Wealth Management Questions with Bill Richardson Part 8

Three Questions for Bill Richardson Part 8

Question 1: We’ve had quite a run as stocks have recovered from COVID-19.  I’m worried that stocks are expensive now.  What are your thoughts?

If you had polled one thousand financial professionals on March 23, 2020, and asked them what the odds were that there would have been a July spike in new COVID 19 cases in the US and by September all major US indices would be trading at historic highs, you wouldn’t have seen too many believe that was possible.  But that is exactly what has happened. 

Now to be fair, companies like Amazon have benefitted from the pandemic as people have learned to shop via the Internet and many now prefer it to putting on a mask and venturing into a mall to pay more and with less selection than they could buy online.  Companies like Zoom have zoomed (please pardon the pun) as businesspeople have shifted from face-to-face to virtual meetings and the whole work-from-home trend has helped stocks like Apple and Microsoft to grow sales.

Remember, there are two major drivers of stock performance:  earnings and price/earnings ratios (the price investors are willing to pay for earnings growth).  As more and more people subscribe to Zoom, revenue will increase and as long as the company contains spending, earnings will grow.  It takes a few months for earnings to be increased and reported so as investors bid the price up, the price/earnings multiple may appear expensive. 

For smaller emerging growth companies, the price of the stock often goes up before earnings are generated.  In this case, the price/earnings multiple is exponential as investors place bets on the ability of the company to generate future earnings. 

Predicting the future is always difficult, if not impossible.  We look for companies that have generated consistent and predictable earnings growth over the past five to ten years and where that is expected to continue, and we try to buy them at a reasonable price.  During volatile periods like we are currently experiencing, the numbers require more in-depth analysis and we take a multi-factor approach (Note:  Most ETFs take a single-factor approach.  That is, they buy stocks that are cheap or growing or have low volatility.  We look at many factors including these.)

Are stocks suddenly expensive in the post-COVID rally?  Maybe.  We owned Zoom through much of the rally but a few weeks ago, we felt that it appeared to be expensive, so we sold it and it subsequently zoomed higher.  Now it is pulling back.  Trying to be perfect, trading short-term swings is tough, especially during volatile markets.   It is best to stick to our disciplines and try to be approximately correct and avoid being precisely wrong. 

 

Question 2: I hear a lot about MERs (Management Expense Ratios) on mutual funds and ETFs and I see that you hold funds and ETFs in your portfolio.  Can I really retire 30% better if I focus on minimizing fees?

There is a ton of messaging on TV, radio and over the Internet about fees and yes, it is important to stay on top of fees that you are paying for investment management but not all fees are created equal.

There is a common theory in the investment industry that only 20% of investment managers beat the index and logic therefore suggests that you should just buy the index.   From our point-of-view, as we live in a technologically advanced world, why not use technology to search out managers who consistently outperform the indices in both positive and negative markets and avoid “index huggers” and underperformers.

We use mutual funds and ETFs in our portfolios but for a strategic purpose.  In our portfolios, we manage the bulk of the portfolios buy managing much of the stock exposure ourselves but we focus on big companies that have a longer-term track record of consistent and predictable earnings growth.  By buying these directly, we avoid a second layer of costs.  The funds and ETFs are used for diversification.  We look for managers who manage small-cap companies, in international markets or that have a speciality that enhance portfolios.  We don’t want to be a single factor manager and speciality managers help to diversify the portfolio, but we don’t just pick any old manager.  We look for managers, in a particular space, who fit into the 20% who outperform their particular benchmark and actually earn their fees.  Sometimes, we even pay a performance fee on top of regular fees if a manager has an exceptional year. 

Bond funds are a particular area for which you should be very careful regarding fees.  When interest rates are below 1%, you should avoid buy and hold bond funds because the fees are higher than your expected return.  Many balanced funds are worse because stock MERs are higher and balanced funds often have equity MERs so you may be paying a manager 2% to hold bonds yielding less than 1%.  We avoid traditional bond funds for that reason and focus on private debt and absolute return bond managers who trade actively and strategically but we don’t even do those unless we have confidence that they have a high probability of generating returns to justify their fees.

 

Question 3: Do you ever use stop losses on your positions?

We have talked a fair bit about our multi-factor approach.  The first step in our process is to choose companies that have consistent and predictable earnings growth, where the analysts believe that will continue into the future and that we can buy at a reasonable price.  We focus on 200 to 300 companies out of the 23,004 in our database.  That’s only about 1% of stocks listed on the major North American stock markets.

Based on our analysis, each stock has the ability to double in price over the next 5 years.  We then look at price charts to find companies from this group who are in uptrends.  When a stock chart begins to look like the trend is changing, we do a deep dive into the fundamentals and if we can’t justify holding it or if we can find a better stock that doesn’t throw our portfolio out of whack, we sell that stock.  That is our approach to stop losses which as you get to know us better, you will see that it is not a traditional stop-loss, but we think it is a better approach.

 

Until next time, have a great day!

Bill