Economy & Markets

The saying is "sell in May and go away." And already stocks are acting like that is true. The Dow Jones Industrial Average shed points two days in a row after the Federal Reserve indicated rates were going nowhere for the foreseeable future.

But quarterly earnings are coming in better than feared, and other worries heading into earnings season - about the China trade situation, economies in Europe and a possible slowdown in the U.S. - have abated. After Apple reported earnings, the S&P 500 hit a new record high.

Markets have rallied on evidence the economy continues on its growth path, with worker productivity on the rise and GDP gains outstripping expectations. But people are still trying to map out a case for what happens when things go off the rails.

Will the boom end with a credit market blow up or a consumer slowdown? A decade of low interest rates encouraged investors to take risks on a global hunt for yield. They found it in loans and high yield and investment grade bonds. An economic slowdown could force a reckoning in these markets. And while consumer spending is a major part of economic growth in the U.S., cracks in credit quality could eventually lead to a slowdown in spending. That could mean the economic growth fizzles out.

Stocks continue to be driven by the technology sector, followed by real estate and consumer discretionary. Energy and materials sectors lag. The S&P 500 trades at a forward P/E of 17.6, and the Dow trades at a forward P/E of 16.7.

Some Numbers to Watch

1. U.S. worker productivity rose at the fastest pace in a decade. The Labor Department said nonfarm productivity rose at a 3.6% annual rate in the first quarter.

2. Federal Reserve Chairman Jerome Powell said this week he doesn't see a strong case for either a rate cut or a hike, indicating the central bank is likely to keep rates steady for a prolonged period. The core personal consumption expenditure price index was unchanged in March and up 1.6% over last year, which is below the Fed's 2% target.

3. Private payrolls surged 275,000 in April, the biggest gain since July and well above expectations.

4. Lower rates aren't encouraging people to shop for real estate. Weekly mortgage applications dropped 4.3% last week and are just 1% higher than one year ago. Home prices also rose at a slower pace in February.

5. The U.S. economy expanded 3.2% in the first quarter, the best start to a year since 2015, but a survey of corporate economists predicted the pace of growth would decline as companies face pressure from rising wages and other labor costs.

Recommended Reading

A recent article in Financial Advisor considered whether a recession and bear market are around the corner, predicting a "two-thirds probability" for a business downturn starting this year. Its reasons included tighter Fed policy, the near-inversion of the Treasury yield curve, the late 2018 swoon in stocks, weaker housing numbers and softer consumer spending. The authors also cited deteriorating economies in Europe and decelerating growth in China, not to mention the U.S.'s trade war with both. Of course, as the article notes, these conditions could only be temporary, especially since the Fed has backed off on rate hikes. But excess U.S. corporate debt and heavy borrowing by emerging-market economies could be cause for concern. For more on this read here. And see below for links to articles and blog posts you may have missed.

Robo Uses: A new study by McKinsey says that traditional asset managers are using advanced analytics to build better decision-making capabilities rather than to replace human portfolio managers. Read more

Evidence Bust: Since the 2008 financial crisis, investing has evolved more toward evidence-based strategies backed by credible research, Nir Kaissar writes for Bloomberg. But he says evidence-based investing has been "a bust" over the last decade. Read more

Hedging Bets: Professional money managers plan to keep or increase their allocation to hedge funds, according to Institutional Investor. Last year, 68% of those surveyed said their hedge fund investments underperformed. Read more

Flight Fancy: Berkshire Hathaway's airline holdings make it among the biggest shareholders in the four largest U.S. carriers, and CEO Warren Buffett said he wouldn't rule out owning one, according to Bloomberg. The comment is triggering chatter about which airline Buffett might acquire, especially since the legendary CEO is looking for a place to park some of Berkshire's $112 billion (as of year-end 2018) in cash. Read more

Back on Top: Activist William Ackman is trying to get back on top by keeping a low-profile existence. His private fund has reportedly shrunk by about $9 billion since its 2015 peak, and the Wall Street Journal says he is adopting a more "Zen-like approach" His public fund is up 31.9% this year, and redemptions have slowed. Read more

Private Equity: In March, the board of California Public Employees' Retirement System approved a plan that could channel up to $20 billion into private equity startups and corporate buyouts over the next 10 years to boost returns. Read more

Bond King: Former Pimco Bond King Bill Gross tells Bloomberg the days of outperformance are largely over. "There are things to look at that still exist in the market that can generate alpha, although the probabilities of generating historical alpha in the same way are much less than they were," he said. He attributes this in part to lower yields and "razor thin" spreads between maturities. Read more

Speculative Bucket: Bloomberg's Barry Ritholtz warns investors that although huge wins get more attention than smaller wins and losses, those big windfalls don't necessarily represent smart investment decisions. If investors want to speculate, he says, it's better to take a small portion of assets and put them in a separate account. "Never confuse lucky gambles with a good investing strategy." Read more

Long Hold: The Akre Focus Fund takes the buy-and-hold strategy seriously, according to WSJ. John Neff, one of the $9.8 billion fund's portfolio managers, explains that investment decisions are made based on four criteria. Read more

