates. The question we need to ask ourselves is "Are the stock market reactions we are seeing correct?" Since the market is mostly psychological, investors need to take a deep breathe and focus on reality, not simply psychology or perception.
Stocks are being held down by underperforming names in the financial services and consumer discretionary sectors. Together, those 2 areas represent 31% of the S&P 500. That's a huge chunk. Regardless of how strong energy, materials, and health care stocks act in times of higher interest rates and fears of an economic slowdown, they won't be able to carry the market on their shoulders. Why not? Energy and materials are only 13% of the market. Health care is another 13%, but that only gets us to 26%, less than the 31% of weakness we need to offset.
The weakness in financial services is real and very much warranted. Banks are going to struggle with a flat yield curve. If you were running a bank and your borrowing costs were risng faster than the lending rates you could charge, your profit margin would be squeezed. No doubt about it. Until the Fed is ready to stop, financials are not right here, so let's hope once Greenspan is gone in early 2006 that rates stabilize.
Conversely, the sell-off in consumer discretionary sectors is a little less warranted, in my opinion. As gas prices have gone from $2 a gallon to $3 a gallon, drivers will need an extra $60 per month to fill up their cars if they have a 15 gallon tank and fill up once a week. The question we need to ask is, where will that $60 come from? I don't doubt that it will be taken out of another area of one's personal budget, but where? It won't come out of every other place.
One of the conclusions I've come to is that it won't come out of food expenditures as much as the restaurant stocks are telling us. I still think the trend toward eating out, not cooking at home, is here to stay, regardless of gas prices. Families might not go out and spend a lot of money on food, but they should still eat out at a reasonable price. With major restaurant chain share prices at 52-week lows, that's an area I would strongly consider buying as prices continue falling.
Ugly Market Could Soon Be An Opportunity
Market psychology in October is never very good, based on what have been some pretty lousy performances in 1987 and much earlier during the Great Depression. Combine that history with the fact that markets rarely do well in the middle of earnings season, and a continuation to the downside short-term could present an excellent opportunity for investors.
The markets are jittery right now due to inflationary fears, which I think are very warranted. There is little doubt in my mind that Fed Funds rates will be at 4.25% by year-end. As far as 2006 goes, it all depends who succeeds Alan Greenspan. If an inflation hawk steps in, rates could very well go even higher if commodity prices keep rising and the government continues its insane spending.
Despite that somewhat gloomy backdrop, corporate earnings have held up okay, and estimates right now are for the S&P 500 companies to earn $85 in 2006. While that number is by no means assured given the current economic environment, the P/E on such estimates right now is only 14x.
If the recent slide continues, and we get the S&P 500 back down to its support level in the 1135-1150 area, all of the sudden the forward multiple is 13.5 times earnings. A lot of good things could happen if we see that kind of valuation (not seen in years) combined with a technical support level holding and a seasonally strong period (November through April) set to begin after we get through third quarter earnings reports. Continued weakness in crude oil prices would only help that scenario.
Despite Cash Hoards, Companies Aren't Paying Out
With cash reserves of U.S. public companies sitting at all-time record highs, investors might think dividend payments would be booming as well. Combined with the relatively new 15% dividend income tax rate, investors should be reaping the rewards of record cash payouts. However, the average S&P 500 company is paying less than 2% annually out to its shareholders.
Why does the average large cap stock pay out less than 2% in dividends? Well as we've seen this year, M&A activity has been red hot. Corporate profit margins are at cycle highs, so further cost savings have to be squeezed out via merger synergies. So far in 2005, deals have been running rampant on Wall Street. One need just look at the recent earnings report from Goldman Sachs (GS) to see evidence of that.
In addition to mergers and acquisitions, the rise of stock option compensation over the last two decades certainly accounts for the reduction in dividend yields. In order to minimize the equity dilution from option issuances, companies need to instate massive share repurchase programs. The money to do so comes straight from free cash flow that would otherwise be widely available for cash payouts to shareholders.
Throughout history, stock market returns have come from the combination of equity price appreciation and dividend payments. Yields that have averaged about 4 percent historically, along with 6 percent annual growth in earnings, explains the 10 percent average annual return from equities since the 1800's.
With 2% dividends and peak margins upon us, it's no wonder that some suspect future stock market returns, say during the next decade or so, will fail to hit the magic 10 percent mark. Even if somehow peak margins can be sustained, which is unlikely, investors are only looking at 8 percent annual returns from stock indices in the near to intermediate term. While that kind of performance pales in comparison to the great bull market of 1982-1999, it will still mark the highest return of any asset class, so abandoning the stock market because of it makes little sense.