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Walking on thin ice

Market Summary – 3rd Quarter, 2014

Here in the land of 10,000 lakes (we actually have 11,842), most of us are familiar with walking on the ice of frozen lakes. When we voyage out onto ice-covered lakes in the middle of winter our faces will become wind chapped, and our fingers and toes will turn numb. At these times we are unquestionably uncomfortable, but also assuredly safe. The ice is thick and the foundation that we stand upon is sturdy. It isn’t unlike what investors go through from time-to-time – the conditions surrounding us may make us uncomfortable but the mind is secure if we know our investments are rooted in a sound, fundamental foundation.

q314 cartoonThe October swoon in the markets has many investors wondering if we are standing on the precipice of a minor hiccup or a larger correction. Until recently the markets had been steadily marching higher. Heading into the 4th quarter, the S&P 500 Index has enjoyed its 4th longest stretch without a 10% correction dating back to 1929. However, recently the markets have been in retreat due to a deluge of negative macroeconomic headlines. These include rising concerns about the impact of the Ebola epidemic, growing tensions in the Middle East focused in large part on the emergence of ISIS, continued signs of economic weakness in Europe, and a dramatic fall in oil prices. These concerns are real, but the collective risk to the financial markets pales in comparison to the 17% sell-off that we saw towards the end of the summer of 2011 when the world was questioning the future of the Eurozone, the aftershocks caused by the potential collapse of banks in southern Europe, and the possibility of the United States government defaulting on its debt obligations. There is never a shortage of bad news.

Today, as markets are again highly sensitive to headline news, many have retreated into perceived “safe haven” investments. These include bonds, utility stocks and other bond proxies, as well as an assortment of various passive index funds. These assets have been favored by risk-averse investors dating back to the 2007-2008 financial crisis, and their growing popularity has led to increased demand and thereby higher prices. But temporary price stability should never be mistaken for safety. The foundation for these perceived safe-haven assets is weak because the valuations are no longer sound. Those that have found comfort in these latest manias and fads will soon realize that they are standing on thin ice.

Investors today have become obsessed with indices and short-term performance. Unable to withstand the hourly gyrations of a volatile market, many now seek comfort in conformity by aspiring to simply match the market. Passive investing is easy and cheap – it requires no homework, no research on individual stocks, and no judgment. Investors are just hitching a ride on an index and expecting it to go higher. This style of investing that pays no regard to underlying fundamental value is rooted in classic bubble psychology.

Passive investing has become a self-fulfilling prophecy

Indexing strategies show no concern for individual company valuation, risk, or opportunity. The only factor driving portfolio composition is the relative size of a company’s stock within the index. Price appreciation becomes a self-fulfilling prophecy as momentum – not fundamentals – drives prices higher . . . until it doesn’t.

This is due in large part to the regular rebalancing that takes place within index funds. The stocks that have increased the most are now a bigger part of the index, so the index fund must now buy more of them. Conversely, the stocks that fell the most are sold the most heavily by the index fund. This is irrational and in opposition to the investing truism of “buy low/sell high”. It is classic bubble-psychology, and demonstrative of the madness of crowds.

The risk of indexing is particularly pronounced within the S&P 500 Index, which is a market-weighted index. In other words, all 500 stocks are not treated equally when index performance is calculated. The larger a company’s market capitalization (the total market value of all shares outstanding), the more impact it has on the calculation of index performance. As the S&P 500 has climbed in value, passive index investors have become more exposed to the “mega-cap” stocks that dominate the index’s market weightings. This imbalance has swelled to the point that it is excessive and dangerous. Consider that today the 20 largest stocks in the S&P 500 (just 4% of stocks in the index) represent 28%2 of the weight of the index. Therefore, the price changes of any of those 20 stocks can have an outsized influence on the index investors’ portfolio.

Traditionally the financial markets served as a price-discovery tool for stocks of individual companies. This was achieved through active managers exercising independent judgment rooted in fundamental analysis. It served as a self-correcting mechanism when prices of individual stocks become too high or too low. The collective opinion of these independent active managers, through buy and sell orders, established the value of a company’s stock. That price typically reflects the value of a business, which is based upon its ability to generate and grow profits over time. If a business’ stock price falls below what an active manager believes to be its fair value, the manager(s) would buy the undervalued stock. Over time this process stabilizes the system.

