In this article, we discuss the long-term advantages of being a style agnostic manager.
The investment management industry tends to assign labels to firms, placing them in various “style boxes.” Firm A may be a “growth manager” while firm B is a “value manager.” These various style boxes perform well during certain periods when their “style” is in favor and perform poorly when their “style” is out of favor. Styles can and do move in and out of favor due to the economic environment, interest rates, or inflation.
During an environment when the economy is bottoming, economically sensitive, cyclical, and value-type investments tend to outperform. Meanwhile when economic growth is slow, and interest rates are low, growth companies and higher yielding investments tend to outperform. If the U.S. dollar is strong, natural resources, foreign equities, and value managers will likely underperform. With all of these variables, it is easy to see how managers in different style boxes move in and out of favor based on changing market and economic conditions.
Osborne Partners is style agnostic. We feel a successful long-term management style should not dramatically shift in and out of favor. One of the main reasons investors consistently underperform markets is because they have a tendency to chase returns. Individual investors and many professional investment managers invest in the strategies that are outperforming at the moment, shifting from style to style depending on which one is in favor. The downside to this strategy is that styles tend to look best when their performance is peaking.
At times, our portfolio is heavily growth oriented (2009-2017 for example), while other times we find superior risk/rewards in economically sensitive, cyclical areas (2020 for example). Let’s review some of the ways we subtly shift our allocation within the global equities asset classes – both domestic and foreign, along with real estate, natural resources, and fixed income. I will also describe our thought process behind these shifts. Then we will comment on some of the potential dangers ahead for passive buy-and-hold index investing.
Global Equities: Generally, the investment team starts with a baseline of a 50%/50% allocation between domestic and foreign equities. From there we use a number of macro and micro factors to first decide the allocation between the U.S. and foreign. Over the past twenty years, we have ranged from 55% to 90% domestic equities (between 10%-45% foreign equities). We generally use all individual securities for domestic equities – avoiding mutual funds and outside managers. For investments outside the U.S., we focus primarily on countries and sectors. What are the macro and micro factors we analyze?
To decide the allocation between domestic and foreign equities, we look at forward valuation versus expected forward earnings to isolate the superior return-to-risk ratio. Additionally, we evaluate the probable direction of the U.S. dollar, U.S. and global monetary policies, and interest rate differentials between regions in making our final decision. For example, here is a chart showing the relationship between foreign equities and the U.S. dollar.
We next shift our focus to the micro factors that are more country, sector, and company specific to build out the asset classes. Within the individual positions, the U.S. equity holdings may have a growth or value bias depending on where we are finding the best return-to-risk ratio. For example, we are far more interested in an investment with 40% upside and 20% downside versus 100% upside and 50% downside – risk reduction is a key priority throughout the portfolio even though our goal is to grow the portfolio. More recently, our domestic-to-foreign ratio has started shifting toward foreign, while within our U.S. equity allocation, we are seeing a better return-to-risk profile in more economically sensitive, cyclical, “value” investments. Again, flexibility is a key part of the Osborne Partners strategy since the U.S. does not always outperform the rest of the world, and growth does not always outperform value. We will never trap ourselves in a particular style box. We consistently shift to where we are finding investments with the best return-to-risk ratio.
Real Estate: Our investment team views the real estate asset class as containing three segments – global REITs, residential homebuilders, and commercial real estate brokers. We have two main decisions to make at all times. First, what percentage allocation should our portfolios own in the real estate asset class, and second, what is the proper weighting of each of the three segments. In this asset class, we of course examine the present and future economy. Specific to the asset class, we analyze the quality of dividends, cap rates (return or yield on the real estate investment), the spread between REITs and bond yields, along with the potential direction of interest rates.
As an example, coming into 2020, we had the lowest exposure to the real estate asset class since 2007. Between the three segments, our exposure could be summarized as “low, low, and no.” Low exposure to REITs because cap rates were very low, and the economy was strengthening, probably causing interest rates to rise. Homebuilders were relatively expensive with the expectations of a solid 2020 selling season. We had zero exposure to commercial brokers, believing the future rent increases would be tame, along with a poor return-to-risk setup. Once the pandemic hit, interest rates plummeted, the Fed made it clear rates would be kept low for a long period, while valuation and sentiment cratered. With most REITs and homebuilders down 40-50% by March, we felt a handful of REITs represented exceptional values without exceptional business risk.
