Do You Know the True Value of Your Investments?

Transcription

1 By Terry Sylvester Charron Senior Director Family Wealth Investment Advisor Group Jennifer Lord Wealth Investment Advisor Family Wealth Investment Advisor Group Do You Know the True Value of Your Investments? When choosing among various investments, we believe it's important to understand their underlying value. The current trading price of a stock, its market value, may or may not be a reflection of the underlying business value of the company it represents. Business value is the discounted value of future cash flows it is a reflection of expectations for the fundamentals and financial position of the underlying company. Market value simply reflects the current trading price of a company's stock, largely based on supply and demand. Understanding the differences between market and business value and how they impact active and passive (or index-based) solutions highlights some of the unintended consequences that can arise from a passive-only approach to investing. What Determines a Stock s Price? In principle, a stock's price is a reflection of a company's ability to generate future cash flows and the quality of a company's fundamentals, which we refer to here as business value. In reality, a stock's price can also be influenced by other factors as well, such as how confident or uncertain investors are regarding a particular market sector, equities as an asset class, fiscal policy or foreign exchange movements. These factors can be dramatic and they can loom large. However, what we have observed to be true in more than 100 years of U.S. market data is that these broader sentiments tend to have much greater short-term influence. When given enough time, stock prices tend to track the underlying earnings of the businesses they represent. Exhibit 1 shows the aggregate growth returns to shareholders and the underlying earnings growth of S&P 500 stocks over a fiveand 25-year period. Over the last five years, earnings growth has lagged market returns, leading to a significant divergence. Looking back over the last 25 years, however, we see that earnings growth and market returns are fairly similar despite such short-term divergences. 1 Do You Know the True Value of Your Investments? August 2017

2 Exhibit 1. S&P 500 Compound Annual Growth Rate Through % 9.3% 8.1% Annualized growth rate of total returns Annualized growth rate of EPS 3.0% 5 Year 25 Year Source: BNY Mellon Wealth Management, Bloomberg Earnings defined as trailing 12M and calculated as Diluted EPS from Continuing Operations. Annualized total returns defined as compound annual growth rate including reinvestment of dividends. It's essential that investors who are contemplating active and passive investment solutions understand the critical distinction between a company's business value and its market value, especially when there are significant changes in share price. Understanding the context of those price moves can have a profound impact on how you react to them. Business Value Requires Extensive Analysis Business value is based on a company's economic prospects. It is an imprecise concept that can only be estimated after extensive fundamental analysis. While there are multiple approaches, the concept of basing valuation on fundamentals is rather straightforward: What is a company worth based on its sales, revenue, profits, cash flow, assets, people, location, etc., compared with other companies in the same sector? Business value is based on these quantitative and qualitative factors as interpreted by experienced analysts. When evaluating these factors, it is the education and experience of analysts that becomes the key determinant of value. Because business value is discovered through extensive analysis, it reflects the price that an informed buyer would pay for a company. In addition to reviewing an individual company's fundamentals, an informed buyer will look at the unique qualities of the company's market for example, a real estate investment trust is evaluated differently than a technology company. Factors such as the size of the company's market, its sector, stage of development, growth potential, customer base and competitor landscape will also fall under careful consideration. Although it may be imprecise, business value is generally stable and changes only gradually when compared to market value. 2 Do You Know the True Value of Your Investments? August 2017

3 Market Value Is Tied to Supply and Demand The key difference between business and market value is the influence that broader sentiments outside of the underlying fundamentals of the business have on the price of a share in the company. Instead of determining value based on a company's economic prospects, market value is subject to the supply of shares and the demand for those shares. It is a precise figure that is published daily in the financial press, and is simply the price that a company's stock is currently trading at in the marketplace. Market value is also extremely volatile and can change dramatically in a single day. The election of Donald Trump on November 8, 2016, offers a perfect example of the volatility of market values. From January 1, 2016 through November 7, 2016, financials were up 5.14%. Post-election, they were up 16.8% (see Exhibit 2). The shift from single-digit to double-digit performance can be attributed to investors' expectations that the policies implemented by the Trump administration could lead to higher infrastructure spending, reduced tax rates and less regulation, which would result in higher inflation and higher interest rates. Financials, primarily banks, are highly correlated to interest rates, which caused the significant positive returns following the election. Exhibit 2. Sector Performance in 2016 PERCENT Total Return 1/1/16-11/8/16 Total Return 11/9/16-12/31/16 Source: Morningstar Direct Source: Morningstar Direct The market value of the financial sector of the S&P 500 changed dramatically in a relatively short period of time, but the underlying fundamentals of the individual companies that make up the financial sector may or may not have changed. This illustrates the extent to which economic and political events can affect the value of a security, sector or asset class. The large impact can be positive or negative, but it does not always reflect the underlying business value or fundamental factors. 3 Do You Know the True Value of Your Investments? August 2017

4 How Do Business and Market Value Impact Active and Passive Investment Solutions? Active managers buy or sell based on how the business value matches up against the current market price. In general, an active manager will buy only if the current market price is below the anticipated (future) market price, based on an interpretation of business value (recent history is perhaps the exception with the excess stimulus provided by the Federal Reserve). A passive strategy, however, always buys or sells at the market price, without consideration of other factors. As we previously noted, market value is subject to the supply of shares and demand for them. With an ever increasing demand for indexed investments, as shown in Exhibit 3, an investor who purchases an index exchange-traded fund (ETF) or mutual fund must purchase every company name in that fund, at its current market price, regardless of the underlying business value of any particular company. Exhibit 3. Index Funds as a Share of Equity Mutual Funds Total Net Assets PERCENT Source: Investment Company Institute There has been a mass migration to indexing over the last seven years. In the U.S., the proportion of total equity funds that are passively managed increased 13% from 2009 to The nature of allocating to a passive index is, by definition, an indiscriminate approach to buying stock. Whatever the price, whatever the underlying earnings, the investment is made. As a result, a valuation metric that looks at S&P 500 market price versus its forecast earnings per share (EPS) shows that while highly correlated over time, the two have recently diverged (see Exhibit 4). While this is just one factor of many to consider, one question on investors' minds is: Will expected EPS rise to rationalize price or will price fall to better reflect future EPS? 1 Credit Suisse Investment Returns Yearbook, Do You Know the True Value of Your Investments? August 2017

