The year that just ended was particularly challenging for investors. Still early in our recovery after the huge shock to the financial system in 2008/2009, the U.S. economy continued to improve, but the growth was rather unimpressive. For the second year in a row, the consensus of a double-dip emerged in the summer, only this year, it seemed more likely given the multiple shocks to the system, including a natural tragedy in Japan, which is still the second largest economy in the world, a game of "fiscal chicken" in Washington, D.C., and a financial crisis in Europe.
For all the cross-currents, U.S. companies performed admirably. S&P 500 earnings are on track to grow 17% in 2011 and are expected to grow another 10% in 2012, both considerably higher than forecast a year ago. Of course, with stocks unchanged in price for the year, this means that they got a lot cheaper. Smaller stocks somewhat lagged larger ones. The best sectors for the full year were Utilities, Consumer Staples and Healthcare (low "beta"), while the worst ones included Financials and Materials. Clearly, this was the year of the dividend.
While our stocks needed every bit of their strong Q4 performance just to get back to where they started, they stood out in a world of weak equity prices. Here in North America, Mexico and Canada both fell about 10%. Europe's big winner was Ireland, which managed a small gain. They have done the austerity already. Germany and France fell over 15%, while others fell more. The UK was down about 6%. Japan fell 17%. Australia too. Emerging Markets were horrible, with all of the BRICs falling in excess of 17%.
Interest rates around the world plunged. Here, despite the downgrade by S&P, our ten-year Treasury rates ended at multi-generational lows, falling from a "low" 3.3% to an "insane" 1.9%. Safe-haven Gold had a nice year (up 10%), extending its streak of positive annual returns, but it struggled in Q4. Commodity prices were generally weaker, though oil rose about 10%. Our currency eroded very modestly relative to the Yen while improving very modestly relative to the Euro.
While the key focus for all economic forecasters this year has to be the prospects for Europe, the problems there are well documented and widely known. This was the year where we all learned about European politics. Just like we had (and continue to have) lots of naysayers and doomsday forecasters here a few years ago (and still), the pundits lean very negatively when assessing the outlook there. Truthfully, none of us knows how this will play out. The problems of high debt can be resolved in a number of ways - restructuring and growth come to mind. The key is to avoid chaos, and there is signficant potential for orderly resolution. Italy, for instance, is actually in better fiscal shape than the U.S. Still, they are being squeezed by the bond markets now. The recent global initiative (three-year credit facility) helps, but it doesn't go far enough. I expect that Europe will figure out a way to keep kicking the proverbial can down the road. The calls for the demise of the Euro, which I made back in 2008 myself, don't carry a lot of credibility in my view.
Surely, global GDP will see a drag from what will likely be a recession in Europe due to austerity measures. Still, we need to remember our post-2001 economy, when the U.S. consumer kept spending even though we were in a big-R recession. From what I have read, the typical European consumer isn't constrained like their governments. One of the benefits of a slowing Europe is the sea-change in Emerging Market monetary policies, which have moved from restrictive to easy in the last few months. The growth stories for these economies aren't built on just exports but rather real demand from the rise of their own middle classes. I think that this is a real trend that will persist.
I step back from trying to forecast every single country's GDP or even ours. I think it's reasonable to expect that growth will continue to be sub-par but positive for us. No U.S. recession, but no boom either. For those concerned about Europe, I urge them to take a look at the stock markets - they are all still comfortably above the lows set in Q3 (which was BEFORE our lows). If Europe will drag us down, won't Europe drag down Europe too? To the extent Europe turns out to be in less trouble than everyone seems to think, the risk could be very strong U.S. GDP. Of course, we have our own fiscal drag, but, if I am right about an improving employment situation during the year, this may prove to be surmountable.
I have shared my specific U.S. equity forecast: 1600 on the S&P 500 (+27%), based on just 14PE and using 2013 earnings that are below the current consensus. While last year, I didn't expect Small-Cap to do better than Large-Cap (after years of doing so), I think that they will perform a bit better this year if I am right about the better stock market. Sadly, retail investors tend to be followers, selling low and buying high. If I am correct about the improved tone, they will be chasing performance, which should stem the big tide of outflows from small stocks we endured in 2011. Additionally, I expect the M&A environment to remain strong, which should help smaller companies. I would expect non-US equities to do at least as well if not better than our stocks, especially Emerging Markets, which are very inexpensive and likely to show better growth. I don't have a strong view about commodities, but I guess I am moderately negative, at least for the first part of the year. Oil seems a bit inflated - I wouldn't be surprised to see supply pressures push it back towards $80. Gold is unlikely to fare well if my constructive equity outlook proves true.
