Growth vs. Value

Part of our daily research includes reviewing financial news that may impact our firm’s investment strategy. We recently came across an interesting article discussing the current disparity in relative valuation of growth stocks compared with value stocks (the link to the article can be found below). “Value” stocks are generally considered to be lower P/E, lower growth, higher-dividend paying stocks, while “growth” stocks are generally considered to be higher P/E, faster-growing companies that pay little or no dividend. The article notes that valuations for growth stocks are now quite low relative to historic relationship to value stocks (this is also supported by work from some of our other research sources).

So what’s the big deal about the valuation disparity of growth vs. value? Answer: the disparity may provide a strategic investment opportunity in favor of growth. Over the past several years, many investors have been favoring high-dividend, primarily large-cap stocks for obvious reasons: fear of volatility associated with smaller-cap stocks; an alternative to declining bond yields for those seeking income; reduced risk tolerance on the part of many investors. This has resulted in compression in valuations for growth relative to value and, hence, has led to the valuation disparity.

From a financial planning perspective, we advocate a diversified portfolio approach; we can and do adjust our allocations to growth and value based on relative valuations and relative performance; and we also seek the higher risk-adjusted returns. As an example of this, we recently changed our mid-cap equity exposure in favor of growth vs. value in order to capture what we believed is a valuation disparity noted above. Because mid-cap stocks are larger in market cap and, as a group, pay higher dividends than small cap stocks, favoring mid-cap stocks over small caps offers the benefit of both higher portfolio income and reduced portfolio volatility. At the same time, holding a diversified index of mid-cap growth stocks as part of a larger, well-diversified portfolio helps our clients achieve their long-term goals by capturing the return of this sector (which has significantly outperformed the S&P500 over the past 5 years) and thereby targeting a superior risk-adjusted return.

Link to article: http://finance.yahoo.com/video/sponsored-26302475/growth-stocks-are-a-coiled-spring-says-nuveen-s-mullinix-30110011.html#crsl=%252Fvideo%252Fsponsored-26302475%252Fgrowth-stocks-are-a-coiled-spring-says-nuveen-s-mullinix-30110011.html

How Long ?

There has been a lot of talk in the financial media lately about the notion that stocks may be in an “extended trading range” like that of the 1970s. What that means is the market remains essentially flat for an extended period, perhaps a couple of years or longer, while churning up and down within a wide price range. The case for this view is based on the belief in an extended period of very slow economic growth (or no growth) which results in very slow or no growth in corporate earnings.

One big question being asked now is “how long will this trading range environment last”? It is interesting to note that the market, as measured by the S&P500, has more than doubled since March 2009 bear market low. It has done this in three waves accompanied by some rather unnerving corrections. Corrections are normal for the stock market: the median decline for the stock market in any given year over the past 85 years has been about 13.5%. So pullbacks of 5, 10, or 15% are quite normal and do not mean we are in a “trading range”.

There are a number of reasons to believe the “extended trading range” scenario may be too pessimistic. First, we think there will be tremendous pressure on Congress and the President (whoever that is) to take action in 2013 to address the fiscal cliff issue and place the U.S. on a stronger footing financially. We also expect improved clarity on government policy particularly with respect to health care. These actions would provide companies more confidence in forward planning which should improve the pace of hiring in the U.S. Also, the current financial health of large U.S. companies is a factor working in the economy’s favor because of their ample resources available to accelerate investments and hiring under the right conditions.

Whatever your view on the extended trading range question, the strategy should not change from a financial planning perspective. We believe the current environment still calls for investing in diversified, balanced portfolios of high quality stocks and bonds, favoring equities now, and with adequate geographic diversification to capture faster growth of markets outside the U.S. We would also emphasize the importance of sticking with a sound financial plan. While markets will fluctuate as they always do, sticking with a sound plan will 1) keep you on track relative to your investments; 2) help keep you from the temptation of trying to time the market or make emotionally-based decisions that can sink a plan and an investment portfolio; and 3) provide the peace of mind of knowing you have a roadmap which reduces guesswork, conjecture, and flip-flopping on your investment strategy, all of which adds unnecessary stress to your life.

A New Marshall Plan

How long will it take the Europeans to figure it out? Watching the day to day events coming out of Europe is like the drip of water torture. No wonder the financial markets are facing such day-to-day volatility. It is clear what the Eurozone members need to do and do fast: craft a master bailout plan to 1) backstop the government debt of the PIIGS (Portugal, Ireland, Italy, Greece, Spain) and 2) shore up the capital of the healthiest banks and let the weakest banks go. How could this happen ?

