Fall 2021 Portfolio Enhancements
Our Investment Team is continually looking for opportunities to improve client portfolios, and we’re constantly monitoring the investment landscape for products and strategies which may improve returns, reduce risk, or improve tax efficiency. After an extensive, multi-year effort, we have approved a number of portfolio upgrades.
We are excited to introduce two new managers, Distillate Capital and Pacer Financial, who we will be partnering with and utilizing to access U.S. and International equities. In addition, we will be employing a new international equity strategy from one of our longtime partners, Dimensional Fund Advisors.
As always, any portfolio adjustments will be customized in consideration of each client’s unique portfolio, and made within the context of their financial plan and tax circumstances. For this reason, utilization of the funds held with these two new managers may not be applicable to some client portfolios.
A successful investment philosophy is one which is designed with your financial plan, and your financial goals, in mind. Thinking about portfolio construction in this way encourages us, as well as our clients, to focus on variables which will drive long-term success, rather than short-term noise. The strategies we use, the investments we make, and the managers we partner with are all evaluated through this framework. As a result, we have historically had long-lasting and deep relationships with the investment managers whose strategies and philosophies best meet our clients’ needs, and while we continuously monitor the investment landscape for new and innovative solutions, our manager turnover has historically been very low.
This focus on producing successful long-term client outcomes is called “evidence-based investing.” This philosophy leads us to believe strongly in the evidence, which shows us, for example, that low-cost, diversified and tax-efficient strategies are most likely to deliver the best returns to our clients.
One investment strategy that has tremendous historical evidence supporting its ability to improve client portfolios is value investing, which is simply being mindful of the price you pay for a stock, relative to a company’s fundamentals. This is something consumers do every day, evaluating the price they pay relative to the value they receive for a good or service. In the same way, value investors are mindful not to overpay for their investments.
Value investing can be thought of as the opposite of playing the lottery. Rather than chasing the small probability of tremendous gain with a high probability of loss, we prefer to invest in strong companies that deliver consistent profits to our clients. Historically, this method of investing has produced strong long-term market outperformance, and can be implemented in a diversified, low-cost, and tax-efficient manner.
While we have deep respect for the historical evidence which supports an investment strategy, we are also mindful that what worked in the past is not guaranteed to work in the future. The world is constantly evolving, and it’s important that we remain diligent in understanding how these changes impact our strategies. For the reasons outlined below, we are making an adjustment to our investment philosophy today to utilize innovative and time-tested strategies designed to effectively navigate a meaningful shift in our economic landscape.
For years, value investors have been heavily influenced by the methods outlined by Nobel Prize winning economist Eugene Fama, and co-author Ken French, in their seminal 1992 paper, and subsequent 2015 paper, which popularized the price-to-book value framework for value investing. Every company has a balance sheet, just like each individual has a net worth statement, accounting for assets and liabilities. Book value in a company is, in essence, the same thing as net worth when referring to a personal balance sheet. In theory, a stock which sells for a low price relative to its net worth, is a stock that is selling for a bargain, and should outperform stocks whose prices are high relative to their net worth. This method of filtering the market, buying the low price-to-book stocks, is not just theoretically sound, but has also performed extremely well throughout history, both in the United States and internationally.
Without getting overly technical, the price-to-book value methodology has become challenged by an evolving economy, which increasingly relies on what are known as intangible assets. Tangible assets, such as plant, property, and equipment, are all valued on a company’s balance sheet, and therefore dictate a company’s book value. Intangible assets, such as a software program that a company develops, are not valued on a balance sheet due to the conservative nature of accounting standards. As a result, the balance sheet has increasingly become a less reliable measurement of a company’s fair value.
While steel plants, coal factories, and shipping companies all have tremendous tangible assets, like buildings, equipment, etc., that we can review on a balance sheet, many technology and healthcare companies have little to no physical assets, and so their stocks will inevitably have high price-to-book values. For example, Microsoft is one of the most valuable companies in the world, but that isn’t because of its large factories and valuable machinery. Microsoft is valuable because millions and millions of people and businesses pay to access its software. This software is incredibly valuable, driving billions in profits each year, but because this software is not a physical asset, Microsoft isn’t allowed to place this incredibly valuable asset on its balance sheet. Unlike companies such as U.S. Steel or Ford, the balance sheet doesn’t tell us a whole lot about Microsoft’s intrinsic value.
This issue is making it increasingly difficult to segment the market using the balance sheet, as a growing number of companies just simply aren’t able to be evaluated through this lens. Fortunately, we can make some small technical adjustments to solve for this issue. While the balance sheet may be less and less useful moving forward, we can still accomplish the fundamental goal of value investing, which we described above as, “being mindful of the price you’re paying, relative to a company’s fundamentals.” To do this, we can look away from the balance sheet and instead focus on profits. Being mindful of the price we pay for a stock relative to the profits produced by that company has also proven to be a very successful method of value investing historically. Using this framework, we will be better equipped to evaluate physical asset companies like U.S. Steel or Ford relative to intangible asset companies such as Microsoft or Apple.
When constructing portfolios for our clients, we need to find partners that can provide the complementary investment ingredients for us to put together in the right mix. We are adding two partners to our menu—Pacer Financial and Distillate Capital—that are using robust methodologies to systematically segment the market using a profit-focused framework. These managers offer diversified, low-cost and tax-efficient exchange-traded funds for us to implement into our portfolios.
Where applicable, we are beginning to transition our clients’ accounts to utilize these strategies. As always, any portfolio adjustments will be customized for your unique portfolio, and made within the context of your financial plan and tax circumstances. If you have any questions, your advisor would be happy to discuss these portfolio changes in more depth.
If you desire more information on this topic, we invite you to view a curated list of articles here.