Peter Mann is a managing director and portfolio manager with Gluskin Sheff + Associates Inc.
We all enjoy a free ride from time to time. The tailwind on the lake that eases your paddling, the "up" escalator at the bottom of the stairs, the neighbour driving by who gives you a ride downtown – it's nice to relax and let someone else do the heavy lifting.
The U.S. equity market has given investors a free ride for a while. There has not been a down year since 2008, and several years have provided double-digit returns.
With annualized returns for the broader U.S. market averaging more than 13 per cent over the past five years, passive exchange-traded fund (ETF) investors have let the market do the heavy lifting and enjoyed healthy returns along the way.
Even amidst the economic and political uncertainty of 2014, the S&P 500 has moved higher on the backs of larger global businesses – Apple, Microsoft, Hewlett Packard, Johnson & Johnson to name a few – with the stocks of many smaller companies treading water or moving lower.
We've had a strong market for several years, but there are signs that the free ride may be over – and that we're entering a lumpy market where active stock selectors will benefit.
How we arrived at this point
The market meltdown of 2008 brought a political response like no other – governments across the globe undertook extraordinary measures to save world economies. They lowered interest rates, increased their spending and purchased government bonds (quantitative easing) to increase money supply.
While many good businesses benefited from these measures, a lot of highly leveraged, poorly managed companies that had fallen hardest during the crisis benefited even more.
The rising tide lifted all companies – good and bad – and as economies stabilized and began their recovery, stocks moved up in unison.
The shift is on
As 2014 draws to a close, however, times are changing. The easy money has been made, and challenges are emerging.
Global growth is anemic, with China's economy slowing and little or no growth in Europe and Japan. And for U.S.-based companies operating globally, foreign earnings have been negatively affected by a strong U.S. dollar.
As a result, the price-to-earnings valuation of many companies is high, with growth estimates – at least on their own – that do not support current stock prices, let alone higher ones.
The lift that monetary stimulus measures provided has long passed, and the U.S. Federal Reserve has moved in the opposite direction in ending its quantitative easing program. Meanwhile, investors know that interest rate increases are not far off.
About a year ago, we started to see a slide in performance in some sectors. We are now seeing mixed performance within sectors, with some companies doing well and others not. In short, it's become a market where active stock selection is critical to strong portfolio performance.
A portfolio of ideas
You may be familiar with portfolio management terms such as "alpha" and "beta." Beta refers to returns based on market growth while alpha is the excess return above market that active portfolio management can generate.
Passive ETF investors over the past few years have not been too concerned about alpha, as their beta-oriented, market-tracking portfolios enjoyed double-digit returns. But what happens when volatility increases and markets stop moving straight up?
Given the run that we have had, the probability is that that is happening now – we have entered a period in which discriminating stock-picking will make all the difference.
The canary in the coal mine might have been the month of September, when we saw the greatest peak of money moving into the passive ETF market. The peak is when smart investors typically exit a particular strategy – and as we approach 2015, the smart money will be shifting to active investment management.
Warren Buffet is the master of this approach. From 1966 to 1981, the Dow Jones Industrial Average rose by just a single index point. This meant that passive investors who tracked that particular index had a zero per cent return on their investment for that 15-year time period.
During those same 15 years, Warren Buffet generated average returns of more than 30 per cent annually through his Berkshire Hathaway holding company. How did he do it? By focusing on individual stock ideas and investing in businesses that generated far more cash flow than they needed to support operations, resulting in growing dividends and an increasing value to shareholders.
The search for alpha
While annual returns of 30 per cent are unrealistic in today's market, active managers can generate alpha in flat or negative markets by focusing on companies that hold a monopoly or duopoly and that generate long-term discretionary cash flow. This includes many service-based businesses, from health care, to cable and media, to financial services.
And bigger is not always better. In the last 25 years, the globe has been effectively "rolled-up" into large holding companies where geography, product breadth and diversity converge under a single business empire. While revenues of many companies grew under this approach – and CEOs were rewarded for their improving top line – wealth did not always trickle down to the bottom line in terms of earnings.
As a result, we've started to see a "rolling down" of these large businesses into smaller earnings-focused entities. As this "un-coupling" of large conglomerates continues, smart managers will look for CEOs who act as chief capital allocator, focusing on free cash flow generation and returns net of the company's cost of capital.
The pivotal role of the U.S. market
The U.S. economy remains the engine that will drive global growth, with the American consumer accounting for nearly a quarter of global GDP.
And while the U.S. has had its foot on the gas pedal for the past five years in terms of stimulating its economy, it is easing up just as other countries are accelerating stimulus measures.
For this reason, we expect the U.S. dollar to maintain its strength – and to grow stronger if the Fed leads the way in raising interest rates, as we expect it will.
Given this outlook, we believe that many of the best stock ideas from around the world will be found in the U.S. market. The economy is broadly diversified, with more service-oriented businesses and an overall cash flow focus that does not exist in other parts of the world where there is more capital intensity.
As well, the strong U.S. dollar will benefit investors who live in other, "weaker currency" world regions.
But a rising tide will no longer lift all portfolios – there will be winners and losers in a very choppy market going forward. The broad market tailwind is fading fast, and the need for a more focused, actively managed portfolio is growing greater by the day.