Patience, Perspective, and Discipline
We mailed a version of this and thought it would be a good piece to begin our blog. Each month we’ll be posting a new source of timeless wisdom set within the current economic context.
As we look back on the financial markets in 2015, what really stands out is how poor returns were across the globe and across asset classes (stocks, bonds, commodities, etc.). Among the major global stock markets, the United States was the best performer, but that’s faint praise given the S&P 500’s 1.4% return. Fixed-income offered little respite, with the core bond index gaining just 0.3%. High-yield bonds fared worse, down close to 5%, while floating-rate loans lost 0.7%. Investment-grade municipal bonds were a relative bright spot, with the national muni bond index up nearly 3% on the year. Overall, 2015 was a challenging year for the financial markets in general, and given the challenges of the past financial year, we think it is particularly important to reiterate our positive outlook for our portfolio positions and review how we arrive at our assessments.
Financial market history is a history of cycles (or like the swings of a pendulum), moving from one extreme to another. Market history teaches us that undervalued assets can fall further, and overvalued markets can overshoot even further on the upside. We need only look back to the tech bubble to see one recent example of this. It is simply the reality that comes with being a long-term equity investor.
Our investment philosophy is based on the belief that fundamentals ultimately drive investment returns. This gets down to the economics of the investment. Specifically, whether we’re evaluating stocks, bonds, real estate, or another asset class, the value of an investment is generally determined by the cash flows the investment generates over time. This type of valuation, unfortunately, is a very poor short-term market indicator. But over the longer term and over full market cycles (5 to 10+ years), history has shown that fundamentals are a powerful driver of returns. Buying undervalued assets pays off over time, but you need to withstand the discomfort that typically accompanies it as you wait for markets to turn in your favor.
We are confident we will be rewarded for our current allocations to European and emerging-markets stocks. But we also know that we don’t know precisely when those markets will turn around. It requires patience—another core element of our investment philosophy—to hold onto (and potentially add more to) these longer-term return generators during the periods when they seem only to be downside-risk generators.
On the bond side, with interest rates having begun what the Fed has said will be a gradual upward climb, our conviction in our diverse fixed-income lineup is stronger than ever. Our investments in flexible and absolute-return-oriented and floating-rate loan bond funds are designed to generate higher returns and better manage their interest-rate sensitivity versus the core bond index in a rising rate environment. And while core bonds may still mitigate some of the shorter-term downside risk from stocks in our portfolios, the degree to which they can do so is more limited in the current market cycle. This past year was a good example of this, with core bonds barely positive while global stocks were negative.
As the first quarter of the year comes to a conclusion, we believe our portfolios are well positioned to generate solid returns over a long term horizon, but we think it is prudent to be prepared for potentially increased market volatility and downside risk (as well as positive returns) over the shorter-term. We may even get the opportunity to add to our undervalued positions or establish some others before this market cycle turns. In other words, we believe the key to successful investing ahead is to maintain the healthy patience, perspective, and discipline necessary for long-term investment and financial success.