Buy Signal: A portfolio manager at the Julius Baer Group tells Bloomberg the historic spread between the most and least expensive stocks is presenting strong buy opportunities for investors. Along with above-average earnings growth, the inexpensive segments of the equities market are a "gold mine for investors seeking another five years of strong returns." Read more

Small Caps: Bloomberg recently profiled Samantha Lau, co-chief investment officer of small and SMID growth strategies at AllianceBernstein. Lau subscribes to some basic rules of small-cap investing, including never sell half of a position, rather exit and revisit. It's never too late to sell a loser, and a good company isn't always a good stock. Read more

Fee Cliff: Fund fees, which have been driven to zero, may actually have farther to fall, according to The New York Times. Major companies will soon be paying customers to invest with them. In March, a start-up called Salt Financial filed a registration statement showing a fund expense ratio of minus 0.05 percent (the SEC has not yet weighed-in). Read more

Holding Steady: The WSJ recently argued against giving up on value investing notwithstanding more than a decade of poor performance. It contends, however, that there's more uncertainty about the strategy than there once was because value investors have never been ground down for so long. Looking back longer term, if investors understood the strategy's success they would be less likely to overreact to bad news, which would mean that value stocks would become less of a bargain. Read more

Miller Views: Bill Miller of Miller Value Partners said in a recent podcast that he remains a value investor despite the challenges of being one given how hard it is to outperform against index funds. He added that the U.S. market is "very attractively priced relative to alternatives," except for utilities and consumer staples, which are trading a historically high valuations because of their low volatility. Read more

Amazon Broker? Financial Planning magazine recently looked at the possibility of tech giants entering the wealth management arena. Of the tech giants, the article reports, Google is the closest to customers. Every wealthtech mobile app is run on an operating system owned by Google, and Google Assistant offers users the ability to check financial markets, manage investments, payments, charity donations and file taxes. Amazon's strength is integration, the article explains, explaining that most wealthtech companies stores their data in AWS. Read more

Quiet Giant: Forbes recently profiled Jeffrey Talpins, a 44-year-old hedge fund manager whose firm Element Capital has returned about 21% annually net of some expensive fees since its inception in 2005. Read more

Opposite Bets: Falling premiums on speculative-grade bonds against lofty equity valuations suggests that equity and debt investors are placing opposing bets on the business cycle, according to Bloomberg. The article reports that, according to Goldman data, U.S. firms with solid financials are trading close to the highest valuation relative to their fragile peers since the dot-com era of 2003. Read more

Bullish Omen: For Sanford Bernstein, the chasm that exists between the valuations of the cheapest and most expensive stocks around the world is a bullish omen for value stocks, according to Bloomberg. Read more

Latest Changes

The Mechanics of Value Investing

Value investing was popularized by Benjamin Graham and, later, Warren Buffett, but it isn't always clear the best way to go about it. Different views on what value investing means have sprouted up over the years, and following any one path can lead to different outcomes than another one. Validea's Jack Forehand broke down what value investing means and how it works.

We all have a tendency to want to put investing strategies into groups. That can sometimes be misleading, though. There are more investment products than I can count that use the word value in their name. But beneath the surface, many of those products couldn't be any more different. Those differences can lead to substantially different outcomes in both the long- and short-term, so it is very important to understand the investment process and parameters used to create any value portfolio before you invest in it. Since I often discuss value investing in my articles, I thought it might be helpful to take a step back and take a look at some of the important details to consider when building or analyzing any value strategy.

Defining Value

But first, I think it is important to define value. When I look at strategies that are referred to as value, I break them down into three distinct categories.

[1] Ben Graham Value - This group of strategies focuses on buying the cheapest stocks. They can use very different metrics to get there, but the end result is a group of companies that are cheap and out of favor. When we talk about the academic research into value investing, this is the group we are talking about. Most academic work will focus on buying the bottom decile (or cheapest 10%) of stocks.

[2] Warren Buffett Value - This group combines value with some sort of measure of quality. The goal is not to buy the cheapest stocks, but rather to buy good companies that are trading at a discount to some measure of their intrinsic value with the hope that the profits these firms make will compound over time. These types of approaches generally end up with more expensive stocks (vs the Graham style above) and stray further away from the academic definition of value.

[3] Bill Miller Value - This style was popularized by Miller in the 90s when he argued that many tech companies were value investments despite the fact that they were very expensive by any traditional value metric. The argument proponents of this type of approach will make is that if you look at companies as the present value of expected future cash flows, then companies with strong projected future growth can be cheap today, even if they trade at high multiples based on things like sales and earnings. These types of strategies stray the furthest from the academic definition of value (they actually have almost nothing in common with it at all).

When I use the term value, I am always referring to the academic definition (#1 above) and mostly discussing it in the context of systematic value models, but you will see the term used in varying ways so I think it is important to establish a clear definition first.

