The rule of three is a principle with various meanings. For writers, it suggests that topics, characters, or events that come in a group of three are funnier or more effective than if a different number was used. For the superstitious, the rule of three can be either positive or negative: “third time lucky” or “misfortunes never come singly”. We intend to unashamedly draw on both meanings below.
The close of the second quarter marked three noteworthy milestones, the first of which has particular personal importance. On June 30, 2014, Black Cypress Capital turned five. So too, did the economic recovery in the United States. And while equity valuations have been making new milestones on a near daily basis, they are now priced to deliver total returns of just 3.0% for seven years.
Over the last five years, we outperformed broad market indices as well as the vast majority of other equity managers. But we are not alone in our success. There are other investors that have fared as well. The question of concern then, is how we–including our competitors–got here. The answer to that will determine the likelihood of future success.
Equity markets have risen with minor setback since early 2009. Today, we stand atop a mountain of gains that in hindsight make our climb seem easy. Remember that it wasn’t. We have had to navigate numerous exogenous risks (a possible Eurozone breakup, the “fiscal cliff”, debt ceiling fights), unprecedented government and central bank involvement, historically low interest rates that many feared were on the cusp of soaring and crushing the recovery, frequent recession “double dip” scares, inflation hysteria, all-time-high correlations between stocks, and over the latter part of this bull market, elevated valuations only becoming even more elevated.
The point is, as a manager of risk we have had a lot of opportunities to err. And though we have successfully navigated the investment landscape with higher returns and less volatility, the outcome of our diligence looks no different from the results of an investor that wasn’t paying attention or that threw caution to the wind.
Our strategy has been and will always be focused first on managing risk and second on generating outsized returns. By its very nature, such a strategy is at war with the hapless risk-taking of a late stage bull market. As a bull market ages, stocks become anchored to a future so bright that historical averages of valuation are claimed to no longer make sense or apply. And stock ideas of the highest caliber become harder and harder to find. Of course, this period can last for years and thus makes the business of managing risk all the more hazardous–in the short-term–for a prudent risk manager.
One of the tasks that we encourage you to do, dear reader (as both an investor in Black Cypress and quite possibly in other managers as well), is to determine how gains made over this cycle have been achieved. It is said that it’s only when the tide goes out that you learn who has been swimming naked. Well, it’s still high tide. And bull markets reward even the most foolish of investment strategies. We submit the following questions that could be asked today to help you determine as much before the tides goes out again. Were risks considered, properly weighed, and taken? Is a risk management process in place to protect against inevitable drawdown? Is the strategy robust across multiple types of market environments, including those with falling stock prices, or is the strategy a product of its time? The answer to these questions is critical.
Five years is considered by many to be the minimum period for which a manager’s track record of performance becomes statistically significant. While we don’t necessarily agree with this rigid five-year rule (shorter time frames can be equally meaningful if relevant circumstances were present), we are pleased to report five years of success. Particularly so because our results were achieved in an environment (stocks continuously rising from elevated valuations) which least favors our strategy. In his book Outliers, Malcolm Gladwell repeatedly claims 10,000 hours (approximately five work years) of “practice” is necessary before above-average performances can be achieved. In light of our already successful past accomplishments, that’s encouraging for Black Cypress’ next five years.
The U.S. economic recovery also turned five last month. While much progress has been made, more work needs to be done to eliminate significant economic slack. The U.S. has added only 500,000 additional workers since the end of 2007. Real wages have barely budged. Inflation-adjusted retail sales are just 3% above 2007 levels. Auto sales, while rising, have not fully recovered. And housing starts would have to rise more than 50% to match the fifty-year average.
Based on historically reliable metrics, the economic expansion should last for at least another year or two. The Fed will complete its quantitative easing program in a few months but will hold interest rates low for a considerable time, encouraging further growth in housing, autos, employment, and consumer spending. And even when the Fed does start to raise rates, the first several increases should have little, if any, negative economic impact.
While the economy has struggled to post meaningful gains since 2007, after-tax corporate profits are up more than 50%. The rise in profits is the driving force behind the broad-based equity advance. U.S. after-tax corporate profits eclipsed $1.7 trillion in 2013, a figure representing over 10% of the nation’s Gross National Product and the highest net profit margin in the country’s history.
High profit margins have important implications for valuation and future expected returns. Why? Jeremy Grantham put it best, “profit margins are probably the most mean-reverting series in finance”. Mean reversion, or regression toward the average, is the concept that if a data point is currently at an extreme level, it will tend to move closer to its average on future measurements. Historically, economy-wide net profit margins have averaged 6.0%.
In analyzing net profit margins, it helps to separate the figure into three parts: after-tax corporate profits is equal to (operating profits less net interest) times (1 minus tax rate). That is, $1.742 trillion = ($2.662 trillion – $0.489 trillion) * (1 – 19.8%). The benefit of this separation becomes obvious when the data is presented graphically.
