It is difficult to make predictions, especially about the future
A number of folks employed within the Financial Services industry make their living by making forecasts about the future. Economists, strategists, and portfolio managers spend a significant amount of time trying to make predictions about the economy, the rate of inflation, and how high the stock market will climb in the years ahead.
When it comes to our investment process, we spend most of our time analyzing companies and spend very little time making forecasts about the economy or the stock market. This doesn’t mean that we don’t read the news or that we don’t have personal views on these matters, but we don’t see much value in trying to make projections about macroeconomic variables such as interest rates or bond yields. We prefer to control our overall risk by focusing on the quality of the companies in which we are invested. Instead of making predictions about the macroeconomic environment, we tend to focus on the earnings power, the balance sheet strength, and the sustainable competitive advantages of the companies we own across our portfolios.
As we think about the second half of 2021, we expect uncertainty and volatility to become more pronounced as investors digest the strong gains made by equities during the first half of the year and the potential for new COVID variants. Looking back on the first half of 2021 there was a huge focus by the media on the growth versus value debate. During the first quarter, the yield on the 10-year U.S. Treasury note rose from 1.00% to 1.75% and this became top of mind for market commentators. The abrupt move in the U.S. 10-year yield during the first quarter led to a surge in value stocks across the energy, financial services, and industrial sectors of the stock market. Growth stocks on the other hand, underperformed significantly during the first quarter on the back of the value rally. However, during the second quarter the yield on the 10-year U.S. Treasury note fell from 1.75% to 1.45%. This led to a huge rebound in growth stocks while value stocks underperformed. In a short matter of time the stock market narrative shifted to whether the value trade had run its course. These changing narratives based on 30 to 75 basis point swings in government bond rates are somewhat puzzling to us given that interest rates are simply one factor used in calculating the intrinsic value of a stock.
In recent years there seems to be more emphasis placed on the short term. It appears to us that market strategists and economists are spending an increasing amount of time trying to make predictions about short-term movements in the 10-year U.S. Treasury yield, the US dollar, and the rate of inflation in the economy. These predictions are then used to determine the best trades for investors such as the decision to be invested in value stocks or growth stocks. We don’t try to make predictions about the economy, the 10-year U.S. Treasury yield, or the rate of inflation. The rationale behind this is that we don’t think it is easy to execute an investment strategy based on forecasting the twists and turns of the global economy and then re-adjusting our portfolios accordingly.
We don’t think it is easy to execute an investment strategy based on forecasting the twists & turns of the global economy and then re-adjusting our portfolios accordingly.
One of the problems with making forecasts is that you can be correct in making a prediction but the investment vehicle that is chosen to capitalize on that prediction might not work out. There is an old adage in the investment management industry that portfolio managers don’t have a crystal ball. But suppose they did have a well-functioning crystal ball that could accurately predict the future. Would it help them? Not always. Suppose that on January 31, 2006, you knew with certainty that the price of gold would more than triple over the next five years, from $570 per ounce to $1,900 per ounce. Given that foresight, one might be tempted to invest in Newmont Mining. Buying shares in one of the world’s largest gold producers would appear to be a no-brainer. Yet by 2011, Newmont’s share price ended up at nearly the same price at which it started in 2006. Let’s take another example. Suppose you could know ahead of time which publicly traded companies would make money and which would lose money. A rational investor might be tempted to invest in the former and bet against the latter. Yet in 1999, the stocks of profitable companies barely moved while profitless tech start-up companies soared by approximately 80%. The same phenomenon occurred again last year in the 12 months that followed the market bottom in March of 2020. The price of a basket of Non-Profitable Technology stocks generated a return of more than 400% in 12 months, which was more than 5x greater than the S&P 500 return of 75% during that incredible rebound. Taking it a step further, let’s suppose you could have known the outcome of the 2016 Presidential Election in advance. Knowing that Trump was going to win, many investors would have bet against the stock market by short-selling stocks given that a Trump victory was a very unlikely outcome based on the polls at the time. Investors who bet against the market at that time would have looked smart. For a few hours. On the night of the 2016 election, stock market futures sank rapidly as a Trump victory became increasingly likely. The S&P 500 fell by more than 5% in premarket trading, triggering a circuit breaker to halt trading. However, by the time the market closed the day after the election, the S&P 500 was up by more than 1%. Between 2017 and 2019, the average annual price return for the S&P 500 was over 14%. This happened despite numerous predictions that the stock market would tank in the event of a Trump victory.
We focus our efforts on individual business fundamentals and the factors that will impact the profitability of our companies as opposed to trying to predict the twists and turns of the economy.
At the end of the day, it is difficult to make accurate forecasts about the future. But even if our forecasts prove to be correct, it doesn’t guarantee that we can profit from them as illustrated in the forementioned examples. When it comes to our fundamental research, we focus our efforts on individual business fundamentals and the factors that will impact the profitability of our companies as opposed to trying to predict the twists and turns of the economy. When we analyze companies, our time horizon is measured in years, not in days or quarters. Our focus is on finding wonderful businesses that have a sustainable competitive advantage or a “protective moat” around their business as Warren Buffet likes to say. We want to own companies that operate in industries with high barriers to entry. These types of companies typically earn above average returns on invested capital for extended periods of time and it enables them to generate sustainable earnings growth. We believe that sustainable earnings growth is a key driver of stock price appreciation over the long term. In summary, our research efforts are focused on identifying high quality companies so that we can invest in them for the long term and let them compound in value for the benefit of our clients.
We hope that everyone is enjoying their summer.
Sources: Forbes and O’Higgins Asset Management.
*Cumberland and Cumberland Private Wealth refer to Cumberland Private Wealth Management Inc. (CPWM) and Cumberland Investment Counsel Inc. (CIC). NCM Asset Management Ltd. (NCM) is the Investment Fund Manager and CIC is the sub-advisor to the Kipling and NCM Funds. CIC is also the sub-advisor to certain CPWM investment mandates. This communication is for informational purposes only and is not intended to provide legal, accounting, tax, investment, financial or other advice and such information should not be relied upon for providing such advice. Reasonable efforts have been made to ensure that the information contained herein is accurate, complete and up to date, however, the information is subject to change without notice. The communication may contain forward-looking statements which are not guarantees of future performance. Forward-looking statements involved inherent risk and uncertainties, so it is possible that predictions, forecasts, projections and other forward-looking statements will not be achieved. All opinions in forward-looking statements are subject to change without notice and are provided in good faith but without legal responsibility. Past performance does not guarantee future results. CPWM and CIC may engage in trading strategies or hold long or short positions in any of the securities discussed in this communication and may alter such trading strategies or unwind such positions at any time without notice or liability. CPWM, CIC and NCM are under the common ownership of Cumberland Partners Ltd. Please contact your Portfolio Manager and refer to the offering documents for additional information.