I’ve got three teenage children, so I’m used to hearing excuses. I think often of the old management cliche, “Don’t bring me problems, bring me solutions.” It is a principle I am trying hard to communicate to my offspring. The specific presentation varies by kid. My usual phrase to my oldest, a boy age 16: “Don’t use your intelligence to construct a persuasive excuse. Use it to find a way to get it done.”
It occurred to me that this principle has application to an issue that has appeared often in this blog in recent months, which is the arguments for and the implications of a secular low-return investment environment.
We recently parted ways with a long-term client. He was referred to us in his late 40s, when he was just starting his career in a new profession, and very concerned that he would never be able to accumulate enough wealth for a secure retirement. We put together a strategy for him, which worked. Over fifteen years, from a near standing start, he accumulated almost $2 million of net worth.
Then it was time to retire, and he left our practice. The biggest reason was our projection that future investment returns will be low, in the 4% per year range. He reasoned that 4% returns would not support his intended spending level, so he needed an adviser who would project higher returns.
In reality, projections of returns have no impact on actual returns, except insofar as they inform portfolio allocations. Back in 1999, at the peak of the tech-bubble, when markets were the most expensive in history, we projected 4% returns going forward. Most of our peers projected returns north of 12%, and stayed heavily committed to tech. Our clients made money when tech collapsed, while the clients of many of our over-optimistic peers lost money, 80% or more in the cases of those who bought heavily into the tech story.
But my now ex-client has alerted me to an issue I’ve not addressed well. We are concerned that current valuations suggest low long-term returns going forward. I am confident we will be right — in the long term. In the short run, it is entirely possible the U. S. stock market will be up 30% next year — or down by a similar amount. We believe we have robust mechanisms to understand the long-term potential of financial markets, and we cheerfully acknowledge we haven’t a clue what will happen next week.
Yet, as I’ve made clear in recent months, those long-term returns trouble me. We believe our central mission, on behalf of our clients, is to “get their (stuff) done.” Not to talk about it. To help them succeed, in a practical, dollars-and-cents way, regardless of the market context.
So what are we doing to “get it done?” I have mentioned our recent increase in baseline cash, intended to provide dry powder for buying in the event of a market decline. But this is only one component of a range of strategies we are pursuing to address this problem of low returns.
We are part of a monthly study group that meets in our conference room for dinner and discussion. The membership includes a spectrum of smart folks from various investment firms, including a senior pension executive for a Fortune 500 company, value equity managers, stock analysts, a mergers-and-acquisitions consultant, and an institutional salesman. This group has been a wonderful resource in helping us to clarify our thinking and improve our strategies. Our last few meetings have focused on this issue of low returns. Last week, we presented some ideas about how we might improve returns, in the context of our DYCOPS portfolio strategy. The discussion was lively, and as usual we ended the evening with a list of practical questions needing future research.
Briefly, here is what we are thinking. Our portfolio strategy varies ownership of paired asset classes (stocks vs. bonds, bonds vs. real estate securities, U. S. vs. foreign stocks, growth vs. value managers, and so on), according to relative values. Our methodology has been quite successful at identifying actionable valuation anomalies, and then over-weighting under-priced asset classes, thereby enhancing long-term returns at the margins. Over fifteen years, our analysis suggests a representative client portfolio at a Moderate Risk level has realized about a 1.4% per year advantage net of fees. That return advantage was not constant, but highly episodic, and concentrated during the tech crash of the early 2000s.
If we’ve gotten the asset allocation right, why have we reaped such small advantage? It appears the answer may be the degree of constraint we impose on our portfolios. Consider that same Moderate Risk portfolio, with a baseline stock allocation of 58%. In late 1999, with the U. S. stock market trading at 40 times trailing ten-year earnings, we cut that stock allocation all the way down to…50%. In early 2009, with the U. S. stock market trading at only 10 times trailing earnings, placing stocks at the lowest price relative to bonds since 1953, we increased our stock holdings all the way up to…68%.
These were among the largest relative-valuation anomalies in the modern history of the financial markets, and our response was a less-than-10% move in the core holding in our portfolio, common stocks.
Why not a bigger move? If we had made a larger bet, what might we have earned? At what cost? We are investigating all of those questions, using the most detailed and specific attribution analysis we have ever performed. Our aim is to quantify the potential economic benefits and costs of a less-constrained strategy.
The point of what has turned into a much longer than usual blog post is this — we are confident in our perspective on valuations. We got it right in 1999 and in 2008-09, when most of our peers got it wrong. Our clients benefited. We are guardedly optimistic that we have it right again today, and that returns will be lower than we like in future.
We know that is a problem. Over the next few months, I intend to have some significant thoughts to offer about possible solutions to the problem of low returns.