The past two years have been difficult for equity managers, and CornerCap was no exception. For the past four or five months, however, our research is showing a return to more normal conditions where fundamental valuations matter.
Despite the challenging markets over the past two years, we have stayed with our value discipline, buying stocks that appeared inexpensive by our objective, bottom-up criteria and selling those that appeared over-priced. Our discipline often steered us to sell or avoid most of the defensive, mega cap stocks because they had gotten ahead of their fundamentals in our view, although this hurt our performance. The market sought perceived safety, regardless of price; our value orientation was not rewarded.
Since early fall, however, we have begun to see a reversal of the defensive crouch. According to our research engine, which evaluates stocks solely on company-specific financial data, we see that investors are becoming more sensitive to valuation. This is a more normal condition, and one that tends to be encouraging for our approach.
In particular, the better performing stocks during the fourth quarter of 2012 had the following profile:
- Lower P/E multiples (usually an important buy signal, although not for the past few years)
- Smaller or mid-sized capitalization (rather than mega cap), which is traditionally the source of better returns over time
- Greater history of volatility (as you would expect with smaller stocks—which is important to understand)
- A range in quality of balance sheet, indicating that a mix of "higher quality" and "lower quality" stocks have rallied
In contrast, the drivers of the past few years—dividend yield, low volatility, and a record of steady earnings growth—did not account for better performance in the past few months.
We are seeing a similar change across broader asset classes. For much of the past two years, the safer investments did the best, regardless of price. Treasury bonds continued their strong relative performance until recent months. Likewise, domestic REITs and MLPs, with their attractive yields, outperformed. We sold our domestic REIT position during the rally, and avoided MLPs given their valuation. More recently, however, beaten-down international stocks have begun to rebound, and bonds have generally weakened. We began adding incrementally to our international holdings during the fall.
Will this “reversion-to-better-performance” continue? Or should we be looking to buy “defensive” stocks or asset classes as they weaken, just in case defense is still required? No one’s crystal ball is good enough to foretell what is going to happen. Our own opinion is that things will continue to get incrementally better, which should support the recent trend. But there is also plenty of room for policy missteps; and besides, trying to anticipate what is going to happen is not how we invest.
Instead, we will continue to do two things:
- Root our investment decisions in fundamental valuation criteria, so that we have a better shot at buying low and selling high, in any market environment. Our research system is designed to recognize extremes caused by emotion, and to capitalize on them with our buy/sell discipline.
- Use what we deem is an appropriate mix of offensive and defensive investment tools, to help clients achieve their short term and longer term objectives, in any market environment. It is dangerous to swap between offensive and defensive tools, since that will inevitably change the expected risk characteristics of the portfolio.
We believe these principles, as always, are the ones to guide our clients through uncertainty.