Perspectives
Year 2003
“Happy days are here again,” - or are they? U.S. economic growth not only has accelerated, it is pulling much of the rest of the world along. The third quarter GDP growth scorched timid expectations, rising 8.2%. Japan’s economy is now growing, and Europe’s economies are improving. China’s economy grows at a torrid pace.
Corporate profits hit a new collective high. No wonder the stock markets did so well.
And what a year the stock market has had; the S&P 500 up 26%, the Dow Jones Industrials up 25%, and the NASDAQ up a whopping 50%. Investors who gave up on the market sell-off during either the summer of 2002 or the spring of 2003 unfortunately missed an opportunity to recover much of their loss.
Small companies were the clear leaders in gains this year. Mid-caps came in next but large companies lagged. In general, growth stocks did slightly better than value stocks. However, it was hard not to have gains last year no matter how one was invested; the key was simply being there. Riverplace Capital was able to outperform the S&P 500, Dow, and Russell 1000 growth indices through good stock picking and by managing weightings amongst sectors and small, mid and large-cap holdings according to market preferences.
The stock market advanced in the face of war in Iraq, terrorism, and ongoing challenges such as Afghanistan, North Korea, and Iran; not to mention domestic corporate scandals. It just goes to show; those kinds of events are not the long-term critical driving forces of stock market prices. They are just the bouncing balls that take some investors’ focus from those things that are paramount: profits, economic health, and long-term value of productive assets. Riverplace Capital kept its focus and our clients have been amply rewarded. We are proud of the results produced during 2003 for our clients. Riverplace Capital again beat its benchmarks; this marks the fifth year out of the past six.
Bonds, last year’s safe haven, increasingly are under pressure. A twenty-year bull market for bonds ended last year. Last spring we forecast that interest rates had bottomed and the trend now was upward. Bonds are now in the early stages of a new bear market.
The U.S. dollar has also been losing value relative to the currencies of many of our international trading partners. This has implications for our economy; in short, it makes our economy more competitive with the rest of the world. However, it will make our trade and fiscal deficits increasingly difficult to finance. The cheaper dollar is a mixed blessing, but one that will help U.S. companies with significant foreign sales.
Forecast
Economy
Frankly, Riverplace Capital and almost all other forecasters were too timid in forecasting economic growth during the latter half of last year. It came in much stronger than anticipated. We still believe, however, that progress will be irregular with strong growth spurts followed by weaker periods and vice versa. This is because high unemployment and rising interest rates periodically will unsettle progress. Terrorism is always a possibility and a presidential election can also create uncertainty. However, Riverplace Capital now believes GDP growth in 2004 will average 4% or higher, because growth in the U.S. is increasingly affected by international growth. Europe is emerging from its own recession. Japan is restructuring its banking industry and coming out of a decades-long slump. China’s growth rate appears to be accelerating. Growing economies among our trading partners offer more sales opportunities for U.S. companies. A cheaper dollar, as compared to other international currencies, helps our international competitiveness, making our goods cheaper and theirs more expensive.
Equities
Last year Riverplace Capital predicted a better than average year. We got more than predicted; in fact, market returns this past year were terrific. We expect more. Riverplace Capital expects next year to be a better than average year too. (It may even be surprisingly good!)
Most conditions are favorable for higher stock prices. Even though interest rates may move higher, they will remain historically low; business profits should continue to expand; investor confidence continues to improve; and corporations are increasing capital spending. Expanding recoveries in foreign economies support these factors. (Yes, happy days are here again!)
Stock performance may shift toward the large multinational companies that can really benefit from the cheaper dollar. However, profits will be the key. Growing profits will drive stock prices higher. Expectation of recovery was last year’s theme; actual results will be this year’s.
Fixed Income
Higher interest rates are inevitable. The question is, “When?” A one-percent fed-funds rate in an economy growing over four percent will not be sustained. Our best guess is that by late spring, rates will be moving higher. Even if the Federal Reserve is slow to respond, free markets will move most long-term interest rates higher.