Operating profit margins:
And corporate tax rates:
Over the last fifty years, operating profit margins have been subject to multi-year swings based on the profit cycle (which generally coincides with the business cycle), orbiting around an average 13.7% margin. During improving economic conditions, operating profit margins increase above this level. During recessions, margins decline below it. But note that there is no mean reversion for interest costs and tax rates. The former has fallen for 30 years while latter has declined for over 50 years.
Operating profit margins are the only part of the equation subject to competition- and business cycle-induced mean reversion. Interest costs and tax rates, on the other hand, are impacted by important secular trends. They must be forecasted apart from mean reversion. Failing to properly separate after-tax profits into its mean-reverting and non-mean-reverting parts could lead one to conclude that profits are currently overstated by 70% ($17.4 trillion GNP * 6.0% historical net profit margin) and set to immediately plunge, instead of concluding that net profits are elevated on the order of 15% (($17.4 trillion GNP * 13.7% historical EBIT margin) – current net interest) * (1- current tax rate), due to slightly-above-average operating margins with the longer-term risk of interest rate headwinds. With that knowledge now in mind, we can segue into addressing the valuation and future expected returns of the S&P 500.
The index is currently hovering near all-time highs. It is expected to earn $104 on sales of $1,144 (both figures per share) for the twelve months ended June 30, 2014. Interest costs are expected to be $18 per share and taxes should approximate $42 per share. S&P 500 operating profit per share is therefore $164 ($104 + $42 + $18). Operating margins are currently 14.3% while they have averaged 13.1% since the early 1990s (as far back as the data goes). This is fairly consistent with our economy-wide figures above.
As made clear both graphically and logically, the operating margin is the only inherently mean reverting series in the profit equation. It is this figure that makes sense to forecast returning to the average over the next five to ten years. We must make separate estimates for future interest costs and tax rates.
Interest costs are likely to rise as the Fed normalizes policy over the next several years. 80% of nonfinancial corporate debt is long-term and thus the increase in interest rates will have greater impact on costs as time progresses. Forecasting taxes is more problematic. Both political parties in the U.S. are discussing lowering corporate tax rates. Even if tax reform occurs, loophole concessions might muddle the impact of the lower corporate rates. Logic favors modeling flat tax rates over the next decade.
The table above should make it abundantly clear how dire the return situation is for index investors. If the current high margin, low interest cost, above-average P/E situation remains in place for seven years, equities would return less than 6.0% per year. The average pension is assuming 8.0% annual returns. Not even a portfolio fully-invested in an S&P 500 index fund under this rosy scenario is priced for 8.0% annual returns, let alone the average diversified pension portfolio containing 40% of fixed income securities.
A much more likely scenario, and the baseline forecast, assumes EBIT margins normalize over seven years, interest costs rise, tax rates remain stable, and P/E multiples decline to the 57-year average. In this scenario, buy-and-hold index investors would earn approximately 3.0% per year for seven years.
That isn’t to say that the short to medium-term forecast is as dismal. And here is where the value of separating after-tax profit into higher order parts becomes so useful. Net profit margins are likely to decline toward their average over the next decade. But if and when they do, most of the move will be due to the effects of rising interest rates and not due to some underlying, unadulterated mean reversion, as if margins have to decline to a long-term average, “just because,” without some relevant economic underpinning.
As stated above, we expect the economy to expand for another year or two and corporate profits with it. This will more than likely lift stock prices further. But while investors would benefit from the additional gains in the interim, long-term expected returns would only suffer further. For instance, if the S&P 500 rises another 25%, stocks would then be priced to lose money every year, on average, for the seven years that follow.
Unless we’ve entered a new paradigm of permanently low interest rates, high and stable profit margins, and peak multiples of earnings, stocks delivering annual returns meaningfully above inflation is, to risk looking as foolish as Vizzini from the Princess Bride, “inconceivable.” Perhaps the third time is the charm. Math and logic argue otherwise.
Fortunately, our portfolio looks nothing like the S&P 500. We are invested in less than two dozen companies, all of which are world-class and in aggregate are priced to deliver double-digit annual returns. While our process-guided, risk-focused approach may have driven little difference in outcome compared to our more carefree competitors to date, our risk management practices should be incredibly valuable in the years ahead.
I am deeply grateful for your partnership over the last five years. There are literally thousands of investment managers and the fact that you have selected Black Cypress is both humbling and motivating. We do not take this responsibility lightly. On the contrary, we consider it a task of utmost importance.
This letter was also featured @ Advisor Perspectives and ValueWalk.
This material contains the current opinions of the author but not necessarily those of Black Cypress and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without proper reference. Past performance is not a guarantee and may not be a reliable indicator of future results. ©2012, Black Cypress Captial Management