Years of artificially low interest rates have led to artificially high stock prices with valuation indicators, such as PE, PB and Shiller’s CAPE, flashing red for some time now. And yet, notwithstanding recent volatility, stock prices resist gravity, making investors scratch their heads about what keeps the stock market elevated.
The simple answer in my opinion is lack of alternatives, especially for long-term investors such as endowment and pension funds, which has created a surge in demand for stocks at the same time that the supply of stocks is dwindling due to the aggressive buyback programs instituted by corporations in recent years. The combination creates an excess demand for stocks. This article highlights the lack of alternatives and the demand side, as exemplified by my recommendations to university endowments, which, by the way, are not any different from my recommendations to pension funds. The supply side will be dealt with in another article.
Universities receive endowments that are supposed to provide permanent support for the desired purpose. As a result, they must at least maintain their purchasing power in the long run. But this is not enough. Universities have long term fixed liabilities, such as tenure track contracts and the salary of tenured faculty may grow at a rate faster than general inflation or tuition fees, especially in specialized areas such as business, law, medicine and engineering. There is also a need to provide support to operations.
That is why universities need a long-term strategy that can produce stability and downside protection with growth opportunities.
In my opinion, the best strategy to produce such long-term results is one focused on the value investing approach. There is plenty of academic research showing that value (low price-to- earnings or price-to- book) stocks beat growth (high PE or PB) stocks in the long run, not only in Canada, but also in the U.S. and global markets. However, one needs to be clear on which particular value investing approach an endowment fund should focus on.
The pure Ben Graham approach, that targets obscure and unattractive stocks, can produce superior long-term performance, but it can result in a lot of short term volatility.
The other value investing approach is the one Buffett follows. He targets companies with barriers to entry and sustainable competitive advantage. This strategy emphasizes quality investing and can produce adequate long-term performance with lower volatility and less sensitivity to the stock market.
The two different styles’ performance is best exemplified by examining the stock returns of Berkshire Hathaway over two distinct time periods, namely 1965-1981 and 1982-2016, as Buffett was a Ben Graham investor early on in his career and, sometime after 1981, his style evolved to quality investing. Between 1965 and 1981 Berkshire Hathaway beat the S&P 500 by about 20% vs about 10% between 1982 and 2016. The company’s worst return in the first period was -48.7% (vs -26.4% for the index in 1974) as opposed to the second period’s worst return which was -31.8% (vs -37.0% for the index in 2008).
As a result, I would recommend investing heavily in an equity portfolio using the Buffett value investing approach with a portfolio concentrated in about 30 dividend paying stocks covering different industries and different regions of the world.
I would normally avoid fixed income securities, especially in these days of rock bottom interest rates, as they have very low expected returns. This aligns with the way Buffett sees things given a 2014 CNBC interview in which he said, “we are all equities … we do not have any bonds in our pension funds”. In my opinion, wide diversification is undesirable as it limits upside and it fails on the downside when protection is needed the most.
Nevertheless, the way I see diversification for university endowments is as follows.
One diversification strategy would be to examine the source of significant university gifts and commitments. If they are very sensitive to the stock market, then it would be wise to reduce direct equity investing or the portfolio should be hedged. If they are sensitive to a sector of the economy, such as real estate, the tech sector or the oil industry, then I would suggest reducing portfolio exposure to these sectors.
Universities in Alberta come to mind as an example. I would not normally recommend investing in commodities as they have low expected returns and limited long-term growth opportunities. In fact, a recent study at the University of Reading in England found that diversification in commodities “remains harmful even when the credit crisis is excluded”.
However, if the university is located in a region with extreme weather and oil dependency is critical, then investing in the oil sector would be wise as a way to diversify or hedge. The same is the case if the university has specialized medical facilities that consume huge amounts of energy.
Investing in private equity to benefit from the illiquidity premium and/or small cap premium is also a possibility as a means to diversify and benefit from the above stated premiums, even though this asset class has become very crowded as yields have declined significantly. But this is also the case with many asset classes given the artificially low interest rates of the last 10 years.
Infrastructure has also become crowded, but offers good inflation protection, as well as stable yields both of which makes it an attractive asset class for endowment funds. The same is the case for real estate, which has good diversification characteristics.
As is always the case in value investing, endowments should guard against the risk of paying too much. They can buy the best company in the world but if they pay too much this will limit the endowment’s profit or any profit opportunities for years. As value investors, they should be very selective and carry out careful due diligence and only buy if the margin of safety is met.
Consistent with my long-held view that portfolio managers underperform not because they lack stock picking ability but rather because institutional factors force them to over-diversify, my advice to endowment funds is to develop their own team of analysts and stocks pickers.
This may be unrealistic for small funds, which are better off accessing external managers with the desired Buffett style. However, for larger funds it is important to develop their own team of managers and analysts. They can benefit from stock picking and save substantially from not having to pay investment management fees.