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U.S. stock indices gave back a morning-session rally as comments from our Fed Chairman were a bit conflicting. Those words were followed by the minutes from the FOMC’s Apr30-May1 meeting that showed there was quite the discussion over “tapering” (reducing QE near the end of the year). Of course we already knew that from the statement that immediately follows these meetings; nonetheless, the S&P 500 slid 2.2% from intraday high to intraday low.
Health care and consumer staples (two traditional safety areas of the equity market) outperformed. Utilities took the brunt of the damage (also a traditional safety play, but if the Fed’s going to allow rates to rise, then the financial-repression play that’s allowed the sector to outperform the market over the past two years is over and done – that’s a big if).
As I’ve said many times, the market is highly sensitive to what the Fed says and does as nothing else matters to traders these days – they certainly don’t care much about the true economic state of things. But because of this sensitivity, market participants sometimes takes a day or two to realize that the Fed isn’t tapering” anything any time soon.
Treasurys also took a good beating. For instance, the 10-year sold off to the tune of a 10-basis point back up in yield – settling at 2.03%, testing the high-end of the six-month range (1.58%-2.06%).
The commodity complex joined in the selloff as gold got whacked by another $17/oz, crude fell $2/bbl and coffee down for a fourth-straight day (time to stock up on joe).
Fortunately for Europe and Asia, their markets ended largely higher as they closed before the US began to sell off.
But today is another day and they’ve been greeted by the pressure. Europe is down 2% across the board. Asia is down a similar amount, with the exception of Japan as the Nikkei 225 got smashed by 7.3% -- and that’s even after the Banzai Wonder Twins activated to inject 2 trillion yen into the financial system in an attempt to stem the damage.
Since we like the investment management business, we thought it made sense to look at investment management stocks on behalf of our clients.
T. Rowe Price (TROW) is in what we call the big leagues. Whereas we just crossed $1 billion in assets under management, TROW has $617.4 billion. TROW does have a bit of a head start though. We just celebrated our 10-year anniversary while TROW has been around for seven decades.
Interestingly, although we are happy to be shareholders of TROW, we don’t use their mutual funds when investing client assets.
According to data from Morningstar, the weighted average expense ratio of TROW mutual funds is 0.84 percent. The weighted average expense ratio for the securities and funds that we use is 0.21 percent – a 75 percent discount!
While we like those high fees as owners of TROW, we don’t like them for our clients since fees generally detract from returns.
Company Profile
Part of the reason that TROW’s expense ratio is higher than the funds that we use is that their funds are actively managed, which means that their funds are intended to improve upon the benchmark index, mostly through security selection and sometimes with market timing. In the case of TROW, they have 185 research analysts supporting their portfolio managers by doing ‘bottom up’ research on a company-by-company basis, seeking stocks that are mispriced in the market compared to their fundamental value.
For TROW, the results over the long run have been good and their high level of assets in retirement plans means that the money is very ‘sticky,’ meaning that assets flow into TROW and don’t really flow out.
In fact, TROW is a model of stability: since becoming a publicly traded stock in 1986, the firm hasn’t posted a single unprofitable quarter. (Naturally, there have been plenty of unprofitable quarters for their clients since that is the nature of the stock market.)
Competitive Advantage
One of the main competitive advantages in the investment management industry is a well-known and trusted brand, which TROW definitely possesses. Even though their fund fees are higher than what we are willing to pay, they are low for the active management segment of the industry and their results are stable and good.
They have also built trust by staying with a common investment philosophy within the firm over time. They didn’t chase the internet bubble and they don’t launch new products with every shifting wind in the market. They have had a responsible approach to investing for decades that benefits their brand.
Financial Statement Review
Normally, I like to start with a look at the balance sheet to make sure that a company is in good basic health. In this case, TROW is so healthy that there isn’t much to say since the company has no debt and $2.5 billion in cash and investments in their own mutual funds.
We’ve also taken an increased interest in the income statement for all of our companies, since there is relatively new research that shows that highly profitable companies tend to have better stock performance than less profitable companies do.
While this may seem obvious, basic financial market theory suggests that the price would reflect the differences in profitability. In that case, you would have to pay a higher multiple for a profitable company and that higher price would offset any benefit.
In fact, when you look at the bottom line, or net income, there is no advantage to investing in companies with higher bottom line earnings. The ‘trick’ is to buy companies that have higher profits at the top of the income statement, which is revenues minus the cost of goods sold (COGS).