One downside to very low interest rates is that they punish the saver. Of course we need more savings to fund our increasing government deficits. Also, low interest rates make borrowing from foreigners increasingly difficult. Low rates for an extended period of time create distortions in the economy too. For instance, those sectors that benefit (such as real estate) get over-done and have to then go through a correction. (This is inevitable, but probably will not become evident for another year.)
Bond values are in a long-term downtrend. In this scenario, managing fixed income portfolios is an increasingly difficult job.
Investment Strategy
Equities
Last year we positioned portfolios to benefit from the ensuing economic recovery. This year we are shifting emphasis to those companies positioned to continue higher-than-expected profitability.
In some cases, higher profits will result from more competitive international operations. In other cases, it will result from increased capital spending, and in still other cases it will come from productivity increases. Results, especially now, are the key. Those companies that do not deliver in this current expansive environment will be eliminated from portfolios. We have excellent replacement candidates waiting.
Right now, sector emphasis is not as important as individual selection; however, we are increasing our investments in the industrial, technology, and health care sectors. Less emphasis is being placed in consumer staples and financial sectors.
Fixed Income
As discussed earlier, this is a challenging environment for fixed income portfolios. We are balancing income needs with the foreseeable risks. Short maturity obligations and liquidity provide us with the ability to capture slightly higher returns, and allow us to quickly make changes as required. Thus we have purchased Treasury notes in the one-to-three year maturity range. Frankly, we see few other opportunities that meet our risk profile at this time.
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Growth or value investing, what is the real difference? What do the terms really mean? How do you recognize one from the other? The object in both cases is to provide superior return to the market averages, but which is better?
Growth investing (Riverplace Capital’s approach) involves the identification of companies that are likely to grow their revenues and earnings faster than the economy (made up of all businesses) at large. These companies’ market values reflect that growth by increasing faster than other firms. Great growth companies outperform their peers for long periods of time. Therefore true growth investing tends to require low portfolio turnover (purchase and sales).
Value investing, on the other hand, seeks to find undervalued stocks. Under valuation generally occurs when the underlying assets are worth more than is being reflected in the stock price. (Perhaps the earnings of a company are quite cyclical, so when earnings are at a low point, the company’s value does not reflect the potential if conditions improve.) If values are recognized and fully reflected, the investment should be sold and reapplied to another undervalued situation. How quickly the market recognizes the value miscalculation determines turnover. Value investing, therefore, generally has a higher rate of turnover than does growth investing.
Obviously there is plenty of gray area in these definitions; periodically, the same company can be classified under both definitions. Also some professional growth investment managers have high turnover and some value managers have low turnover. High turnover in a growth portfolio usually reflects poor selections or disguises a trading strategy merely using more volatile growth names. Low turnover for a value manager can also reflect poor selections, where either the value is not there to be recognized or is taking too long to be reflected.
Studies have shown that over the long term, both styles produce almost identical results, so for most investors, this factor does not matter much. However, the one style often performs best when the other is performing poorly, so some portfolios are constructed using both styles to reduce near term volatility, by having one style that is working in each year. Again, over a longer period of time, little difference is observed.
The most important factor for solid long term investing is the quality of the manager. Because all of the studies cited are based on averages, having a manager who performs above the relevant index is the paramount factor to any long-term investment strategy. Riverplace Capital Management has demonstrated the ability to outperform the averages and we have been consistent in our approach, so why don’t you Talk with Us?
Major Indices as of 12/31/2003
Large Cap Stocks (S&P 500) 26.38%
Dow Jones Industrial Average 25.32%
Mid Cap Stocks (S&P 400) 34.02%
NASDAQ Composite 50.01%
Small Cap Stocks (Russell 2000) 45.37%
MSCI EAFE 35.28%
Lehman Corp. Bond Index 8.33%
Inflation 1.80%
(Equity indices are twelve-month returns excluding dividends)