September 30, 2020 Commentary
Good news! Fall has arrived. The days are shorter and the nights are cooler. It’ll be nice to sleep with the windows open for the next few weeks, hear the sounds of the neighborhood, and get some fresh crisp air in our lungs. An added bonus, recently discovered: my kids love piles of leaves! Talk about great risk adjusted returns: 10 minutes of effort to rake a pile and then hours of entertainment for the kids, which means quiet for the parents.
Watching the kids sort through the pile reminds me of the year we’ve been having. It’s been a crazy mixed up jumble of headlines: lots of noise and little signal. Trying to make sense of it has been confounding. So, as we sort through what has happened, what is happening and what may happen, we’re reminded that forecasters thought 2020 was going to be a smooth year and how wrong they were.
When we wrote in March, we noted that it only took 23 trading days for the market to fall 34% during the initial Covid-19 panic. Never would we have guessed that, as we write you in September, the market would be fully recovered and is reaching all new highs in only 97 trading days. That’s a greater than 50% return for stocks from their lows. Wow!
Many times, we have pleaded the case that if we are going to invest in the stock market, we must embrace volatility. It is the very fact that the markets fall precipitously at times that allows for equity returns to be higher than the rates earned on savings accounts. Heightened levels of uncertainty are when the best investment opportunities show up. This is because timid and ill-informed investors bail out, leaving significant growth opportunities for those who stay the course. To survive these falls we must prepare ourselves financially, but more importantly we must prepare ourselves both mentally and emotionally.
Doing nothing with intent and purpose is, in fact, doing something.
The patient investors have been rewarded with a “V-Shaped” rebound in asset prices.
The surprising rebound in prices may have been shared by all, but it has not been shared equally. The market seems to be rewarding fast growing tech stocks and discounting mature, stable financial and industrial stocks. There seems to be a clear dichotomy between “Old Economy” businesses and “Internet 2.0” businesses. Since all client’s portfolios are properly diversified, everyone has exposure to both.
Diversification is the friend of the long-term investor. It helps to spread the risk and hopefully deliver better risk adjusted returns. Conversely, diversification is also the bane of the short-term focused market watcher. We advocate all clients take a long-term view, diversify broadly, and act with prudence and patience. (See our blog on Investment Philosophy)
Old Economy vs Internet 2.0 Stock Comparison
So, here we are with the tale of two funds, and remember: Price is what you pay, value is what you get.
A money manager shared across many accounts is Davis Fund Advisers. They are also the sub-adviser on funds such as Selected American and Clipper Fund and they run a suite of active exchange traded funds under the Davis Funds label. In their commentaries, they illustrate the divergence between mature profit-making companies and speculative growth companies. I’ve created my own version below.
The grouping of Old Economy stocks has returned an average of NEGATIVE 12.8% over the last one year whereas the grouping of Internet 2.0 stocks has returned an average of POSITIVE 190.4%. That is a monstrous spread!
Now, the Davis Select Equity ETF (DUSA) owns all of these Old Economy stocks. Fortunately, it’s not the complete portfolio, but owning anything other than glamour stocks has been a drag. On the other hand, a fund we don’t own, ARK Next Generation Internet ETF (ARKW) owns all of these Internet 2.0 stocks and others like them. This funds’ performance has been nothing short of eye-popping. So far in 2020, through September 30th, ARKW is POSITIVE 88.57%. Compare that to Davis’s NEGATIVE 2.44% year-to-date return.
On a relative basis, the basket of Old Economy stocks and DUSA is providing large and positive earnings and an enormous level of mature sales. It looks like a fair deal. Conversely, the Internet 2.0 stocks and ARKW provides neither of these things. It looks extraordinarily overpriced.
What’s missing is another key metric for comparison: sales growth (not shown above). Over the last 1-year the Old Economy stocks have grown their sales a meager 1.1%. The Internet 2.0 stocks have grown their sales a whopping 47.8%. It’s this spectacular sales growth that the market is rewarding.
Therefore, the current stock flavor of the day is rapidly growing, unprofitable, and new internet companies. So, for nearly the exact same price, you could buy a) $277 billion in sales with $22 billion in profits growing at 1.0% or b) $22 billion in sales with -$1 billion in profits growing at 47.8%. Assuming that the high growth rates continue, it will take the Internet 2.0 stocks nearly 7 years to eclipse the Old Economy stocks in sales. It seems the market is expecting this to happen and is pricing it accordingly. Hopefully they make money by then too.
Investment Planning Techniques
It’s up to the investor to choose whether or not they want to pay for potential. But, here’s a tip: In a speculative phase, everyone who is buying overvalued stocks is counting on a greater fool to buy at even higher prices in the future. At some point, the stock market runs out of greater fools.
We’re preparing client portfolios for expected volatility, especially those in or near retirement. Being conservative with your portfolio when retirement planning is one way to protect from risk. That’s because piling into high growth stocks when they are being richly rewarded by the market and experiencing a less-than-temporary price drop can dramatically diminish the chances of having enough cash to make it through retirement.
There are other investment planning techniques too. First, ensure that you have the time necessary to recover from a down cycle in the market. Have enough safe and “liquid” assets free from the vagaries of the market to allow for stock prices to recover from their fall. How much short-term safe money you need is not just dependent on your spending needs, but also on your own “risk” tolerance. For individuals prepared to stay the course, risk is simply not having enough money when you need it. This is a risk you don’t want when living on a fixed income in retirement. This differs from the definition of risk used by institutional investors which is based on short-term market volatility, and that is a very important distinction.
With the market having had an extremely strong rebound, and as we head into the fourth quarter of 2020, we’re weighing the trade-offs of high prices for high growth and fair prices for low growth. How it plays out over the next ten years is anyone’s guess. We’re just reminded of the need to stay diversified since the market can change the flavor of the day on a whim. Perhaps mature companies aren’t being rewarded today but they may be tomorrow.
Adam K. Wright, CFA, CFP®
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