The idea of looking at gross profits instead of net profits is twofold. First, gross profits do a better job of explaining the basic economics of a business. The basic economics of the pharmaceutical industry are highly profitable because once you have a useful drug (admittedly, a hard thing to do), you can charge very high prices for a long time thanks to your patents. Utilities have much smaller gross profits because they have expensive operations to maintain and their profits are constrained by state governments through regulation.
The second issue is actually related in the sense that the gross profits are less manipulated by management which works very hard to manage the ‘bottom line’ since they know that Wall Street takes a keen interest in quarterly earnings.
Financial companies report their profitability differently than other sectors, so the calculation is different, but if we look at gross profits to equity ratio as a proxy for the gross profitability of the three largest investment managers in the S&P 500, you can see how profitable the industry can be.
The three other companies in the table are Franklin Resources (BEN), home of Franklin Templeton funds and other brands, Blackrock (BLK) owner of iShares, a product that we use frequently and the largest investment management firm in the world.
The line labeled ‘Average’ reflects a simple average of the metrics for the three companies and the line labeled ‘Financials’ covers almost the entire financials sector which also includes investment funds, banks, insurance and real estate. (There are a few exclusions due to incomplete data.)
Notice how BLK has the highest profits, but also has the most equity (assets minus liabilities), so their gross -profits -to –equity ratio is the lowest of the peers, but still higher than the overall sector.
Valuation
Of course, as we have stated in these Spotlight Stock articles many times, having a great business won’t be a good investment if you pay too much for it.
Even though investment managers are twice as profitable using this metric as the overall financial sector (banks, insurance, real estate, etc.), it won’t be any good if the prices are ten times those of other companies in the financial services industry.
As we have discussed in the past, I like to look at both the intrinsic and relative value of each company on our Approved List. The intrinsic value is based on a discounted cash flow (DCF) model created by Morningstar and we use a variety of relative value metrics to compare stock valuations with each other.
In this case, even though the PE Ratio is far from the only valuation metric that we use, I have updated the previous table that shows the gross profitability of each company to include the PE ratio.
As you can see, TROW is the most expensive company using this metric, but it is also the most profitable.
Using these metrics, TROW is 29 percent more profitable than BEN, but only eight percent more expensive, so we think that it is the best value of the three (and the best value within the financial services sector).
The table below shows the current valuation for TROW compared to the entire S&P 500 over the past 10 years.
Using these four basic fundamental metrics, the stock isn’t as cheap as it was in 2003 (coming out of the Tech Wreck), but not as expensive as it was going into and coming out of the 2008 financial crisis.
Using Morningstar’s DCF model, we think that the stock is fairly priced, meaning that it isn’t particularly cheap or expensive.
Risks
As a battle-scarred veteran of two stock market crashes, I can say from experience that the risk in the investment management business is definitely the overall market risk.
When your compensation is based on the value of the assets that you manage and those assets fall precipitously, so does your income.
That said, TROW managed their expenses well during the crisis and didn’t have any negative quarters in terms of net income, but the stock did fall about 40 percent in 2008, in line with the market drop.
A longer-term risk is the increased adoption of index funds and other passive management strategies. Vanguard already dominates this market.
By the way, Vanguard is a ‘mutual,’ which means that the company is owned by the people who own Vanguard funds. That means that all of our clients own a piece of Vanguard because they own Vanguard funds. Unlike companies owned by outside shareholders, profits at Vanguard are returned to shareholders in the form of lower expense ratios.
Part of the reason that Blackrock isn’t as profitable as TROW is that the iShares segment competes directly with Vanguard in the Exchange Traded Funds (ETF) market and is forced to compete on price. Given their massive scale and unique ownership structure, Vanguard wins most price wars.
Conclusion
For the past several years, Acropolis has maintained an underweighted position to the financial services sector, especially banks. We have maintained our exposure to financials through sector ETFs and TROW.
While the gross profitability research is relatively new, many of our companies fit this profile, including TROW. We may look at even more companies using these metrics since the results tend to mimic what we would have estimated anyway, for example that Citigroup is poorly run and a bad value.
Although the relative valuation for TROW compared to the overall market is high with a PE of 22.21 as of this writing, it is in line with other investment managers, who are much more profitable than other companies in the S&P 500.
In other words, we are willing to pay up for highly profitable companies, but not too much. That’s where we believe the art of investment management comes into play.
The science can go a long way, but we still use our own judgment in the hope that our qualitative analysis will add to the quantitative strategies that we employ.
To read this report in a PDF format, please click here.
Disclosure
T Rowe Price Group (TROW) does not represent all of the investments purchased, sold, or recommended by Acropolis Investment Management, LLC.
The performance of this investment was not a criterion in determining it as a ‘Spotlight Stock.’
Do not assume that this stock or any other investments identified or discussed were or will be profitable.
