Covenant Weekly Market Synopsis as of May 11, 2017

May 15, 2017

Thus far in May, domestic equity indices have been consolidating with the DJIA, S&P 500 and Nasdaq hovering near record highs. Developed international stocks have fared better for the month and the year – as have emerging and frontier market equity indices. Corporate earnings per share for the first quarter in the U.S. are showing a marked improvement, rising +14.7% from a year ago. The energy sector is a notable standout, with earnings growth of 641.2% since Q1 2016 (source: Thomson Reuters) when the price of oil was bottoming around $26 per barrel. Having recovered to nearly $50 per barrel at the end of Q1 2017, the energy sector is no longer in recession. The market appears to have anticipated the earnings improvement as investors have taken their foot off the accelerator the last 1.5 months after buying with both hands in January and February. Interest rates on US Treasuries remain largely range bound as recent economic data (a lower unemployment rate than expected, combined with lower inflation) did not interrupt the market’s view that the Fed will raise rates again in June. Precious metals posted modestly higher prices for the week, but remain down for the month (Gold -3.1% and Silver -4.3%). The US Dollar moved higher by 0.5% for the week, but remains down 3% year-to-date. Finally, the VIX Index (a measure of expected market volatility) declined 1.6% last week and has fallen nearly 26% year-to-date to 10.4 (vs. a longer-term average of approximately 20.0).

For a detailed view of weekly, month-to-date and year-to-date asset class performance please click here.

Investment Lessons from the Masters of the Universe:  This is a little geeky, but try to stick with it as it includes valuable lessons from some of the greatest investors of all time. Factor exposures, while long understood (and pursued) in the hedge fund industry, have gone mainstream in recent years through the launch of a multitude of “smart beta” investment products. Whereas traditional strategies track a specific benchmark index (e.g. S&P 500, Nasdaq, Russell 2000, etc.), “smart beta” strategies focus on one or more investment factors (e.g. Value, Size, Quality, Momentum) that have historically produced enhanced risk-adjusted returns over traditional benchmark indices. There is a vast amount of academic research supporting smart-beta advocates’ claims that a rifle-shot approach to selecting stocks that possess certain factors will deliver comparable, if not better, returns with lower risk than passively investing in a capitalization-weighted index (e.g. the S&P 500). This remains an area of intense interest for investment managers as well as investors who are increasingly adopting this approach for at least a portion of their investment allocations.

Pursuing certain types of factor exposures is not new, in fact it is often referred to as an investment style. Yet, today we have better tools to analyze factors and measure their impact on a portfolio’s performance. AQR Capital Management, a leading quantitative investment firm, recently presented research analyzing the investment track records of several famous investors. Each of these investors is outspoken about their investment style and thus AQR’s research was designed to verify if the investor’s results matched their stated style. The results of the research are interesting in that they deliver transparency into what enabled these investors to become Masters of the Universe.

Although AQR’s research paper discusses four different investors, for the sake of brevity, only one example is included here.

Warren Buffett – Berkshire Hathaway(BRK)

From January 1977 to May 2016, BRK produced annualized performance of 17.6% vs. 6.9% for the stock market (measured as excess returns over cash). How did Mr. Buffett generate 10.6% annualized outperformance over this nearly 20-year period? Quoting Mr. Buffett in 2008, “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down”. There is no doubt that Mr. Buffett likes a bargain, but what is not as well understood is that BRK also benefitted from cheap leverage from its insurance business. The leverage enabled Mr. Buffet to put approximately $2.30 cents to work in the market for each $1 of BRK equity. Additionally, when evaluated against well-known factors, Buffett’s performance is less mysterious. Of the 17.6% annualized performance, only 3.6% of it (termed “Regression Alpha”) is unexplained by four common factors of Quality, Low-Risk, Value and Market.

Berkshire Hathaway Stock  (Jan 1977 – May 2016)


Source: AQR Capital Management

In other words, the clear majority of Berkshire’s returns were generated from leverage, the general movement of the market, and to a lesser extent, identifying high-quality, bargain stocks. That’s not to say Mr. Buffett is not a great investor, but what makes Mr. Buffett great is not what is commonly reported.

AQR’s research also analyzed the track records of Bill Gross (PIMCO Total Return Fund), George Soros (The Quantum Fund), and Peter Lynch (The Magellan Fund). As with Buffett, most of the performance for each manager can be explained by persistent exposure to identifiable factors that have historically produced excess returns. These managers deserve some credit as many of these factors were not widely understood nor documented when they produced their market-beating performance. These Masters of the Universe essentially figured them out on their own, which was a key ingredient to their success.

An even more important aspect to their success is that Buffett, et al. remained disciplined in their investment process. Despite numerous setbacks in which these long-term factors underperformed (Berkshire’s stock fell more than 50% on two occasions during the study period), they stuck to their respective investment plans and over the long-term produced some of the best track records in the history of investing. Regular “Joe’s/Jane’s” like the rest of us can learn from their approach. The first lesson is to maintain a diversified portfolio so you can weather inevitable periods of underperformance. The second lesson is to stick with your investment plan.

Be well,