by Tom Bradley
Our team came in on Monday morning to a longish email on our strategy and recent investment moves. It was suggested that I publish it for clients to read, so here is a slightly gussied up version.
Since Scott posted The Grind on October 25, the markets have continued to be volatile. My observation is that the declines have been broad but uneven. A few stocks have held up (or even gone up on good news), but most are down and some have got crushed.
The credit markets (corporate bonds) have also been uneven and at times, downright perplexing. The normal pattern of events has been warped by the demand for yield product. For instance, low quality bonds (CCC-rated) have held up better than higher quality ones (BBB-rated) due to a shortage of high yield product. That almost never happens. Meanwhile, some emerging market bonds are up for the year while others have been eviscerated (Brazil, Turkey).
Embedded in our strategy is the assumption that stock prices overreact to short-term news. There are lots of things to be concerned about, which I won’t list here, but their impact on the long-term value of our companies will be minimal. Therefore, weak and emotional markets are an opportunity for us to add value for our clients.
Given that we never know where things are going, we generally want to keep some powder dry. What I mean is, we don’t want to use up all our cash reserve immediately such that we can’t do the right thing (i.e. buy) a year from now if markets are even lower. This applies on three levels: (1) our managers in the funds, (2) Salman and I managing the Founders Fund and (3) our Investor Specialists advising clients.
So far, we’ve been sticking to our well-worn playbook. In the commentary below, I’m referring to the Founders Fund (FF), which was light on stocks and heavy on cash entering the correction.
Managers buying: Our fund managers are taking advantage of lower prices by adding to existing holdings and initiating new ones. A few examples of recent purchases include Marathon Petroleum and Sika in the Equity Fund, and CGG in the Global Fund.
Rebalancing: After the initial price declines last month, we did some buying in the FF to maintain the equity weighting (54-55%). In addition to allocating client inflows to the equity funds, we twice deployed some of our cash reserve, each time on a day when the market was down.
"Go up with more than you went down with": We’ve continued to buy in recent days, but the goal has been different. Last week we took the first steps towards increasing the equity weighting in the Founders Fund. Our rationale is as follows:
We don’t know how low markets will go, or even if they’ll go any lower.
- As always, we’re happy to take the lead from our managers. They’ve been buying.
- As long-term valuations normalize, so should our equity allocation. A key metric that we monitor, the Valueline P/E multiple (an aggregate price-to-earnings multiple for 1,700 stocks), has fallen materially and is now closer to its long-term average (the most recent reading was 16.8 times, down from 20-21 early in the year). This decline is the result of two things: (1) stock price declines and (2) much better earnings (with the help of tax cuts in the U.S.).
- Unfortunately, profits (the E in P/E) are still sky high, which means we’re paying average multiples (historically) for cyclically-high earnings. Not ideal, but better than it was.
Approximately right: As I’ve said many times, long, strong economic and market cycles don’t end with a modest, harmless correction. As such, it would be nice to keep the FF cautiously positioned and try to be heroes (i.e. if the market tumble further), but it’s hard to justify having a below-normal equity weighting when valuations are close to normal. Remember: We only want to deviate from our SAM (strategic asset mix) when conditions are extreme enough to warrant it.
Fixed income still unattractive: Speaking of extremes, we’re staying light on bonds because the fixed income markets have not corrected like the equity markets. Interest rates are up a bit in Canada but are still running well below U.S. levels and slightly below inflation. Credit spreads (the extra yield for owning a riskier bond) have widened but are still on the narrow side. And in the high yield and levered loan areas, it’s been silly. Buyers are falling all over themselves to lend money with few if any conditions.
In summary, in the FF we’re working from a position of strength. We’re starting to use the large cash reserve to buy stocks. At this stage, we’re moving deliberately and only buying on down days.
Chris (Stephenson) has said it many times: "This is when we differentiate ourselves and have the biggest impact on client outcomes." I say, right on! Job one is helping clients stay calm and stick to their plan.
We also want our clients to take advantage of the market weakness. Our fund managers are doing most of the work in this regard, but I can think of a few situations where our clients need to act too.
Waiting on the sidelines: We have a number of prospective clients (and some clients) who are largely out of the market (or significantly underinvested). It’s time they got started. The correction has been meaningful enough and they have a lot of buying to do. As Bob Hager said, "Weak markets are not a time for precision."
People averaging into the market: For clients who are dollar-cost-averaging into the market, it’s important that they stick to their schedule. With markets bouncing around, it’s easy to find excuses to delay or abandon the plan. But this market is exactly why they’re dollar-cost-averaging — i.e. to take advantage of lower prices.
Falling markets are never easy to watch but are part of investing. If you’ve got any questions or concerns about the recent declines or your account, don’t hesitate to reach out to us at 1-888-888-3147.1
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