With low valuations but challenged fundamentals, I put extra credence in the charts, which look positive to me. The trends I see are a long-term bull that started in early 2009 that has now been tested twice. The 2011 lows proved to be higher than 2010's. More recently, we reestablished the bull trend in October in my view and tested it later in the quarter. This third leg up is still relatively early in my view. The last peak in the market was in 2007, when the S&P 500 touched 1576. While 1600 may seem like miles away, it would represent just a 1.6% increase in five years despite EPS that will likely be 20% higher than the prior peak. My guess is that this sounds quite ridiculous to most people, which is encouraging to this contrarian.
Top 20 Review and Structure
Top 20 lost about 3% in 2011, while the S&P 500 gained a little over 2.1%. The Russell 2000, which is the index for smaller stocks, lost over 4%. Certainly my focus on smaller stocks, where I feel like my research is more likely to pay long-term dividends, hurt returns, but I made some terrible picks. Unlike 2010, when it was very difficult to do better than the initial portfolio, trades this year helped. The beginning-of-the-year model lost over 10%. We were able to exit the two worst performers (TECUA and SKX) at what proved to be good exits (despite taking losses). While some of the stocks we sold kept rallying, we did book gains in HAYN, CHS and CPRT early in the year. We also punted AMAT and STJ at a nice profit. SYNO, of course, was the highlight of the year. Sticking with CSCO proved to be a good decision in retrospect, and we made some nice pick-ups of INTC, DORM, SHFL, SCVL, FLIR (twice), SMCI and AKAM . On the other hand, SVNT was a complete disaster. Fortunately, we never added to the position, which was kept small initially due to the nature of biotechs. We booked losses in MFLX, PLXS, SKX and TECUA, but the latter three sales proved timely. The purchases of DGI and DRIV proved to be way too early, and MPR (April) and IIVI (June) were poorly timed. Same with the repurchase of STJ in July. Some of our current holdings, to which I added on weakness, have weakened further. In all, though, despite having way too many problem stocks and totally missing how sharply we would correct in Q3 (when most of our damage took place), I was pleased that our ultimate performance proved significantly better than the initial portfolio from year-end.
Looking at just Q4 briefly, we ended up marginally lagging the S&P 500, which was disappointing not only because it was the third consecutive quarter but also because I should have done better. Our smaller stocks should have boosted returns. Premature exits from SHFL and LOW proved costly as did hanging onto SVNT. DGI and DRIV performed absolutely horrible, and STJ and CRK were disappointing as well. We had exposure to a lot of smaller Industrials, and they performed poorly in aggregate, with just one name beating the S&P 500 while the other five lagged. Thankfully, SYNO worked as did a few other stocks.
As I look at the model today, the weighted expected price return over the next year (based on my targets for each stock and the how much we hold of each in the model) is over 60%. Perhaps this is too optimistic, but I think it points to signficant potential upside relative to the market. We have a lot of smaller companies, with 9 below $1 billion market cap. Another 5 are $1-2 billion. 2 stocks are in the $10 billion range, while 2 are "Mega-Caps". The last stock (the ETF) has a large-cap constituency.
Looking at sectors, here is how we stack up:
- Industrials = 36% (+ 26% vs. S&P 500)
- Technology = 26% (+ 7% vs. S&P 500)
- Financials = 13% (even vs. S&P 500)
- Consumer Discretionary = 9% (-2% vs. S&P 500)
- Health = 7% (-5% vs. S&P 500)
- Energy = 6% (-6% vs. S&P 500)
- Other = 3% (+ 3% vs. S&P 500)
We have no Consumer Staples (12% of S&P 500), no Utilities (4% of S&P 500), no Materials (4% of S&P 500) and no Telecomm Services (3% of S&P 500). Clearly, I don't attempt to match the composition of the S&P 500. If the economy proves to be sharply weaker than expected, the structure of the portfolio could prove risky given a higher overall beta (1.2X).