Additionally, homebuilders had never traded at such a steep discount to their book values with so many fundamental variables as tailwinds – record low interest rates, low inventory, high land option positions. So obviously, our discipline is different than buying a single REIT index and passively holding it through all environments.
Natural Resources: We believe this is another asset class that requires and benefits from active management. The varying segments of natural resources such as hard commodities, soft commodities, and energy see wildly different returns at times, while the asset class as a whole has long periods of outperformance, followed by long periods of underperformance. As a team, we analyze whether the asset class is in a boom, bust, or neutral period. We also examine the global economy, the supply and demand of individual commodities, and the currency situation since a weak dollar tends to help the asset class.
To us, this asset class requires patience and the flexibility to increase and decrease holdings when macro factors like currency valuations or economic growth change. We have been underweight this asset class for a number of years, but recently felt a few commodities possessed the ideal combination of low supply, improving demand, and a potentially weak U.S. dollar to warrant an investment. Copper is an excellent example of a commodity that we believe meets these criteria.
Passive Buy and Hold Investing in today’s environment: Passive buy and hold investing can be an excellent solution for some investors in some environments. However, today’s environment may cause this style to have a lower probability of success in the future. Why?
Since the global financial crisis that ended in 2009, we have witnessed an unprecedented period of record low interest rates, and an economy that has run into a wall every time growth begins to expand – the 2011 recession outside the U.S., the 2015 profits recession, the 2018-2019 trade war, and the 2020 global pandemic. Each time interest rates were pushed lower, causing investors to bid up higher yielding and defensive sectors like utilities, consumer staples, and telecom services. Additionally, every time economic growth was stunted, growth equities were bid up. This past decade has left a number of indices from the S&P 500 to the Nasdaq 100 to the Russell 1000® Growth and Value with extreme concentrations – concentrations that have dramatically reduced the widely touted benefit of diversification that these indices historically enjoyed. This will be dangerous in the future.
Today when an investor buys the Nasdaq 100 for “diversification,” they shockingly own three companies that comprise 35% of the index. In fact, seven companies comprise 50% of the index, while the other 93 companies are 50%. From a sector diversity standpoint, the technology sector plus Amazon equals 75% of the index (Amazon is classified as a consumer discretionary company). Finally, from a valuation standpoint, the index trades at 31x next-12-month earnings, nearly 18x EV-to-EBITDA, and approaching 5x EV-to-sales – all of these metrics are at the highest point since the Nasdaq imploded in 2000.
The S&P 500 is not very diverse either – the five largest holdings represent 25% of the index. Those five are close to the same size as the bottom 400 holdings – not the definition of diverse. Additionally, as shown below, the S&P 500 is now comprised of 78% growth and defensive stocks – an all-time record, including the 2000 internet bubble.
What about the investor or firm who says, “I’ll simply shift the portfolio back and forth between the growth index and the value index”? In previous decades, that was an optional way to manage a portfolio and own a diverse set of holdings in a diverse number of asset classes. This no longer exists. If an investor owns the most popular growth index, the Russell 1000® Growth, they own the following:
· 60% in technology plus Amazon.
· Five companies that total 44% of the index, with the other 995 holdings comprising 56%.
· 95% large capitalization companies.
· Valuation of 32x next-12-month earnings versus a long-term average of 18.5x.
The Russell 1000® Value Index may be more diverse, but due to over a decade of low interest rates, over 30% of the entire the index is invested in low growth, higher dividend paying companies that now trade at extreme valuations. These are sectors like utilities, consumer staples, telecom service, and pharmaceuticals that are growing earnings at long-term growth rates of 0-5% per year, while trading at valuation multiples well above their long-term averages.
We believe by managing portfolios comprised of multiple asset classes, clients achieve diversity and reduce risk. By using almost entirely individual securities and avoiding mutual funds and outside managers, clients’ total fees are reduced and their portfolio is managed in a more tax efficient manor. By actively managing the portfolio, we can subtly shift the portfolio between styles and asset classes without the fear of dramatically underperforming because our focused style is out of favor due to the present economy. Combine all of these, and it is easy to understand why we have been active and style agnostic for decades.