Victory

Where do you want to be invested when faced with the prospect of a bear market? Some say that high dividend yields provide protection when stocks fall. This implies that since the yield rises as the stock price declines, new buyers will be attracted as the price drops. Such buyers could help establish a “floor” below the stock. While this sounds good in theory, we find scant evidence that it actually works in practice. This strategy fails when needed most because “high yielders” tend to be fundamentally weak. While some high-yielding stocks may be good bargains, most high yields reflect…

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Beta, Revisited

With the U.S. stock market near highs, we look at the role “beta” plays in portfolios and why we favor combining “beta” with fundamentals. We find that 1) the pandemic era brought a rise in average “betas”, and 2) that “betas” behave differently based on fundamental quality.

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There is more risk in the world than most people realize, and it is often inadequately measured. Here we look at how we measure risk and how quality can help address both volatility and unwanted surprises.

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Basic Math

Investing is not just about creating high returns but consistent returns. Therefore, we must contemplate how to address risk well in advance of demanding markets. This commentary addresses how some basic math can help explain the value of investing in high quality.

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Easy money policies and rising debt lead us to focus on quality first. In past commentaries, we made a case for owning high-quality firms over low and offer an alternative to “growth and value.” This week, we want to explore how we think about what we pay to own high quality. How We Asses Quality When we say “quality,” we really mean flexibility, resilience, and consistency. To find these characteristics, we test firms for low debt, productive assets, and operating consistency. Each quarter we examine the largest 1,000 U.S. companies along these lines, rank the results, and assign quality grades…

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The gardener must sow seed in fertile ground for a garden to grow. Once planted, young seedlings must be cared for and cultivated. If all goes well, the seed grows into an abundant garden, while also producing the seed and nutrients for next year’s plantings. In this way, the gardener achieves a sustained cycle of growth, and everyone benefits. The same is true for a business. Like a seed, a firm must sow investments in assets that yield a profit if it hopes to grow. Additionally, investments will be subject to risk and unknowns, some will produce profit, and some…

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Illusion and Reality

Our economy grows decade to decade, with corporations capturing an increasing share of global income in the form of profits in recent years. Along the way, low interest rates prompted growth, encouraged risk-taking, and pumped up the value of future profits. It is not surprising, then, that stocks have enjoyed a historic rise, achieving great returns far above other asset classes. Not even a global pandemic was able to short-circuit this wealth creation process. In this week’s commentary, we revisit an old idea — namely that real factors dominate growth and stock returns in the long-run, while illusory factors can…

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Leverage and Quality

It is essential not to overlook critical assumptions. One of the most basic stock investing beliefs is that firms will continue to exist — firms do not live forever. Beginning as a start-up and ending in decline, firms undergo many changes over their lives. An idea becomes a business that generates growing profits and revenue. As a result of sound investing, the company continues to grow, finds new markets, and fends off competitors. At some point, the demand for the firm’s product or service slows, competition erodes advantages, and the business shrinks. In an age of rapid technological change and…

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President Biden signed into law a $1.9 trillion Coronavirus aid package last week. New spending of $1.1 trillion is expected this year, with the remaining $0.8 trillion spread out over the coming years. The spending is on top of last year’s $3 trillion fiscal support program, sets up 15% annual deficits for 2020 and 2021, and increases debt to 110% of GDP.   Why should we care about such spending, especially when the economy is hobbled by COVID-19? Indeed, the package will indeed help many. There are $670 billion in checks and enhanced unemployment benefit checks on the way to…

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Quality First

There is lots of discussion about the return of speculation. Cryptocurrencies, message board short-squeezes, soaring penny stocks, “blank check” companies, and record issuance of risky debt dominate today’s headlines. It is hard to imagine that, just under a year ago, financial markets were in freefall. Greed replaced fear in the span of a few short months, despite an ongoing pandemic. This week we return our focus to “quality” as a key factor in portfolio construction. Risk-On! Notice the chart below. It is a ratio of the most volatile stocks in the S&P 500 divided by the least volatile. When investors…

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Valuations, Revisited

The stock market is on a historic run, with U.S. stocks eclipsing $42 trillion in value for the first time ever last week. The broad market, measured by the S&P 500, continues a decade of strong returns with the rolling 10-year real return for the market above 10% (Chart A, below). Chart AS&P 500 Trailing 10yr Real Annualized Return Market of Stocks Many of this year’s “stay at home” themes are playing out and the technology sector is on a tear. Yet, this year reminds us it is not so much a “stock market” as a “market of stocks.” Even…

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In the realm of corporate finance, “real options” are those that allow managers flexibility to make decisions in the future. Instead of making all decisions upfront, managers can wait and make additional choices in the future. The assumption, of course, is that conditions could change or more information might be available then. One of the simplest real options managers have is timing. Delaying investment in hopes of improved information in, say, a year could help improve the project’s value. The same line of thinking can be applied to allocating assets in the context of a thoughtful investment portfolio process. Some…

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For years, stock investors have fixated on “style,” which means investing in “growth” or “value.” “Value” in this context is usually defined as buying stocks with low price-to-book or low price-to-earnings ratios. Some are now rethinking the very foundations of this framework as the return to value indexes continues to shrink (Chart A, below). Others are leaving behind simplistic notions of “style” investing and looking for all sorts of new factors to find performance. In our view, adding a multitude of new factors to the mix is also the wrong approach. The right perspective simply relates price to a few…

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The best-performing stocks since the beginning of the pandemic have had one thing in common — a high degree of financial flexibility. The worst-performing stocks were the least flexible. Before we start, it is important to define “flexibility.” For us, it has always meant low debt and high profitability. These characteristics tend to build buffers that help ensure survival during difficult times. Where to Find Flexibility Technology stocks, for example, have been a good place to find flexibility lately. The average technology company is very profitable, with very little debt. The sector’s return on assets (10.6%) is higher than any…

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The stock market is up over 40% from the March 23 bottom. This spectacular 50-day rise bookends the 33% market drop from mid-February to the March bottom. Overall, the S&P 500 moved by more than 70% in a little over three months, leaving many investors bewildered. But recent market action implies that most traders are expecting conditions to improve from here. Stimulus measures, reopening the economy, and hopes for a virus vaccine or treatment are all part of the recovery scenario. In this week’s commentary, we look at what is driving the case for both bears and bulls. We also…

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