5 Exhibit 4. S&P 500 Price and TTM Earnings Per Share Exhibit 4. S&P 500 Price & TTM Earnings Per Share PRICE EARNINGS PER SHARE '97 '99 '01 '03 '05 '07 '09 '11 '13 '15 '17 20 Source: Factset Market Aggregates Price Earnings Per Share The Importance of Maintaining a Long-Term Perspective Business value is generally not affected by market value, but market value must eventually reflect business value yet it often deviates by a wide margin. Although events such as the U.S. presidential election are catalysts for a change in the market, markets are forward looking. Much like campaign promises, time will either confirm current market valuations or show them to be too high or too low. If today's market has been mispricing public companies for thematic reasons and through indiscriminate vehicles like ETFs, there will likely be a reconciliation of fundamental and market value at some point. This is precisely the point at which investors could begin to benefit from active solutions that seek to avoid the overvalued stocks and exploit the undervalued. It's important to remember that businesses with valuations based on fundamentals, paid for at the right price, are not typically those that keep pace in bull markets. They tend to manage their growth with restraint and caution. Their discipline often delays gratification during favourable market environments (such as when interest rates are low), and they often consolidate the market during troughs, when competitors have run themselves into the ground. When markets are no longer consistently moving upward, the stocks that were purchased based on company fundamentals will be those that remain secure. These are the companies that we'll see active managers pursuing, as they should be shielded from the full extent of a market correction or from general market malaise. Investment managers who focus on fundamentals take a long-term view, usually defined as a business cycle or the time between market peaks or troughs. Historically, these tend to be five- to 10-year periods. Therefore, although these active managers may not outperform during bull markets, they tend to succeed in the long run. 5 Do You Know the True Value of Your Investments? August 2017

6 We Rely on the Fundamentals Investing in the stock of quality businesses with strong fundamentals has long been seen as part of a productive, long-term investment approach. And while no one would contest this principle, sometimes it is still no match for a successful bull market. As experienced investors, however, we strive to align our strategy with this concept of purchasing stocks based on business not market value, while focusing on our ultimate objectives. Although passively managed solutions can play a role in an investment approach, relying on market sentiment and indiscriminate vehicles like ETFs may not produce the results we are aiming for. If the market has mispriced a company, it will eventually correct itself and realign with the fundamental value. As we look to meet our clients' investment objectives for the long term, we must return to fundamentals and continue to make active and disciplined investment decisions. About the Authors Terry Sylvester Charron Senior Director Family Wealth Investment Advisor Group Terry Sylvester Charron is a Family Wealth Advisor for BNY Mellon Wealth Management. She works directly with families and their advisors to address investment and wealth needs. Prior to her current role Terry was a Senior Portfolio Manager, managing some of the firms largest family relationships; and investment strategist, working directly for Chief Investment Officer on asset allocation research, policy setting and alternative investment strategies. She has been responsible for identifying and developing new investment opportunities, such as hedge funds and variable insurance vehicles, designed to expand and enhance clients asset allocation strategies and after-tax performance. Her research on investing through taxable and tax-exempt vehicles has appeared in Journal of Private Portfolio Management (now Journal of Wealth Management) and others. She is currently Vice Chair of Mellon Hedge Advisors, LLC investment committee, a wholly-owned RIA of BNY Mellon; and a member of: Alternative Investment Committee and Family Wealth Solutions committee. Ms. Sylvester Charron has consulted with high net worth individuals for over 25 years, the last 19 with BNY Mellon. She holds a BA degree in business administration from Boston College and a master s in business administration from the Simmons Graduate School of Management. Jennifer Lord, MBA Wealth Investment Advisor Family Wealth Investment Advisor Group Jennifer Lord works with BNY Mellon Wealth Management s Family Wealth Investment Advisor group. In this role, she provides equity research support for a national team of advisors that specialize in the ultra-high net worth segment providing investment advice to individuals, families and institutions. Prior to her current role, Jennifer spent 5 years as an investment analyst at Walter Scott & Partners in the U.K. In this role she conducted research for the firm s long-only, global, equity portfolios. She was directly responsible for over $500 million of client assets. Jennifer holds a BA in political science from Boston College and an MBA from Imperial College London. 6 Do You Know the True Value of Your Investments? August 2017

7 @BNYMellonWealth bnymellonwealth.ca This material is the property of The Bank of New York Mellon Corporation, its subsidiaries and affiliates (collectively, BNY Mellon"). This material, either in whole or in part, must not be reproduced or disclosed to others or used for purposes other than that for which it has been supplied without the prior written permission of BNY Mellon. This material is provided for illustrative/educational purposes only. This material is not intended to constitute legal, tax, investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intended to be a full and exhaustive explanation of the law in any area or of all of the tax, investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation. BNY Mellon Wealth Management, Advisory Services, Inc. is registered as a portfolio manager and exempt market dealer in each province of Canada, and is registered as an investment fund manager in Ontario, Quebec, and Newfoundland & Labrador. Its principal regulator is the Ontario Securities Commission and is subject to Canadian and provincial laws. Trademarks and logos belong to their respective owners The Bank of New York Mellon Corporation. All rights reserved Do You Know the True Value of Your Investments? August 2017