The equity markets have taken a respite in 2014 after returning more than 32% in 2013. For the first quarter of 2014 the S&P 500 Index has returned 1.8%. While the present equity market is more selective and volatile than 2013, Martin Investment Management, LLC believes that current credit conditions continue to favor the equity markets. The 10-year Treasury is yielding approximately 2.7%. The forward P/E ratio of 15.4 for the S&P 500 is reasonable in the context of con-tinued low inflation and interest rates. Margin expansion has been the largest influence on profit growth and should continue with present low inflation expec-tations. We believe that mergers and share buybacks may continue to increase shareholder value for large capitalization stocks. The S&P 500 Index shareholder yield from buybacks and dividends is very attractive at 4.8% compared to the 10-year Treasury of 2.7%. We regard the growing influence of the activist investor as some indication that there is value in large capitalization stocks. While the present return may appear modest this quarter, the power of compounding an-nual rates of positive returns over time is noteworthy.
The first quarter of 2014 has not been without economic, climatic, and po-litical challenges. In contrast to the large equity market’s $23 trillion total market capitalization, the 64 new IPOs in 2014 only raised a total of $10.6 billion in equi-ty market capital. The number of companies listed on U.S. Exchanges (the sum of AMEX, NASDAQ, NYSE) has decreased from almost 9,000 in 1998 to presently 5,008 companies. In a world, which continues to deleverage, obtaining capital and receiving outsized equity market returns can be more difficult during an era of financial repression, when the Federal Reserve keeps interest rates abnormally low. Flows into bonds have dwarfed flows into equity funds since the financial crisis began, despite the low return that bonds offer presently. The severe weather across most of the country has slowed the U.S. economy this winter. Increased political tensions have escalated between Russia and the West from Russia’s invasion of Crimea in order to regain a warm weather shipping port. Because Russia’s main export is energy, some fear that Russia will use Crimea to ship weapons to the Shiites, creating more Middle East turmoil, for the opportunity to increase the price of oil. Threats from North Korea are also escalating at this time.
The four largest central banks remain accommodative but policies are be-ginning to shift. The U.S. Federal Reserve and the Bank of England are more likely to tighten than to ease further while the European Central Bank (ECB) and the Bank of Japan (BoJ) are still trying to find ways to accommodate their respec-tive economies. The close correlation between stocks and their currency suggests that the Nikkei stock exchange appears to be held hostage by the yen that is caught in a stalemate by the BoJ’s expansive quantitative easing program. Contrarily, the euro has strengthened by 15% since May 2012, and the ECB’s balance sheet has shrunk by 30% since June 2012. The ECB has allowed severe internal devaluations to take place in the peripheral countries such as Greece (wiping out a third of nominal GDP) and Spain (real wages declining more than 20%). This is because the ECB is not considered a national central bank and is removed from the severe economic and financial fallout in some of its member countries. Internal depreciation of the periphery countries has allowed the ECB to avoid the underperformance of the yen relative to the euro. The U.K.’s easy monetary policy and very devalued sterling have helped offset the net slowdown from fiscal austerity and allowed the economy to gain traction. The U.S. Federal Reserve has shifted to a more discretionary approach from a rule-based strategy for its monetary outlook. Although the U.S. dollar may be under downward pressure in the short term, the U.S. dollar remains on an upward sloping trend line. The U.S., the U.K., and Swiss equity markets also benefit from their tendency to have lower beta (risk) stocks than the euro zone or Japan.
In a March/April 2014 CFA Institute Journal article, “Quality Control,” Su-san Tramelli, CFA, discusses several working papers on quality as a way to add value to one’s equity portfolio over time, especially when one merges it with valuation. The belief is that holding all else equal, similarly priced firms with lower operating risk and higher, more stable profitability should generate higher average returns than unprofitable firms. Adding a profitability strategy with an existing value one reduces the overall portfolio volatility to the market. “Operating profitability, a measure of recurring profits scaled by the company’s book value,” is a better proxy for expected profitability than a company’s earnings. Investors should invest in stocks with a higher degree of quality (profitability, growth, safety, and payout). Companies with quality characteristics also tend to remain high quality up to ten years later and are positively related to favorable stock prices. In the same article Cliff Asness states: “We find that high quality is associated with high prices, but not high enough. As a result, high-quality stocks earn high subsequent returns.” Companies with high quality and reasonable valuations with respect to fundamentals deliver the most consistent outperformance over time. Tramelli concludes that classic bottom-up investment advisers, who carefully select stocks, may offer a strong alternative to indexing, quantitative models, and momentum investing to construct best of breed portfolios.
While we realize that underlying economic factors influence the equity markets such as the behavior of central banks, currency valuations, weather, and geo-political events, we do not make our decisions based on changing macro fac-tors. Martin Investment Management, LLC believes that adding exposure to lower beta and high quality stocks in a consistent disciplined manner by pur-chasing the equities at reasonable valuations enables equity portfolios to have the opportunity to outperform the indices over time. Lower beta is defined as a security’s price being less volatile than the market, and high quality is defined as those companies, which are profitable, stable, and growing with positive cash flows and competitive positioning. We are very cognizant of a company’s intrin-sic value relative to the market by analyzing future cash flows. We prefer to buy a strong company at a fair price and hold its equity for the long term. We appre-ciate how sustainable and persistent the returns of high quality companies tend to be over time.
We wish you an enjoyable spring season!