Acropolis has changed the selection criteria for the Spotlight Stock series in order to conform to SEC regulations and guidance.
Stocks selections for publication are based on the following rules:
1. Each stock is the largest individual stock based on market capitalization on the Acropolis ‘Approved List’ by sector as of August 31, 2012.
2. If a stock that follows this criteria has already been written about (Procter & Gamble, United Technologies, Norfolk Southern), then the second largest holding as of the above date will be presented (McDonald’s, General Dynamics, Chevron).
3. The stocks will be presented in the alphabetical order of the sectors (Consumer Discretionary first, Utilities last).
4. Upon publication of all the Spotlight Stock commentaries for the companies listed below, new companies will be selected.
Although specific publication dates are undetermined, the following table lists the companies that will be presented in the order they will be presented.
Well, we were without an economic release on Tuesday (and Europe was quiet on the data front too), but data seems to have become an anachronism so who cares. And certainly this market doesn’t concern itself with such tired old-school indictors of economic activity, particularly when we’ve got a Federal Reserve engaging in both talk and action.
And yesterday was no different as U.S. stock indices rebounded from early-session losses as StL and NY FRB Presidents Bullard and Dudley stated that the FOMC should keep the bond-buying program going. Those words combined with the action of a $3.5 billion POMO day. Voila!
In addition, Dudley publicly voiced his concern that investors could “overreact” even before “normalization” of monetary policy occured. Overreact? I guess it’s only an overreaction on the other side of the coin. When equity prices are in ramp-fest mode, it’s not overreaction at all, totally rational and fundamental, of course.
Getting back to market activity, a safety sector was able to sneak back to the top of the list (following two sessions in which cyclicals were in full control) as health care (2013’s best-performing sector) joined consumer discretionary and financials as the leading sectors. Telecoms and utilities continue under pressure, as has been the case for three weeks.
The commodity complex was weighed down by the precious metals again as gold and silver returned to getting thumped after a day of respite. Gold was down $20/oz. to close at $1,363 and silver slipped about 1% to $22.35/oz. Crude also joined the weakness, after four sessions of gain, as it declined $1.15 to $95.57/bbl. Wholesale gasoline slid five cents to $2.85/gal. (which should result in a pump price of about $3.50 – though the national average is sticking around $3.65). The industrial metals, nat.gas and cattle kept the complex from a larger decline.
In Europe, the major equity bourses ended mixed as the UK’s FTSE led the gainer, while France’s CAC-40 led the losers.
The results were mixed in Asia as well as the Shanghai Composite led the gainers; Japan’s main indices also gained a little more ground. India pressured the Pacific Rim as the CNX Nifty Fifty declined 0.7%.
U.S. stocks sold off after beginning Monday’s session higher, Treasury yields backed up (prices down) and the commodity complex gained for a second session. The S&P 500 ended the day exactly 1,000 points above the nefarious 13-year low, which was touched intraday on March 9, 2009 (h/t Cliff Reynolds).
The reversal in stocks followed comments from Charles Evans in which he chose to inform everyone (or anyone who’s been hiding under a rock, I guess) that the Fed’s balance sheet will reach $4 trillion by the end of 2013. Man, that’s a lot to unwind, as if they can even do so at this point. In any event, the market seemed to take that as an admission that they can’t do much more; although, obvious by the mild decline, traders weren’t terribly worried.
Energy, financials and industrials have become the new leaders (at least for the past couple of sessions). Conversely, staples, telecoms and utilities are the new dogs over this brief stretch. We’ve even seen a little rotation into tech, which remains the year’s second-worst performing sector.
The Treasury market sold off to the tune of about two basis points on the 10-year – settling at 1.97% (high end of the six month range).
The commodity reversal (antithetical to that of stocks as they began down and ended higher) was totally driven by action in silver and gold as the former rallied 8% from the session’s low point and the latter by 4%.
So the commodities rallied a bit, but have been sliding since May 2011. The complex is very much manipulated by central bank action, but may be a better indication of global economic reality than that of stocks. (That of course wouldn’t be hard to beat as equities take a backseat only to the bond market in terms of Bernanke’s manipulation.) While most of the 22% slide within the complex over the past two years has been driven by the precious metals components, outside of a few commodities that consumers can’t escape on a day-to-day basis, the declines have been widespread.
U.S. stock indices fed off of a surging U of M confidence index on Friday to close higher again (up 12 of the past 15 sessions). It was all cyclicals in charge as energy, industrials and financial (thanks David Tepper) led the charge. Safety languished as staples, telecoms and health care were the biggest laggards.
