Submitted by Delta Asset Management on October 20th, 2017
Submitted by Delta Asset Management on July 19th, 2017
“If you are more likely to purchase stocks during periods when the market is rising or tend to sell out of positions during periods of market pessimism, you are probably speculating excessively. The emotional urge to trade based upon the direction of the market has nothing to do with investing or attempting to ascertain the underlying value of a common stock.” - Benjamin Graham
One of the most significant developments in the investment markets in the last 20 years has been the growth of indexed-based investing and the move to passive fund management. Passive investing has grown in popularity among investors, and the recent rise in exchange-traded funds (ETFs) has accelerated the trend. Passive investments now account for 28.5% of assets under management in the U.S. Mutual funds, which track an index, have grown six-fold over the last 17 years while the assets of ETFs have grown 130-fold.
The rapid growth of passive investing warrants greater study of its impact on financial markets, particularly in a downturn or bear market. A recurring argument against indexing is that aggregate or mass movement of funds in and out of the S&P 500, the most commonly followed index, could cause concentration risk, higher price correlation and reduced benefits of diversification. Equity indices weight the stocks they contain by market capitalization. As a result, a few larger companies (such as Alphabet, Amazon, Apple and Facebook) dominate and skew the performance of benchmarks. This weighting effect can be seen when comparing the S&P 500 Index with an equal-weighted S&P index, which removes the large capitalization bias. Year to date, the market cap weighted S&P 500 is up 11.3%, while the equal-weighted index is up 8.1% (as of 8/31/17).
In the pre-passive investing era, a sell-off would entail investors reducing their separate stock positions. Individual investors would own different portfolios of individual stocks and sell different stocks contained in their portfolios, depending on their particular investment parameters. Some stocks would sell off more than others. Conversely in a rising market, there would be uneven performers as some stocks performed better based on the preferences of individual investors.
Contrast this behavior with the new phenomenon of a market with substantial passive investment exposure. A reasonable question is: What is the effect on the value of passive investment vehicles (index funds, ETFs) if a sizable percentage of the total U.S. market moved in lockstep during a rising or falling market? Substantial buying or selling of the same stocks at the same time could exert greater upward or downward pressure on prices, exacerbating highs and lows.
Active management is not exclusively about finding opportunities that translate into outperformance; it is also about managing the downside risk during periods of higher market volatility.
Furthermore, passive investment vehicles, such as index funds, do not consider valuation when buying or selling. With a large number of investment decisions on autopilot, more and more money will be invested with funds whose value is largely independent of factors that have traditionally guided investors, such as profitability, efficiency, competitive threats, management performance, growth potential and broader economic conditions. Passive investment products do not distinguish between the good and the bad. They invest in all of the stocks comprising the index, irrespective of any views about value or quality.
Submitted by Delta Asset Management on April 7th, 2017
There is a strongly held perception that Wall Street’s analysts tend to call a stock a “strong buy” when its price and earnings are high and to label it a “sell” after its price and earnings have fallen. Many investors also tend to follow the momentum of the market, wanting to invest when the market is rising and sell when the market is falling. Such investors and even some sophisticated stock analysts confuse the high earnings during favorable economic times with the average earnings power of the company. Investments purchased at peak earnings or at high multiples often do not offer an adequate margin of safety or long-term rate of return.
Value investing is conceptually easy to grasp but a difficult discipline to practice as it runs contrary to a herd mentality.
Margin of safety is a fundamental principle of value investing, which states that an investor will purchase a stock if it is priced below its intrinsic value. Intrinsic value is the economic value of a company based on its long-term earnings power. The difference between the purchase price and the intrinsic value is the margin of safety. The greater the difference, the larger the margin of safety that provides an extra cushion in the event of future pressure on earnings from a myriad of factors (economic, market or company specific). Prices fluctuate more than intrinsic value, meaning opportunities exist to take advantage of irrational pricing and market psychology.
The purpose of margin of safety is not just to preserve the initial capital investment, but to improve upon it. When a stock is purchased below its fair or intrinsic value, the expectation is that in some future time period the stock price will converge with its fair value in a rational market. If the growth expectations end up being correct, an investor who has bought at the discounted price will ultimately earn a superior rate of return.
Our First Quarter Letter noted that the current bull market celebrated its eighth anniversary on March 9, 2017. Value investing and margin of safety concepts are not so attractive in rising markets. The essence of value investing is finding a veritable bargain, which can be difficult in an aged bull market. As we’ve mentioned before, value investing is conceptually easy to grasp but difficult to practice as it runs contrary to a herd mentality. It entails researching investment options in depth, usually to discover the stock is fairly priced even though it shows some value attributes. It requires patience and a willingness not to participate in market momentum or a particular sector fad. It also requires fortitude to invest “in the foulest of weather.” Purchasing stocks in a declining market without knowing the bottom can be challenging. Stocks tend to trade at their greatest margin of safety during negative economic periods when investors are overly pessimistic.
Submitted by Delta Asset Management on February 6th, 2017
The current bull market celebrated its eighth anniversary on March 9, 2017. Since it began in the aftermath of the “Great Recession,” the Standard & Poor’s 500 benchmark index has gained 249%. While there are some pundits who point to evidences of a bubble, particularly after the post-election rally, other signs point to a global economy that’s been picking up steam fueled by promises of corporate tax cuts and a fiscal spending boost.
How does this bull market compare to those of the past? As bull markets go, this one is neither the best performer nor the longest. The dot-com bull market of 1990 to 2000 is the longest on record and is also the best-performing with a 417% gain. In the area of valuation, the current bull market comes in second to the dot-com bubble, though it’s getting close. The S&P 500 was trading at a multiple of 30 times earnings when the dot-com bubble popped in 2000.
Long-term investing, however, puts the spotlight on what really matters – the growth of economic value and competitive advantages of a business.
Stock market rallies and declines are usually precipitated by a dramatic change in outlook for future profits. Before November 8, Wall Street seemed comfortable with the status quo represented by the anticipated election of Hillary Clinton. On election night, the Dow futures plunged 800 points when Donald Trump’s upset became apparent. The consensus was that the stock market would drop dramatically in the event of a Trump victory. However, it did not take long for the stock market to rapidly adjust to the reality of a Trump administration and economic policies, which were in some cases quite different from either party.
The post-election rally has been driven by a number of assessments (lower taxes, infrastructure spending and deregulation) on the economic front that was broadly interpreted as positive. This bellwether election represents the first time since Dwight Eisenhower was elected in 1952 that a Republican president will enter office with GOP majorities in both the House and the Senate.
We feel there is greater value in focusing on individual companies and their economic merit as opposed to macro factors such as monetary and or fiscal policy, which are constantly in flux and give the stock market its overall random nature.