On the other hand, the model has a more conservative capital structure than the S&P 500. Just 5 of the stocks have more debt than cash. Our very worst name with respect to debt isn't too much worse than the average for the S&P 500.
Valuations stand out as being reasonably cheap. 5 of the stocks trade below 1.5X tangible book value (two are below). With the exception of one, all of the stocks have positive tangible book value. The weighted EV/EBITDA multiple is just 7X. 2/3 of the names trade below 13PE (even cheaper if adjusted for cash).
While I feel like the balance is better than it was a year ago, the portfolio has a value bias. The one other attribute worth noting is some exposure to the U.S. government. While several of the names have some exposure, I view three of the names as having significant revenues generated from defense spending. I also believe that at least half of the stocks are potential acquisition candidates.
As a reminder, my long-term goal with the model is to significantly outperform the S&P 500. It won't happen every quarter and, unfortunately as 2011 proved, not every year. We launched in 2008 and were able to beat the market by over 6% (from late May) in a crazy market. In 2009, we totally blew away the market, rallying 69%, which was more than 42% better than the S&P 500. 2010 continued the glory, with a 52% return compared to 15% for the S&P 500 (almost 37% better). To be fair, it was a good year for Small-Caps, which did about 12% better than the S&P 500. I tempered expectations a year ago because I didn't want people to think I was some sort of miracle-worker, suggesting that 12-20% ahead of the market was my aggressive long-term goal. In reality, consistently beating the market by just 3-5% would be exceptional. Thus, while the longer-term track-record of the model is spectacular despite the rough times since the market peaked in April (17.8% annualized return compared to a slight decline for the S&P 500), I would hope that the future performance won't see such protracted periods of poor performance as the model endured this year.
Conservative Growth/Balanced Review and Structure
Unlike Top 20, CG/B was able to beat its benchmark. Using quarterly rebalancing, the gains were modest, as the model returned a little over 5% compared to the blend of the S&P 500 (60%) and the Barclays Aggregate Bond Index (40%), a relative advantage of just 0.17%. Excluding rebalancing, the model performed better, as the stocks (up 2.11%) and the bonds (up 7.85%) in aggregate rose just 4.4%. That's the beauty of rebalancing, as quarterly adjustments led to higher returns, primarily due to the extreme move in Q3 (bonds rallied sharply, stocks sank).
Like Top 20, though, our initial portfolio proved to be a relative loser, with the stocks in the model at year-end 2010 declining a little over 2% in 2011. We were able to use market volatility to make some good sells as well as good buys along the way. My bullish outlook on stocks for the year and bearish outlook for bonds proved wrong and certainly cost the model somewhat, but we were able to overcome those structural challenges with some active trading. Some of the trades that stood out during the year included AFL, MCHP and CSL, where we established positions and quickly sold at profits. We also had a timely sale of AMAT in early February, though I prematurely added it back in April. INTC stood out in terms of new buys during the year, while WAG proved to be a poor decision. We had excellent sales of several stocks during the year, including FLO (ultimately), LOW, CVX, BCR, CHS and OMI. Sales later in the year in CALM and LOW proved premature. While the year was disappointing with just a slight beat, I am pleased with the absolute return in a tough year, especially considering how wrong I was on the big picture in Q3. I was especially pleased that the model was able to keep up in Q4 given how challenging it can be to match a very strong equity market with "conservative" stocks.
Unlike Top 20, CG/B is positioned much more in line with the market. We do have an exceptional underweight in bonds, though, with just 11% of the portfolio invested in the asset class. Additionally, we have no government (or corporate) exposure - it's all in mortgages, which offer more yield and less interest-rate risk (absent a really big spike in rates, in which case the interest-rate exposure increases). We are also overweight stocks currently, just under the 75% maximum. Almost 15% is invested in cash, as I expect bond returns will likely be negative.