For the week, the S&P 500 gained 2.07% (for 2013 it’s 16 weeks up and just four down).
Treasurys sold off pretty hard, sending the 10-year yield back to the high end of the six-month range – settling up seven bps to 1.95%.
The commodity complex wasn’t playing along though as the precious metals got thumped again; OJ and cattle also sold off. Industrial metals and energy rallied on the high hopes of the confidence readong, but not enough to offset the decliners.
For the big name among those precious metals, gold is down seven days straight (good for $110/oz.). It’s now below the level it plunged to in April and is 12% below the support it had enjoyed during the late 2011 and mid 2012 sell offs (which was $1,540). One has to suspect that gold’s become the new asset to short.
In Europe another ugly day of data didn’t adversely affect equity prices (and why should it -- In Bernanke They Trust) as the continent’s major bourses shook off early-session declines to close nicely higher.
Over in the Pacific Rim, the Banzai Wonder Twins continue to activate as they sent the Nikkei up enough to more than recover from the prior-session’s decline. China ripped higher (although stuck at a level first hit 12 years ago). New Zealand and the Philippines didn’t get the memo to jolt higher, the only ones to close in negative territory.
U.S. stocks fell for the first session in five as Federal Reserve Bank of San Francisco President Williams gave a speech in which he talked about the “tapering” of QE. Tech, which has been the dog of 2013, was the only sector to close higher, helping to keep the S&P 500 from a deeper decline.
That Williams mentioned this even as the past two days of data have been especially ugly is not just strange, but uncompelling. There’s no way the big three on the FOMC (Bernanke, Yellen and Dudley) are going for this. Besides, this is just part of one of the Fed’s games that they play. That is, offer a façade that there’s some level of hawkishness residing within the Eccles Building. Nevertheless, the market didn’t appreciate the commentary. And frankly, since the major indices didn’t fall harder, I’m not sure they took the speech all that seriously anyway.
The Treasury market didn’t buy the comments whatsoever as the long end of the curve rallied to the tune of six basis points. That sent the 10-year yield down to 1.87%.
European equity bourses, which began their session higher, ended lower as they fell in sympathy with US stocks.
Over in Asia, the major indices ended mixed as China led the gainers, while the NICs (newly-industrialized countries) along with Japan led the losers.
And speaking of Asia, the Japanese economy expanded at the fastest pace in a year, and on an inflation-adjusted basis at a level that is rarely seen (+3.6% annualized rate) for an economy that’s dead in the water. But Japan doesn’t have inflation, which is why the Banzai brothers have taken monetary policy beyond extraordinary levels. Thus, most of the increase was due to the deflator (the GDP inflation gauge) collapsing at a 3% annual rate. The nominal rate increased just 1.2% annualized. Of course, anything with a positive sign in front of it gets economists all excited these days. Still, we shouldn’t get carried away, as the press has begun to do, with thinking Abenomics is working.
U.S. stock indices rallied from early-session weakness as traders couldn’t care that the day’s economic releases (both domestic and out of Europe) were broad-based ugly. Who needs economic growth when we’ve got central banks implementing a policy of whatever it takes, or so the thought process goes…for as long as that lasts.
Safety returned to the top-performers list as staples and utilities were among the winners; they were joined by the financials. Energy and tech (again) were the dogs.
The long end of the Treasury curve rallied along with stocks, sending the 10-year yield down four basis points to 1.94%. Still, that yield remains near the upper end of the six-month range (1.59% to 2.06%).
European equity indices rallied despite that fact that the euro zone’s recession extended to six quarters and shows not only zero sign of recovery but that the contraction is likely to deepen.
All major economies, with the exception of Germany (which just barely escaped consecutive negative GDP prints), remain in technical recession. And that elephant in the room I’ve been talking about (France) posted its third quarter of economic contraction out of the last four.
So with the euro-zone recession extending to six quarters (the longest in the euro era, but of course not as deep as the 2008-09 recession) this sets the stage for the ECB to engage in QE. Yes, they’ve pledged to backstop troubled-country debt but have never actually taken action (haven’t needed to as investors, or is it just their banks that continue to gorge on the toxicity, continue to lurch for yield with no regard for risk). Heretofore, the obstacle to Super Mario rolling out his version of QE has been the Berlin Wall of the German Bundesbank/Bundestag. But with Germany so close to recession, I suspect even they will cave.
Two weeks ago I had the pleasure of attending a presentation by Michael Pompian, author of Behavioral Finance and Wealth Management and several academic works that are incorporated in the behavioral finance curriculum for CFA Institute.
Pompian’s book linked above is an excellent read for anyone seeking to improve their investing. Listening to him speak inspired me to write about the important role psychology plays in finance decisions among investors.