Obviously financial resources of all G-20 countries would be required: $3, $4, $5 trillion?? The current Euro bailout facility of about $1.6 trillion is not adequate. The capital is available amongst the G-20 central banks. The new facility would be a larger reserve that would backstop the debt of the PIIGS as a long-term workout plan is implemented. A comprehensive workout plan, including austerity measures, could serve almost as a second Marshall Plan (the first was implemented to re-build a decimated Europe after World War II). A comprehensive plan like this would go a long way to restore confidence in the capital markets. 

Our belief is the Eurozone members will eventually work out a plan that has some of the elements described above, but timing and structure remain highly uncertain. We believe the Europeans understand the gravity of the situation, but of course, political pressures can affect decision-making, timing, and ultimate outcomes. In the meantime, from a financial planning perspective, we continue to advocate investing in a highly diversified portfolio that provides exposure to global growth opportunities and delivers above average income. Both the diversification aspect and higher income component of the portfolio will help to reduce its volatility while providing opportunity for return in a “trading range” environment. While slower growth may be with us for a while longer, appropriate asset allocation and diversification with a tilt towards higher income will help investors weather this slower growth period and be positioned for improved market conditions, which we expect eventually.

Let’s Get Radical

We’ve noted a number of articles lately about the prospects for rising retirement ages for the baby boomer generation. It’s all over the media these days. Some articles now estimate many boomers may be working well into their 70s. To anyone who has given it much thought recently, this should come as no surprise. The facts are pretty sobering:

§  The Federal Reserve recently reported that the median household headed by a person aged 60 to 62 with a 401(k) account has less than one-quarter of what is needed to maintain its standard of living in retirement.

§  The Fed reported that the median 401(k) plan held only $149,000, according to the Center for Retirement Research, an amount that would be virtually impossible to retire on.

§  AARP recently reported that one in four older workers exhausted all their savings during the recession with a growing number of older Americans facing bankruptcy.

§  Recent studies have estimated Social Security will run out of money by 2033.

This situation has several implications from a financial planning perspective:

1.        It is obvious that extending the retirement age will have to be an option for many Americans and that the notion of an easy life of leisure after age 65 is probably now a pipe dream for many if not a majority of baby boomers (one problem with this: it is unlikely the economy can create enough jobs to support all the boomers who will need one). 

2.        “Radical” notion: traditional asset allocation models may be a thing of the past.  The traditional strategy of transitioning a portfolio to bonds in retirement will not provide the returns necessary to enable retirees to meet their spending goals. People will need more growth investments in retirement, which means holding more equities in retirement than has traditionally been the case. This implies retirees are going to have to stomach greater portfolio volatility which many may find distressing.

3.       Global balance with emphasis on large, quality companies. The not so radical notion from an investment perspective is to increase portfolio emphasis on large, quality, globally diverse companies that can capture growth of faster-growing economies and translate that into higher earnings, dividends, and cash flow for investors.

4.      Increase cash flow from your investments. Cash flow has become a new mantra in the investing world and for good reason: it pays the bills. Creating greater cash flows in portfolios can accomplish several things at once: a) increase spendable income; b) reduce portfolio volatility; c) create a rising income stream through dividend increases.

5.       Another “radical” notion: save more, spend less. Granted, this is easier said than done, but this discipline will have to be embraced given the prospect of lower stock returns and Social Security cutbacks. Without a grasp of what is realistic, the American “dream” is turning into a nightmare for many. With proper planning and renewed saving and spending discipline, many people can achieve a comfortable retirement. But the boomers have always changed the rules, and this generation will probably change the rules that have defined “traditional retirement”.

Europe Again ?

The stock market has taken a bit of a breather during April due to concerns over corporate earnings, moderation in economic growth, and concerns over the potential for a repeat of the last two years in which the market peaked in April. So far this month, corporate earnings have been good with about 80% of reporting companies exceeding analyst forecasts. Also while some recent economic indicators have been a touch softer, it is normal for economic data to modulate throughout a cycle and the data would not portend a new recession or serious slowdown.

The other problem? Investors have begun to fret again over the European financial situation. This started several weeks ago when both Spain and Italy experienced a significant increase in interest rates in issuing sovereign bonds. Spain recently indicated that its fiscal deficit this year would be higher than expected. Greece downgraded its forecast for economic growth. Political developments in France have raised concerns that potentially new leadership there would not be as supportive of austerity regimes in Euro countries.

While investor concerns regarding Europe are warranted, in our opinion, they may be overdone. Let’s look at a few facts:

1)      U.S. combined import/export trade with EU countries is about 4% of U.S. GDP and about 13% of total U.S. import/export trade. These are not levels which have the potential to dramatically impact U.S. growth or drag us into another recession by itself.

2)      The U.S. economy is large, diverse, and resilient enough to generate self-sustaining growth without high levels of demand from Europe.

3)      The U.S. is experiencing rising export demand from developing and emerging economies.

4)      The IMF and World Bank have recently boosted the European financial rescue fund to $1.7 billion (increasing protection for European banks).