Once you define value, you then need to make a series of important decisions to take that concept and express it as an actual investment portfolio. Here are a few of the most important things that go into the recipe of building a value strategy and what to keep your eye on for each of them.

The Process of Building a Value Portfolio

• What is the Universe?

This is a very important question that many people miss. The data shows that the value premium is magnified in smaller stocks, so including them should boost long-term returns. But including smaller stocks also limits the ability of a fund to scale and increases tracking error relative to the S&P 500, which makes it harder for investors to stick with the strategy.

• Which Metric(s) to Use

There are a wide range of options here. Most of the academic research into value relies of the Price/Book ratio and many large value firms like DFA use it as their primary value metric, but recent research from O'Shaughnessy Asset Management has shown that in a world where the vast majority of assets are intangible and not included in Price/Book, this ratio may not be very applicable. The most popular metrics outside of Price/Book are Price/Earnings, Price/Sales, Price/Cash Flow and EV/EBITDA. All of these metrics have their strengths and their weaknesses. For example, the PE ratio is subject to earnings manipulation and the Price/Sales treats profitable firms the same as unprofitable firms. Even EV/EBITDA, which is currently one of the favorites of many practitioners, can favor capital intensive firms over firms that have less capital requirements. The fact that each metric has its own inherent flaws leads some to conclude that using a composite of all of them is probably the best option. But either way, if you invest in a value strategy, it is important to understand what you are getting because different metrics can produce very different outcomes (just ask anyone who has followed Price/Book for the past decade).

• How Many Stocks to Hold

Like many things in investing, there is no hard and fast rule here, but in general, the more focused a portfolio is (within reason), the more exposure to the value factor it has, and the better the long-term returns will likely be. But with more focus comes more tracking error, which means that focused portfolios will often deviate widely from the market and will go through extended periods of underperformance that make them very hard for investors to stick with. The past decade is a great example of this. Focused portfolios also can't handle as many assets, and fewer assets equal fewer fees for an investment manager. This is why many value managers will turn their portfolios into closet indexes with hundreds of stocks. That isn't necessarily a bad thing as long as the fees are similar to the fees of investing in the index, but you would be surprised how many funds are still out there with 1% fees and a portfolio that looks just like the index. These are the portfolios investors should avoid.

• How Often to Rebalance

With factor-based portfolios, how often you rebalance can have a significant effect on returns. Momentum portfolios typically require more frequent rebalancing to produce their best performance, but value can do well with quarterly or annual rebalancing. In fact, many of the value models we follow like our Value Investor model based on Ben Graham perform best when rebalanced annually.

• How to Handle Industry Concentration

Some value managers feel that concentrating in sectors and industries that are cheap enhances returns. Others feel that value works best when it is used to pick individual stocks and not to make industry bets. I don't think there is one correct answer, but strategies that will concentrate in specific sectors do tend to have higher tracking error, which means they can be tough to stick with.

• How to Weight Individual Positions

Many quantitative managers tend to equal weight their portfolios, but some will weight their highest conviction positions more heavily. Closet index funds typically market cap weight so they don't stray too far from the benchmark. Others will use things like inverse volatility weighting, which overweights the least volatile stocks in an effort to have each position contribute an equal risk to the portfolio.

This certainly isn't an all-inclusive list, and there are many other decisions that go into building a value portfolio. In the end, some of the smartest investors in the world differ on the answers to these questions so my point here is not to suggest there is one correct way to do it. The point is that like any investing strategy, it is important to understand what you are getting with a value strategy before you invest. Doing the work up front can prevent surprises and help you find a fund, manager or strategy that best fits your investing goals.

Newcomers to the Hot List

Autohome Inc. (ADR) (ATHM)- This Chinese auto sales advertising website scores highly on the model portfolios tracking the styles of Martin Zweig and Peter Lynch as well as on Validea's momentum portfolio.

Credit Acceptance Corp. (CACC)- This auto financing company scores highly on several models including those tracking the strategies of Warren Buffett, Wayne Thorp and Pim van Vliet.

Emcor Group Inc. (EME)- This building and industrial services company scores highly on the models tracking the styles of Peter Lynch, James O'Shaughnessy, and Joel Greenblatt.

Essent Group Ltd. (ESNT)- This private mortgage insurer scores well on the models tracking Dashan Huang, Peter Lynch and Martin Zweig as well as on Valida's momentum portfolio.

Monster Beverage Corp. (MNST)- This soft drinks maker scores highly on the models tracking Warren Buffett and Partha Mohanram.

Nexstar Media Group Inc. (NXST)- This television broadcasting company scores well on the models tracking Wesley Gray and Martin Zweig and on the momentum portfolio.

News on Hot List Stocks

Royal Dutch Shell reported a strong first quarter, with profit of $5.4 billion, beating the consensus of $4.5 billion.

Mastercard also beat quarterly profit and revenue expectations, citing a strong U.S. job market, rising wages and online shopping trends.

Emcor Group reported first quarter profit of $72.4 million, or $1.28 a share, beating Wall Street estimates.

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The top scoring stocks not currently in the Hot List portfolio.

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