07/16/2018

S&P 500 Investment Analysis – June 2018

Implicit Dangers of Passive Investing – What’s in your ETF?

  • Passive investing has provided operational efficiency alongside strong appreciation over a nearly 9 year bull market run.  This has led wealth managers and institutions to consider passive management to meet return goals and boost firm profitability.
  • The S&P500 contains a number of potentially overpriced stocks or highly-weighted individual securities that can stunt future benchmark performance.
  • A well-designed active strategy can outperform benchmarks, develop a competitive track record, provide incremental value to justify wealth management fees and differentiate an investment process from competitors which becomes increasingly important as passive returns slow and managers compete on performance.

Passive management has increasingly received accolades as the ideal way to invest in equities due to diversification benefits and low explicit fee structures.  Large institutions push this narrative, as it allows strategies to scale to massive AUM levels that may not be achievable with active management.  Portfolio managers can benefit, all else equal, from a passive investing framework due to ease of implementation and limited back office needs.  While it is clear that the low fee argument is valid when risk is defined as tracking error relative to a benchmark, it is misleading to assume that the construction of the benchmark does not carry an alternative source of risk when equity prices disconnect from underlying fundamentals.  Passive management carries implicit costs related to owning a basket of stocks that weights positions based on the whims of the marketplace when irrational behavior becomes commonplace.  Wide spread passive management may also lead to lower equity risk premiums when an excessive amount of market participants rely on others to perform due diligence to discover prices for individual securities as new information becomes available.

Competitive track records for portfolio managers are required to retain clients and gather new assets, and this will become increasingly important as broad market returns diminish.  As the first installment in a global equity series, this article summarizes the impact of several important themes in investor preference over the last several years to identify opportunities and risks in the large cap US equity arena through the lens of the S&P 500.  We will review the historical performance of AFG’s 50 stock model portfolio since its 2004 inception, and how it is well-suited to exploit recent benchmark trends over the coming quarters and years.

S&P 500 Trends: Where are we now?

As we begin to explore the investment prospects of a passive investment strategy in the large cap US equity marketplace, it is helpful to review a number of events that have impacted investor preference over the last four years to better understand equity prices today.  In 2014, investors attributed the significant drop in oil prices as a catalyst to increased consumer spending, while interest rates fell below 3% for 30 year treasuries and inflation expectations fell close to 1%.  2015 was dominated by the FAANG trade as growth significantly outpaced value and momentum metrics dominated valuation metrics.  2016 was defined by a reversal of valuation and momentum themes from the prior year, but the summer saw significant volatility sparked by Brexit while most of valuation’s run occurred following the US presidential election in November.  2017 saw markets continue to rally based on the promise and realization of corporate tax law changes, but momentum themes and growth styles continued to drive investor preference.

Low interest and low inflation

Low interest rates and low inflation impacted investor preference in several ways.  Large cap dividend paying stocks in defensive sectors became attractive income alternatives to low interest debt, and low inflation tends to favor growth stocks as future cash flows are worth relatively more with lower nominal discount rates.  The following chart highlights this style preference shift since 2014.

AFG International Reserch Database: MV/IC [Investable Universe – Sector)] from 9/30/98 to 4/30/18 (Local Return)
Universe Size: 400 to 500 Companies – United States (S&P 500)  | All Sectors | All Cap | ADRs Included

Green bars highlight the performance of companies with low market value over net invested capital ratios (value stocks) and red bars highlight the performance of companies with high MV/IC ratios (growth stocks) on a quintile basis.  From 1998 forward, we can observe that value stocks generally outperform growth over long-term time horizons, but growth stocks paced the market during the tech bubble and lead-up to the financial crisis.  From 2014 forward, however, investor preference has been in favor of growth stocks with the exception of 2016.

Low interest rates and limited competition from other asset classes led to an abundance of cheap debt for larger cap stocks to fuel organic growth, M&A activity, share buybacks and dividends.  For some larger cash-flow heavy global firms, cheap debt was used to meet domestic spending, share buyback and dividend needs while foreign reserves were stockpiled offshore.  Current S&P500 constituents have nearly $7.8T in balance sheet debt on 2017 annual reports, an increase of more than 23% over 2013 levels of $6.3T.

Megacap dominance

The market cap of the S&P500 is now nearly $25T, but half of the value is tied to the 50 largest companies and 15% is allocated towards the five largest stocks, including the FAANG stocks but swapping Microsoft for Netflix.  Facebook, Amazon, Apple, Netflix and Google (Alphabet) have appreciated remarkably over the last several years with an average return of 240%, while the overall S&P500 is up more than 43% since the beginning of 2014 Q4.  S&P500 performance would diminish by almost 7% over this time frame if FAANG stocks were excluded from the performance calculation, so it is clear that these five stocks have had an enormous impact on overall benchmark performance.  In other words, more than 16% of the gains in the index are related to 1% of the benchmark constituents.

