Investors face three challenges these days: There is no return on cash instruments; credit spreads are very tight, making fixed-income investing vulnerable to rising interest rates; and the S&P 500 isn't cheap, based on valuation metrics that don't rely on the next 12 months' earnings.
To be clear, the modest 14 times forward multiple on S&P 500 earnings may prove to be a positive equity indicator if the abnormally high corporate profit margins turn out to be sustainable for a significant period of time. Corporations are experiencing operating margins of about 13%, versus postwar median margins of 9.5%.
We would urge caution in assuming that margins won't revert to the mean; they have always done so in the past.
Investors should understand that stocks and bonds are marketed daily like most goods and services in the economy, and thus often carry a marketing premium. An opportunistic capital allocator is particularly sensitive to this fact and sits patiently until an investment situation is presented in which the odds of success are high and the reward far outweighs the risk.
In the absence of such situations, opportunistic capital allocators ought to do nothing.
Many think that investing in simple market exposure will result in adequate returns. We disagree.
The financial services industry often references an annualized return of 10% for the period of 1926 to the present. Although that is accurate, it ignores the fact that the S&P 500 (including dividends) failed to produce an annualized return of even 8% in more than 40% of the monthly rolling 10-year periods dating back to 1926.
In our opinion, highly price- conscious investors who opportunistically allocate capital are more likely to outperform the market.
Such investors have the advantage of waiting for opportunities, unlike the vast majority of mutual fund managers, who must live with investment mandates requiring them to remain fully invested at all times.
WAITING FOR OPPORTUNITIES
When will new opportunities arise? The investor never knows.
Great investing is demonstrated in the resolve to work relentlessly, wait patiently and strike with enough force to have a meaningful portfolio impact. In this way, individual investors living without investment mandates possess something many professional investors lack —namely, the flexibility or prerogative to do nothing.
Nevertheless, there are drawbacks to opportunistic capital allocation. This category of investors in general, and deep value-oriented ones specifically, often are picky about price and consequently miss reasonable risk/reward investment opportunities while waiting for perfect conditions.
Second, if markets rise unabated, this strategy is likely to underperform popular indexes — for a period, especially if a conservative investment stance is taken and no attempt is made to “chase” securities. The opportunity cost of cash is more than offset by the ability to act boldly when situations are presented that have a high margin of safety.
Investors should view their opportunity set as not just what is available today but what may become available tomorrow, as well.
Why not stay fully invested at all times? In a word: pricing.
Benjamin Graham once said that investing is most intelligent when it is most businesslike, words that Warren E. Buffett described as the most important ever spoken about investing. Investors should be in the business of valuing companies (in terms of their earnings power and asset value), determining an appropriate discount level required to live with the risks embedded in the security and buying when that price level is met.
An investor should ask: Would I take this company private?
One doesn't take a company private as a result of anticipated
Federal Reserve action, rate expectations or attempts to handicap money flows into select asset classes. That is market “stuff,” and it isn't what smart investors ought to do.
Rather, they should remain businesslike. That is most likely to add value to their process.
Jim Roumell is president of Roumell Asset Management LLC and portfolio manager of the Roumell Opportunistic Value Fund.
