A Year-End Letter to Clients: How the World's Wealthiest Families Invest

The last two years have seen a separation of performance by the economy and stock market in the United States versus the rest of the world. While the U.S. economy is showing steady signs of recovery, much of the rest of the world is still struggling.  As a result, the bulk of the global recovery in markets since the financial crisis of late 2008 has been fueled by the U.S.

Source: MSCI

These returns are in local currency. The difference would be more dramatic if shown in U.S. dollars, since the recent strength of the dollar means that investments overseas are even weaker when translated into U.S. currency.

Given strong recent performance by the United States economy and stock market, the question is how to position portfolios for the period ahead and in particular what to do with the equity component of portfolios. Commentators are generally divided into two general categories: those who continue to be optimistic about prospects for the U.S. market versus those who see U.S. stocks as poised for a market correction.

Given this uncertainty, some clients have recently asked if they should sell stocks. In light of that, I want to reiterate three principles that guide my approach to constructing portfolios.

Principle one: No one can predict short-term market movements

In last fall’s client letter, I mentioned that since the advent of financial news networks, a cottage industry has sprung up of pundits forecasting the direction of markets in the next three, six and 12 months. 

Anyone who claims they can predict short-term market movements is either kidding themselves or kidding you. The evidence on this is clear-cut – a comprehensive study by Vanguard examined 15 popular measures used to forecast returns – and found that none of them had meaningful predictive power for the next 12 months. Indeed, the most accurate of these only explained less than half of returns over the following 10 years. 

In the interest of getting at least one call right, many market forecasters seem to use the philosophy of “predict early and predict often.” If you’re still unsure, you may be interested in this article on “The Four Worst Market Calls Ever.” 

Principle two: Valuations matter

Having said that it is impossible to time markets with accuracy, the Vanguard study of 15 market indicators showed two measures that have the highest correlation with returns in the following 10 years.

In second place came the price-earnings ratio, using trailing earnings for the previous year. The best predictor of future returns was also price-earnings, using earnings for the previous 10 years adjusted for inflation, an approach popularized by Yale’s Robert Shiller, recipient of last year’s Nobel Prize for economics.

Using 10 years of earnings, as Shiller suggests, the outcome is quite concerning: At the end of 2014, the U.S. stock market was priced at 26-times average earnings for the past 10 years, more than 50% above the long term average of 16-times 10-year earnings. While this valuation does not approach the 44-times seen at the height of the tech bubble, it does suggest that in the next 10 years, returns on U.S. stocks will likely be lower than their historical average.

Here’s an excerpt and chart from an article from last September, based on an interview with Shiller:

"As of yesterday my price earnings ratio ... was 26.3," said Shiller. (Note: That’s still roughly where it is today.)  "There's only three major occasions in US history back to 1881 when it was higher than that. One is 1929, the year of the crash. The other is 2000, which I call the peak of the millennium bubble, and it was also followed by a crash. And then 2007, which was also followed by a crash."

Source: Robert Shiller, Yale University

As a result, Shiller has urged investors to be cautious, but has also pointed out that this measure is not designed to time when to enter and exit the market in the short term. He points out that even when high, the market can continue to rise – and equally the market can fall even when this measure is low. That said, this measure does raise a red flag for long-term investors – and makes the question of where to invest challenging when stocks appear expensive, cash pays next to nothing and bonds provide low returns and risk capital loss when interest rates rise.

Principle three: A lesson from the world’s wealthiest families

A January article from the Wall Street Journal provided a partial answer. It described 3G, the Brazilian investment firm that has purchased consumer products firms H.J. Heinz and Burger King and is rumored to have companies such as Campbell Soup, Pepsico, Kellogg and Kraft in its sights. To fund its ambitions, the article describes how recently 3G raised $5 billion from three dozen of the world’s wealthiest families. Among 3G’s partners are sophisticated investors such as Warren Buffett and Bill Ackman, the 48-year old activist investor whose success led to a recent donation of $17 million to Harvard.

3G’s secret is to focus on investing fundamentals similar to those of Warren Buffett: Undervalued brands that have strong competitive positions and robust cash flow. This approach is available to more than just wealthy families: When markets are expensive overall, you have to work harder to find companies with strong cash flows and solid balance sheets, but history suggests that it is still possible. By partnering with money managers with the right track record and investing discipline, the odds are good that long-term investors will still be able to see returns that will reward them for their patience and discipline.

Take the right risk for your comfort zone – but no more

I recognize that today seems like a particularly uncertain time. To help navigate through that, we employ three core principles of diversification, maintaining balance and risk management:

Diversification

In last fall’s client letter I pointed out that another response is expensive markets is to look outside the United States. In late August, Princeton’s Burton Malkiel wrote a Wall Street Journal article titled “Are Stock Prices Headed for a Fall?” In that article, he suggested that investors add emerging-markets stocks to their portfolios. Those stocks’ valuations based on 10-year earnings are more than 40% below that of the U.S. market. Still another strategy is to look selectively at stocks in Europe and Japan that trade at lower levels than comparable U.S. companies.

Diversification doesn’t just means holding stocks and bonds; it also entails ensuring that there is broad exposure across industry sectors. Investors who were overexposed to the energy sector saw the recent collapse in oil prices from over $100 to under $50 hit their portfolios particularly hard. And on the topic of global diversification, note that the drop in oil prices, if sustained for the period ahead, will be positive news for large oil importers in Europe and Asia.

Maintaining balance

Another lesson from wealthy families is the importance of not just starting with a diversified portfolio but maintaining that diversification as markets rise and fall. As a result of the strong performance by stocks, chances are that unless there has been action taken to reallocate funds along the way,  portfolios that had the right balance three years ago are out of balance today, with an overweighting to equities. That overweight can lead to greater downside risk than was built into the original portfolio.

Controlling risk

We design portfolios with the view of providing clients with the best possible returns on a risk adjusted basis when looking across a full market cycle. To do that, we look at the broadest possible range of alternatives, both within the United States and around the world.

Ultimately, every client’s needs are unique, and we work hard to develop the portfolio that is right for your personal risk tolerance and situation. If we haven’t talked recently, I would welcome the opportunity to sit down to update your circumstances, to ensure that your portfolio is designed to provide the returns to achieve your long-term goals with no more risk than is necessary. 

I hope that you have found this review helpful. And as always, thank you for the opportunity to serve as your financial advisor.

Dan Richards conducts programs to help advisors gain and retain clients and is an award winning faculty member in the MBA program at the University of Toronto. To see more of his written commentaries, go to www.danrichards.com or here   for his videos.

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