Yahoo Finance, Price Returns (GSPC, FB, AAPL, AMZN, NFLX, GOOGL), 10/6/2014 – 5/14/2018

Passive equity flows

Over this time horizon, there has also been a continued investor focus on passive equity investment.  According to Morningstar, there has been a shift of nearly $650B in actively managed assets toward passive management between 2014 and 2017.

Research from Goldman Sachs, Factset and Bloomberg identify that passive ETFs and mutual funds hold 14% of the S&P500 in aggregate by mid-2017, up from 4% a decade prior.  Accounting for restricted shares, active shares only reflect 77% of shares outstanding by 2017 Q3 compared to 94% in 2005.  In general, this could imply that broader market price movements are increasingly linked to passive inflows and outflows.  It is possible that some stocks may be swept to higher market prices in rising markets while the fundamentals for their business are actually deteriorating.

Implications Going Forward

Understanding recent trends in the S&P 500 are helpful in determining appropriate active weights to improve portfolio performance.

Value vs. Growth

Increasing inflation will shift investor preference towards value stocks.  Rising inflation will increase nominal discount rates, and growth companies tend to deliver a larger portion of cash flow later than value stocks, which will lower the intrinsic values  of growth companies (all else equal).  Rising interest rates (and the loss of deductibility of interest expense) will lower the demand for debt and limit growth through debt financing going forward.  Debt-financed M&A will slow, so companies that pursue growth through acquisition may struggle to meet investor growth expectations.  Growth companies that use debt to offset negative free cash flow will struggle to balance long-term goals and short-term cash shortages.  An active manager can exploit this style pendulum shift through active weights in favor of value stocks.

FAANG Regulatory Risks

As mentioned earlier, Facebook, Apple, Amazon, Netflix, and Google account for nearly 15% of the S&P500 and have accounted for a large portion of returns for the overall benchmark since Q4 2014.  Amazon, Google and Facebook in particular are under scrutiny for potential monopoly concerns or uncertainty regarding their business practices.  While diversification across a broad market would typically mitigate these regulatory fears, these stocks currently carry market cap weights between 2.2% and 3.1% of the S&P 500, which reflects weighting schemes similar to 30-50 stock portfolios.  Given these weights, investors equipped to perform due diligence to properly understand regulatory impacts on growth and profitability goals for these firms will be much better suited to navigate changing regulatory landscapes.

Avoiding Benchmark Torpedoes

Numerous equities reflect market prices that appear to be a function of sector/style themes, yield trends, and passive inflows propelling their stock prices to unreasonable levels.  On a single-company basis, this may reflect minimal risk in overall benchmark performance that could be diversified away, but it is clear that this risk may cover a material portion of the overall benchmark.  To help clarify this, we can first explore a single company as an example.

EquityInsights.com, Intrinsic Value Chart – KO, 5/24/18

EquityInsights.com, Wealth Creation Chart – KO, 5/24/18

The Coca-Cola Company has appreciated nearly every year since the market rally began in 2009.  Coca-Cola realized gains as oil prices fell in 2014 due to assumptions of increased consumer spending and cheaper operating costs for the firm.  As a “Dividend Aristocrat”, the stock also became an attractive income-focused alternative as interest rates fell.  Meanwhile, the firm has restructured bottling assets off of their balance sheet, leading to lower levels of operating cash flow despite gains in EBITDA Margins.  Sugary beverages have come under increased scrutiny due to health concerns, a number of municipalities have instituted soda taxes to curb consumption, and Coke has taken on a large level of new debt to ensure that dividend growth and repurchase plans continue, which has led to ongoing deterioration of Economic Margin levels each year.  Since 2015, intrinsic value estimates for the stock have deteriorated while market prices continued to climb, which seem to reflect the impact of passive investing inflows on market values (as well as the large Berkshire position which likely will not be traded due to tax considerations).

While a passive manager will simply accept KO in their portfolio at nearly a 1% weight, an active manager will benefit by allocating towards stocks with more attractive investment prospects.  Even more interesting, we’ve seen this before!  Mega cap, blue chip stocks appreciated significantly over their intrinsic value estimates through the rise of the tech bubble, but market prices reverted back to reasonable levels aligned with intrinsic value estimates in the several years following the tech collapse., including PG, KO, PEP, GE, MCD, HON, CAT, RTN and LMT. This current theme is not unique to Coca-Cola.  Similar trends are summarized below for stocks with a market cap greater than $50B, and full intrinsic value charts for each stock can be downloaded here.