By contrast, passive investing is solely concerned with a company’s representation in an index. Fundamental value isn’t even an afterthought. When the price of a stock falls more than the market, the index sells it without consideration of value. These passive investors are failing to appreciate that price declines in the stocks of good companies present a great buying opportunity – the lower the price, the lower the risk!

Yet many investors have become captivated by passive index strategies. As the following chart shows, there has been a tremendous outflow of money from active managers into passive investment vehicles. In a market dominated by passive investment styles, the self-correcting mechanism built upon an assessment of fundamental value is largely absent . . . at least temporarily. The incredible influx of funds into passive investment vehicles is magnifying the troublesome excesses of the market, creating both great risk and great opportunity. In other words – there are lot more people now standing on thin ice – exacerbating the risks of passive index strategies.

Cumulative flows to and net share issuance of domestic equity  mutual funds and ETFs, billions of dollars; monthly, 2007-2013

The S&P 500 Index is not the “market,” especially in 2014

Headline numbers can be deceiving, and the total return generated by the S&P 500 through September 30, 2014 is a prime example. While the index was up by 8.3%, the average stock within the index was down approximately 7% from its 52-week high during this period3. As you dive deeper into the universe of stocks, things look even worse. 79% of stocks in the Russell 3000 Index (covering 3,000 stocks across all market capitalizations) are down 10% or more from their highs, according to data compiled by Bloomberg4.

As we described earlier, and as a consequence of the massive flow of funds into passive index strategies, the S&P 500 Index no longer reflects the overall market. Stocks in the S&P 500 are considered among the largest in the U.S. market. But there are other quality stocks of smaller size represented in other indices. The following table demonstrates how the S&P 500 is failing to capture the state of the market:

Consequences of following the crowd

To those passive investors whose only wish is for market-like returns…be careful what you wish for. Investors cannot continue to blindly embrace these passive investment tactics and expect a positive outcome. Consider that investors who bought into a Dow Jones Industrial Average index in 1965 needed nearly 17 years to make their money back. Those that purchased a NASDAQ index fund at its peak in 2000 still haven’t broken even nearly 15 years later. And investors in an S&P 500 Index vehicle in 2000 lost more than 45% from peak to trough; it would take 13 years for them to see their investment fully recover. At the same time, great wealth was created by skilled active managers who were able not only to find attractive opportunities, but more importantly, to avoid investment disasters.

Today, too many investors have too much money sitting in the wrong part of the market. As noted, a large group of stocks that are unrepresented or underrepresented in the S&P 500 have already gone through a significant correction. Many of these stocks offer superior value, particularly in a time of significant volatility.

As water seeks its own level, so do valuations in the market. The short-term positive feedback cycle (or self-fulfilling prophecy) caused by passive investors chasing the momentum of stocks will ultimately break down. What was once popular will again become unpopular, and passive investors will be taught the time-honored principal that price (not size) is everything.

Value is the best defense in all markets

We maintain that building great wealth is more about avoiding large losses than it is about chasing gains. A portfolio that loses 30% needs more than a 30% return the next year to break even – it needs a 43% return. An active, value-oriented investment approach is designed to take as much risk as possible out of the investment process. Investing in a business at a fair price should mitigate much of the risk of falling through thin ice and suffering great loss of wealth that may be difficult to recover. While there may be times of uncomfortable volatility, value investors’ capital is ultimately safer! The ability to avoid losses enables investors to continue to invest prudently, and own stocks of high quality businesses that compound over time at reasonable rates of return. This is how great wealth is created.

Whether walking on a frozen lake on a blustery, cold January day or investing in unloved and unpopular stocks, the feeling can be extremely uncomfortable. These overlooked companies can exhibit higher volatility, and can be poor performers over the short-term. However, these seemingly adverse conditions lead to both long-term protection and opportunity. Patient, value-oriented investors also know that if the fundamentals of stocks they own are sound, the market will eventually recognize their true value. Investing in misunderstood, unloved and inexpensive businesses serves a dual purpose; it protects you from the worst of the declines that occur when, like today’s passive investors, you pay too much for an investment. Equally important, it leaves room for significant upside potential that will build great wealth over time.

~MPMG

Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted.

The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.