Unlike traditional finance models, which assume that investors always make perfectly rational decisions based on all available information, behavioral finance recognizes that we as humans make mistakes. Generally these mistakes are a result of our limited cognitive abilities (cognitive biases) or emotional tendencies (emotional biases).
Cognitive biases stem from statistical, information processing, or memory errors. For example, investors may fail to update probabilities (especially within a Bayesian framework) or they may not gather and properly consider all relevant information. Instead, investors gather what they believe is sufficient information and apply heuristics to analyze and shape the information. The result is faulty reasoning and decisions that are not optimal from a traditional finance perspective.
Cognitive biases are grouped into two categories: belief perseverance and information processing. Belief perseverance bias occurs when an investors clings to their previously held beliefs despite contradictory information. One example would be an investor ignoring information that conflicts with their view or only remembering information that confirms existing beliefs. Information processing biases occur when an investors sorts and processes information illogically.
Unlike the deliberate nature of cognitive biases, emotional biases are more of a spontaneous reaction in attempt to satisfy basic human desires of avoiding pain and producing pleasure. The psychological predispositions that cause investors to irrationally frame information or a decision are harder to correct for than cognitive errors.
Mr. Pompian’s book thoroughly covers 20 different behavioral biases that fall into the cognitive or emotional bias categories. Below are brief descriptions of five biases I see frequently among individual investors. Read them carefully and try to identify the biases that you may experience in your own investing.
Read more: Market Minute: Five Biases That Hurt Investor Returns
U.S. stocks advanced on Tuesday, making it 15 winning sessions out of the past 18 for the S&P 500, even as what had become the fulcrum security (the Italian 10-year) sold off (yield higher) for a fourth-straight day.
It was all cyclicals driving the market higher – an unusual situation thus far in 2013 – as financials, materials and energy led the move. Telecoms, tech (still a 2013 dog) and utilities were the biggest losers – although even these groups ended higher.
That which has been seen as the fulcrum security for some time now (as it has gone so has the rest of the risk asset world), looks to be relinquishing that position – the Italian 10-year is down four sessions straight, yet most developed-nation equity indices continue to run higher.
Also, while the Treasury market sold off (corroborating the risk-on move), credit did not as both investment grade and high-yield corporate bond indices declined.
Overseas, all major European equity indices rallied, about 0.50% on average, as Italy and the UK led the gains. In Asia it was a mixed scene as the Chinese indices led the decliners (Japan also pulled back), while the South Korean KOSPI led the winners.
U.S. stock indices ended mixed on Monday as the broad S&P 500 and NASDAQ managed fractional gains, while the Dow Industrials, mid and small caps lost ground.
After a two-session respite, safety returned to its 2013 role of sneaking into the top-performers list as health care and consumer staples joined financials as the only sector to gain ground yesterday. Telecoms and basic materials were the biggest losers.
The Treasury market sold off for a sixth day in seven, resulting in a yield back-up good for 30 basis points over this stretch. It appears the talk of the Fed “tapering” 2013 QE is the culprit – I think we’ll all look back in a couple weeks and laugh at such musings. Bernanke & Co. aren’t slowing the scheduled $85 billion/month in bond purchases during 2013 any more than European governments are engaging in the austerity they continue to blame their now 18-month long recession upon. (And speaking of which, I’ve noticed the financial press finally beginning to acknowledge that European austerity is more a perception than a reality. So for those who have relied on media reporting rather than seeking out the facts themselves, they’ve been tricked into thinking European governments have made progress in reforming the social model that currently buries the continent.)
The commodity complex sold off for a second day as the prices of crude, wholesale gasoline, cotton and aluminum pressured. Gasoline is down to about 10% since March -- although, still 20% above the five-year average. It settled at $2.82/gal. on Monday (add roughly 65 cents and you get the price at the pump). Crude declined $1.22 to $94.82/bbl.
The prices of corn (back near its all-time high), OJ (still 30% off the all-time peak hit in 2012) and wheat (just a touch above the five-year average) kept the complex from a deeper decline.
Most European equity indices lost ground, with the exception of the UK and German bourses that managed slight gains.
Over in Asia, indices were mixed as China, India and Indonesia got clocked. Japanese indices led the gainers, which as I’ve been noting has been the case for several months. Malaysia and the Philippines came along for the ride. It is getting quite interesting for Japan’s Nikkei – and the Banzai brothers that juice it higher. Not only does the index trade at 28 times earnings, even as the country remains mired in a two-year recession. But it has also hit a technical resistance level that’s summarily resulted in 40%-60% plunges three times now since 1996.
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