Consumer: Reaction to falling oil prices and stable dividend history led to market sentiment outpacing fundamentals around 2014/2015.  (4.24% of benchmark)

Industrials: Expected increases in infrastructure spending saw large gains in industrials following the 2016 election in the US.  (3.29% of benchmark)

Utilities: Stable dividend history and regulated industry created income alternative in low interest rate environment. (0.52% of benchmark)

*AFG Research, 1 Year Pricing data from 6/7/2017 to 6/7/2018; Return from S&P High data from 1/23/2018 to 6/7/2018

In total, these stocks reflect more than 8% of the S&P500 and will likely stunt benchmark returns going forward due to pricing trends that are disconnect from underlying firm performance.  The S&P 500 reached a record high in late January, and a number of these stocks have already depreciated significantly over the last several months following the early 2018 market correction.  As interest rates continue to rise, it is likely that income-focused investors may find alternative opportunities, and these stocks will likely stunt overall benchmark performance.  An active manager will improve performance by allocating away from these overpriced high yield stocks until their prices stabilize at sustainable levels.

Disciplined Stock Selection

Historically, skilled active managers have been able to construct diversified portfolios of stocks that outperform the S&P500 over longer-term holding periods by applying disciplined stock selection that incorporates valuation, momentum, and quality characteristics.  The table below highlights top and bottom quintile performance for AFG’s single-factor variables and multifactor variable for stocks within the S&P 500.

AFG International Reserch Database: AFG Single Factor and Multifactor Metrics (Live Website Version) from 9/30/98 to 4/30/18
Universe: 400 to 500 Companies – S&P 500 | All AFG Sectors – Monthly Rebalancing/Equal Weight

These results highlight equal-weighted variable quintiles against the market-cap weighted benchmark.  In individual years, performance themes ebb and flow, but over long-term time horizons, a multifactor approach to stock selection can help navigate shifting market themes to better serve long-term investment goals.

Active Management Implementation

A well-constructed research process that incorporates valuation, momentum, and quality-based insights combined with analyst-led model building and due diligence can also deliver performance in excess of S&P 500 returns.  On a forward-looking basis, active style weights towards value stocks, FAANG regulatory due diligence, and avoidance of benchmark torpedoes can also provide a boost to performance over the next several years.  The following table highlights performance of the AFG50 since its June 2004 inception.

AFG 50, 6/10/2004 to 4/30/2018 Total Returns vs. S&P500 (SPY) | Information Ratio: 0.33; Sharpe: 0.59

As of its most recent quarterly rebalance at the start of 2018 Q2, the AFG50 reflects an active weight of 15% towards value compared to the S&P500, which will provide enhanced returns as investor preference shifts towards value.  The portfolio also avoids all of the potential torpedoes listed above, instead selecting stocks with attractive valuation characteristics based on both screening criteria and analyst model building efforts.

Contact an AFG representative if you have any questions on incorporating active management techniques into your research process.

Economic Margin (EM) is a corporate performance metric owned by the Applied Finance Group, Ltd. that corrects accounting distortions to measure true economic profitability and accurately calculate intrinsic values for companies worldwide.  Additional insight into Economic Margin is available on here.  Additional insight into AFG’s approach to estimating intrinsic value based on forecasted Economic Margin levels is available here.

The Applied Finance Group provides an archive of research articles and analysis on ValueExpectations.com.  This site also provides additional information regarding AFG’s client tools, including model delivery strategies, mutual funds, and research platform access.  Please contact us if we can assist in any questions you have regarding the scope or application of our investment ideas and research platform.

Disclaimers

The Applied Finance Group, Ltd. certifies that the views expressed in this report accurately reflect the firm’s models. The information in this report is based on material we believe to be accurate and reliable, however, the accuracy and completeness of the material and conclusions derived from said material are not guaranteed. The information is not intended to be used as the primary basis of investment decisions, and The Applied Finance Group, Ltd. makes no recommendation as to the suitability of such investments for any person. Any opinions and projections expressed herein reflect our judgment at this date and are subject to change without notice. Due to individual investor requirements, this information should not be construed as advice meant to meet the investment needs of any investor. This information is not an offer to buy or sell, or a solicitation of an offer to buy or sell any securities. Some material presented in this report was acquired from company annual reports and/or company presentations.

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About Derek Bergen, CFA 3 Articles

Partner at The Applied Finance Group
Focus areas: Equity Analysis, Portfolio Consulting, Quantitative Research.
Joined AFG in 2005

About Derek Bergen, CFA 3 Articles

Partner at The Applied Finance Group
Focus areas: Equity Analysis, Portfolio Consulting, Quantitative Research.
Joined AFG in 2005