Manager Interview - Part 1
We decided to put together a series of the hard-hitting questions that investment managers are being asked today. We asked our research team and internal advisors to hit us with everything they got. Due to the length of the interview, we will break into a 2 part series. It feels like a great way to end the year, to let into the mind of a manager. Enjoy!
1. What is a reasonable return expectation for a balanced, all-stock portfolio over the next 5 years?
This is certainly difficult to predict because speculation can take over and drive prices much higher over shorter time frames. That said, stock returns are comprised of 3 main variables: dividends, earnings and company valuation. Valuation is defined as the price investors are willing to pay for each dollar of profit generated by a company, often measured as ‘price to earnings’ or PE. As such, the market growth of any stock growth can generally be explained by these three variables. Going forward, I see dividends in the market at 2%, earnings growth likely will average slightly above 5 year GDP, and valuations staying the same or retreating some. Without getting too technical, we’re likely to see 2% dividends + 3-5% earnings growth + -2% to 0% valuations. This means a total annualized return expectation could be around 3-7% from today’s level. I tend to be in the middle and feel 5-6% is a very likely number.
2. 5-6% doesn’t seem like a lot given the risk for owning all stocks?
We are at a place where it is hard to see another five years without a pullback. Quite frankly, it is getting hard to see another one year without a pullback, which would reset the market a bit. In late stages of a market run-up, we see valuations get overheated on speculation. Investors move themselves up the risk ladder to chase of returns. In the late 90’s we saw this last a good three years before the correction came. We never know how long the cycle will last or how it may end, but we generally see the larger the boom, the larger the decline. Between 2009 and 2015, the strong returns represented a recovery from the 2008 recession, as well as some normal appreciation. The recent two year run-up is starting to bring stock valuations into questionable territory. But when we look around, we have to ask: what else, other than stocks, can an investor buy? Returns of 5-6% over the next five years may feel low, but it is much better than 0-1% earned in savings accounts, 1-3% on treasuries, or 2-5% on corporate bonds. Stocks still remain the most attractive investment, but the margin is shrinking fast. With inflation still low, most institutional managers I talk with are still favoring stocks. Until we see some sort of fear enter back into the market, we will likely see stock market growth for a bit longer. That said, bonds are starting to look more attractive for lower risk investors.
3. Why have moderate risk income accounts lagged the general market so much over the past year?
It’s funny, I never thought getting only 10-12% annual returns in a moderate account would be reason for worry; seems like we should be celebrating! However, the Wilshire 5000 is up near 20% since 10-22-2016. This is a case of greed starting to take over. A 10-12% return over one year in a moderate account is above my expectation and exceeds all planning objectives. We are very pleased with all income accounts. Over long periods of time, we like to see accounts with high income and lower risk than the general stock market achieve around 60% of the market’s performance. That would mean around a 12% return over the past 12 months. We remain right in-line with that number for the trailing year, and just a hair below that for moderate accounts. This is actually a tremendous performance given the bond market index is near 0% return and the Dow Jones Select Dividend Index is near 14%. A mix of 60% dividend stocks and 40% core bonds would be expected to produce around 8.4% rather than the 12% we’ve experienced. We have been slightly over the industry standard and still in-line with our correlation to the market during a time when bonds have given us nothing in returns. When the market corrects, we generally see solid outperformance for the moderate income accounts and will see correlations spike between 60-80%. Until then, we will likely see about half the market upside if things continue to run at such a fast pace. The balance between risk and reward persists; moderate income accounts are designed for income and reduced risk and should lag behind aggressive all stocks portfolios during a time like this. If markets are booming, moderate accounts should and will continue to get about 50%-60% of the stock market’s upside. When things correct, these income-focused accounts will hold up better and always deliver a more consistent income stream.
4. Growth accounts have excelled on all fronts, should clients move now?
Great question. Our growth-focused accounts’ performance has been tremendous, posting great returns in 2016 and this year. Near 50% run-up since the last market decline on 2-11-2016 is a very nice return for long-term investors. Depending on the Evergreen Wealth growth strategy, 15%-19% returns year-to-date has been tremendous. Naturally, now is the time we see more risk averse investors start to get antsy. Even though they have a plan designed for 5-7% returns and are outpacing that, they see growth investors using our other strategies earning very large returns and therefore start to reconsider the risk they are willing to take on.
My reaction is twofold. First, the right answer for a long-term investor is always 100% stocks. Let me be very clear; the right answer in the very long-term is ALWAYS 100% stocks. So, if someone can handle 40-50% declines every decade or so without making an emotional move - and can hold tight for 10-20 years - they should likely be 100% in stocks.
Second, we need to be careful we are not moving our focus away from long-term objectives. Many clients we work with prefer for us to capture income to meet tangible near-term spending needs, while reducing risk. An income focus, therefore, naturally reduces our ability to get all the upside and shifts us away from 100% stocks. If our focus is on meeting income needs, and more consistent returns, then staying the course with a balanced income strategy is likely the right move long-term. If this strategy is meeting your needs, what is the real reason we would consider changing strategies?
Someone who expressed fear a couple years ago and is now willing to take on full risk scares me. We have to dig a little deeper to understand motives. If someone is being driven by greed and recent run-ups rather than a maintaining a fundamental long-term perspective, we should move carefully. Occasionally we do find that a miscommunication happened at plan design and we should adjust to a more aggressive long-term strategy. This is not all that common.
As an investment manager, we see everything outperforming benchmarks currently, so any discontent during good times should be addressed quickly. We have strategies that are proven to deliver higher growth returns, and if someone is not happy currently then they clearly are in the wrong strategy. We will need to be careful making any changes after a market run up, but knowing a shift is desired would allow us to be strategic.
5. What is a reasonable expectation for Moderate Income Accounts if you see stocks at 5-6% over the next 5 years?
I will make the assumption that moderate is being defined roughly as 60% stocks and 40% bonds. We already addressed the stock question, with an expectation of 5-6%. Bonds are easier in some regards because they pay a guaranteed coupon (interest) if held until maturity. They may fluctuate a bit, but we can calculate with a bit higher certainty. With 10-year treasuries at about 2.4%, and higher yielding corporate bonds at about 5%, we will assume a proper balance and aggregate interest rate of about 3.5%. We do not expect much upside with rates so low, and will likely be limited to the interest paid and a small addition for management replacing some lower rates with higher rates over time. So, we end up with a 60% stock portfolio getting 6%, and a 40% stock portfolio getting 3.75%. The total average expectation would be around 5%. This is on the lower end of our desired 5-7% returns for most moderate accounts. However, most accounts are running well ahead of current planning needs and we would expect a few years of experiencing 1-3% less than our target. Ideally, a market pullback would provide a nice opportunity for active management rotation of holdings to generate an added 1-2%. The lack of declines is hurting our ability to be more opportunistic, but we know that will change in time and we therefore remain patient.
Evergreen Wealth Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.