5)      Many economists believe Europe could emege from recession by early 2013.

6)      The outlook for corporate earnings in both the U.S. and many developing countries remains positive.

From a financial planning perspective, one of the best ways to insulate against the risk of the European crisis is to properly diversify portfolios by both asset class and by country and industry sectors. Underweighting exposure to the Euro countries is still appropriate, in our view. Overweighting exposure to areas like emerging Asia, Latin America, and the U.S. can provide portfolios adequate exposure to growth. Also, a good financial plan takes into account the fact that there will undoubtedly be good and bad periods for which one can plan. In addition to proper portfolio diversification, tools like Monte Carlo analysis and gaining a deeper understanding of client risk tolerance can increase confidence in a plan during periods of volatility while capturing returns in more attractive market and geographic sectors.

The Income Conundrum

We recently held our first quarter investment committee meeting. From a macro perspective, we continue to believe the near term outlook for interest rates and inflation remains relatively benign. While we believe inflation will eventually accelerate, given continued high unemployment, low wage growth, accommodative Federal Reserve policy, and slack capacity utilization, we believe the prospect for a significant acceleration in inflation is still a ways off.

With respect to equities, we remain generally positive. We see further evidence of improvement for the U.S. economy reflected in recent employment growth, retail sales, consumer confidence, and durable goods orders. Additionally, the U.S. housing market appears to be in a bottoming process and Europe’s recession appears to be milder than expected. Large corporations continue to generate high profit margins and cash flow, which we believe will continue to support capital investment, dividend increases and share buybacks, all positive for U.S. equities. A couple of macro risks that bear watching include the potential for an escalation of the situation in Iran as well as slowing of the economy in China.

An interesting feature of the current environment is the very low yield on bonds. This has created a conundrum from a financial planning perspective for people who have counted on bonds to deliver a steady stream of retirement income. With yields so low for bonds, alternatives to bonds may have to be considered. These alternatives include equity securities such as preferred and utility stocks, high dividend stocks, and high yield bonds, all of which entail higher volatility (risk).

So the question becomes “are we in an environment in which people must take on more risk to achieve their income goals?” Perhaps, but there are ways to improve portfolio income (and growth) without having to take on significantly more risk. How can this be done? In a word, “diversification”. Through diversification a portfolio can be structured that is appropriately allocated with respect to major asset classes (stocks, bonds, real estate, etc.) but that also provides a higher income component through incorporation of higher dividend stocks and higher income alternatives to bonds.  In this way, the potential for higher volatility arising from holding more equity-type investments can be offset by asset class and geographic diversification and by holding a diversity of asset types that have low correlation to each other.

Warren Buffett: Stocks Are The Safest Asset ??

Warren Buffett recently penned an interesting article for Fortune Magazine discussing his thoughts on why stocks present a better long-term opportunity than gold or bonds.  The article was such as gem because it provides great insight into Buffett’s way of thinking about investments. His point in a nutshell is this: the most important element of a sound investment is its ability to enable the owner to maintain long-term purchasing power (i.e., stay ahead of inflation). He also points out that the “risk” of an investment should not be measured by its volatility but rather by the probability that it fails to maintain or increase purchasing power over the expected holding period. This is not the way most people look at investments.

He believes owning stocks of quality, dividend-paying businesses (both public and private) are the best way to achieve the objective of maintaining long-term purchasing power. Gold can’t do this because it does not produce anything, such as a cash dividend. Bonds can’t do it now because of the fixed nature of their cash flows and very low returns currently. Therefore, to Buffett, stocks offer the “safest” investment because they have the highest likelihood of delivering returns that will maintain or increase the owner’s long-term purchasing power.

For financial planners, Buffett’s concept of investing has important implications. One of the most important objectives in planning and investing for clients is maintaining purchasing power over long periods, in many cases, decades. We do this through owning equities (common stocks), just as Buffett points out, because they deliver the elements important in maintaining purchasing power. We also invest in stocks because they are highly liquid and provide flexibility in customizing and fine-tuning portfolio investments and providing adequate diversification. Another important aspect of Buffett’s philosophy is the need to plan and think for the long term. By thinking long-term, as Buffett does, the client has a much-improved chance of achieving his/her financial goals and mitigating the impact of short-term market fluctuations.

We would hasten to point out, however, that as financial planners, we do believe bonds and commodities, such as gold, play an important role. Why? Because these assets have low correlations with stocks and thereby offer the benefits of diversification. By incorporating stocks and bonds together in a diversified portfolio, you can provide the growth necessary for a successful plan, while reducing the volatility of the portfolio.

If you have a chance to read the article, we would highly recommend it. Here is a link to it: http://finance.fortune.cnn.com/2012/02/09/warren-buffett-berkshire-shareholder-letter/

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