August 13, 2015

For the first six months of 2015, not much has happened in the investment world as reflected by stock market indices. Although recently setting new all-time highs, as measured by the S&P 500, stocks have returned only 1.2 percent as of this writing. And one percent of that return is from dividends. Likewise, interest rates are just about where they were at the end of 2014. A one-year bank CD returns perhaps only 0.1 percent. Two-year U.S. Treasuries yield 0.6 percent. And five- year municipals yield just 1.5 percent.

So what is the answer to our rhetorical question, what’s a portfolio manager to do? It’s a fairly simple answer. Because we are long-  term focused investors and highly disciplined, we do what we always do.

“In the case of stocks, we look for individual companies trading at levels we feel offer good long-term values.”

In the case of stocks, we look for individual companies trading at levels we feel offer good long-term values. And for bonds, because we’re highly principled, we focus on high-quality and secure issues which will pay us a fair return in comparison to other fixed-income alternatives of lesser quality.

In the case of equities, it is clear that market indices or averages are just that—averages. So at any given time, some individual companies may be trading at overvalued levels. Others are likely trading at discounted levels. And, like Goldilocks, many trade just right where they should be. But on average there’s been no change to the whole index. A portfolio manager’s job is to sift through the individual investment opportunities and make some changes to specific companies in a portfolio. Some might be sold or reduced, others might be bought, but most will probably be held.

For example, let’s examine a company we’ve recently been buying, which, for compliance purposes, we’ll call XYZ Company. XYZ is a high- quality, best-in-class industrial growth company. We feel its management is terrific. They have no debt and pay a 2.7 percent dividend yield. On the surface, this company’s products are not too exciting. Again, for compliance purposes, let’s say they supply everyday tools and supplies to manufacturers and the construction industry, the types of things you and I would buy at a home improvement store.

But because they are so well managed and are a dominant player in their businesses, we expect XYZ Company’s earnings to grow about 15 percent over the next few years. This company is rarely ever cheap. But over the past two or three years, the stock has gone down in value about 10 percent. In that same time period, the “average” S&P 500 stock has gone up 40 percent. During that time, sales, earnings and cash flows at XYZ have continued to grow handsomely. We find value in such a situation and have, therefore, been adding XYZ to portfolios, exactly as we always do.

“Our principled discipline suggests we don’t believe earning nothing in cash is a good long-term strategy.”

What about bonds? Isn’t the Federal Reserve (Fed) expected to raise interest rates soon? The simple answer is yes, rates will likely rise in the not- too-distant future. So if rates are likely to rise, wouldn’t it be okay to simply stay in cash and earn next to nothing? Our principled discipline suggests we don’t believe earning nothing in cash is a good long-term strategy. Here’s our thinking.

When it comes to fixed income assets, there is generally a trade-off between returns and maturity. If one invests longer, then expected returns are generally higher. But longer maturities also imply greater risks when interest rates rise. So, when analyzing returns in the bond market, we prefer to compare returns between one asset and another. For example, as of this writing, we know we can only get a 0.6 percent annual return from  a two-year Treasury. But the one-year CD only gives us a 0.1 percent return. At this point, we’d prefer the Treasury to the CD over the next two years.

Yet if interest rates rise, won’t we find short-term CD rates higher too? The answer is yes. But over the next year, the Treasury will have returned 0.5 percent more than the CD. And CD interest rates would have to be a lot higher in the second year to make up for that difference.

So in the area of bonds, we must consider alternative investments and opportunity costs of one purchase versus another. Also, because bonds usually constitute the stable part of our portfolio, we look at any credit risks in the bonds we buy.

“... when analyzing returns in the bond market, we prefer to compare returns between one asset and another.”

In our simple example, we feel we take less risk in owning the two-year Treasury than the one-year CD. The Treasury is extremely liquid if we need to sell it, and the credit rating of the U.S. government is very high. In fact, the insurance behind bank CDs is the U.S. government itself. Plus, CDs often come with early withdrawal penalties. So overall, we feel very comfortable getting a somewhat higher return from the Treasury than we do from the CD even though the maturity is longer.

So, in answer to our question above, we’re doing exactly what we always do. The only thing that’s changed in the last six months is the short-term results. But we are principled, disciplined, long-term investors who feel we will be rewarded over the coming years by making the same sound investment decisions we always have.


Download Article: An Unchanged StockMarket and Low Interest Rates: What’s a Portfolio Manager to Do?

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