Looking at the stocks, Health represents 23% (+11% vs. S&P 500), while Technology is 20% (+1%). Financials at 18% (+5%) and Consumer Discretionary (+5%) are the next largest exposures. Rounding it out are Energy at 9% (-3%), Consumer Staples at 7% (-5%) and Industrials at 7% (-4%). We have no exposure to Utilities (4% of S&P 500), Materials (4%) or Telecomm Services (3%). These exposures are dramatically different from Top 20 (or SSETF), but so is the mandate. This model isn't about maximizing returns but rather generating income, reasonable capital appreciation and protecting from loss of capital. The "beta of the stocks is slightly lower than the market.
I do think that the stocks in the model are very reasonably valued. Forward PE ratios of 11.7 are below the 12.4X for the S&P 500. Our dividend yields are 2.8% compared to 2.1%. EV/EBITDA is low at <6X. The very highest P/TB ratio is 6.6X, with an average of 2.6X. Balance sheets are much stronger than the overall market, with the very worst debt to capital ratio at 21%, which is below the average for the S&P 500. 9 of the 14 names have more cash than debt. Finally, the portfolio as it sits now has an interesting dynamic: The weighted 2011 return was -8.6% - we aren't sitting in a bunch of inflated stocks. The very best performer over the past year is up less than 17%.
Like last year, I expect bonds to be a drag. In fact, while I had hoped for zero return in 2011, this year I don't expect even that much. Officially, I expect bond returns to be about -4%. As far as the stocks, my targets suggest the potential for 46% return. More realistically, in the context of my 27% expected return for stocks in general, I would hope (with a 70-75% equity exposure), to experience a 30% return. Again, it's very difficult to keep up with a strong market with "conservative" stocks. The weighted return, then, might realistically be closer to 20% in the scenario I describe, compared to the index at about 14.5%. As a reminder, the model lost 6% in 2008 (from late July) compared to a 15% decline in the stock/bond index. In 2009, the model returned over 24% (6% better than the index), while improving to almost 27% in 2010 (14.7% better than the index). Our annualized return since inception has been 13.8%, which is 8.7% better than the index of stocks and bonds. So, after an "off" year of 5% in 2011 in which we essentially tracked the benchmark, I am hopeful that 2011 might look more like 2009 and 2010.
Sector Selector ETF Review and Outlook
I could not have picked a worse time to start SSETF, with the launch taking place just days before the high for the year in late April. While I was optimistic about the returns over the balance of the year, I was somewhat cautious at the time of the launch and structured the portfolio with atypically large exposure to Mega-Caps and very little to Small-Caps. I also included some low-beta sectors - Health and even Utilities. The really big bets were Financials and Emerging Markets, and those exposures proved very costly. From 4/29, the S&P 500 fell 8%, but Financials have declined 21% and Emerging Markets by 24%. This explains more than 100% of the underperformance in the model.
The current portfolio has evolved significantly, as we reduced a large Mega-Cap exposure and replaced it with a large Small-Cap position, while also adding to our losing bets. I continue to have confidence in both the Emerging Markets exposure as well as Financials, but I will be quick to abandon them should the recovery in stocks begin to fade. Our model is definitely set up bullishly, as the beta is 1.23X. On a weighted basis, our ETFs we currently hold were down 11% in 2011 - we will benefit from mean-reversion should it play out.
As I mentioned at the launch, my expectations for being able to beat the market with ETFs are MUCH more tempered than with stocks. I would hope to do so by 2-4% in a year, so 2011 was a big dent in the record I hope to build (at -3.8% compared to the S&P 500). It definitely wasn't my market (especially in Q3, when we endured 87% of the relative underperformance), but we did manage to recover somewhat in Q4 as we added significant Small-Cap exposure but continued to struggle with other parts of the portfolio. So, as disappointing as the performance has been since our launch in late April, I remain optimistic that 2012 could more than make up for the rough start. Emerging Markets had a terrible year, but they are very volatile. They continue to lead our stocks over longer periods of time despite the poor recent performance, offer more growth potential and are valued at lower PE ratios. Financials, on the other hand, haven't shown good performance relative to the market in over 5 years and stand out for their valuation and extreme investor apathy. Aggressive, yes, but these look to be smart contrarian bets to me. Small-Cap is a bigger bet (1/3 of the portfolio spread out in three different ETFs), but it won't likely play as important a role in the future performance as the other two that I have described. Our two other ETFs are S&P 500 sector ETFs.
