Sat, 31 Jan 2015
Starting from current valuations, stocks simply aren't capable of delivering double-digit annualized total returns, says Morningstar's Matt Coffina.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Last year was another good one for stocks. I'm here with Matt Coffina--he's the editor of Morningstar StockInvestor newsletter--to see how his portfolios did versus the broader market and his outlook for 2015. Matt, thanks for joining me.
Matt Coffina: Thanks for having me, Jeremy.
Glaser: Let's start by looking at the numbers. For the Tortoise and Hare portfolios that you manage, what did that performance look like versus the S&P 500?
Coffina: We had a good year. Both the Tortoise, which is our more conservative portfolio, and the Hare, which is our more aggressive picks, outperformed the S&P 500--the Tortoise by a slightly wider margin than the Hare. And on a combined basis, our portfolios were up 19.1% in 2014 versus the S&P 500, which was up 13.7%. So, we outperformed by 540 basis points. And that was actually our best year of relative performance since 2008. It's generally somewhat more difficult for our portfolios, which tend to be more conservatively oriented. It tends to be somewhat more difficult to outperform in what is a good year for stocks, like we had last year; but we had a pretty good year overall.
Glaser: Let's look at some of the factors that led to that outperformance. What holdings do you have that really contributed to that the most?
Coffina: There were a few themes that I would point to. Definitely, the decline in long-term interest rates helped us, especially in our Tortoise portfolio. So, some of the top-performing sectors last year were real estate, utilities, health care--generally more defensive, somewhat higher-yielding sectors. We had some exposure here, especially in the Tortoise, with companies like ITC Holdings (ITC) and HCP (HPC), which is a health-care REIT. And those stocks generally outperformed.
We also had a lot of repeat winners--stocks that did very well in 2013 that carried over to 2014. Often for similar reasons, but there aren't necessarily any broader themes that I can point to. It's really company-specific factors at work. So, for example, Energy Transfer Equity (ETE) continued to accelerate its distribution growth, continue to find new capital investment projects. General Dynamics (GD) continued to manage very well through the the defense-spending headwinds that they are facing. They continue to grow earnings; their backlog was very healthy.
Another name that did very well for us would be Lowe's (LOW). That actually fits in another category, which is retailers. All of our retailers did very well. Lowe's was a big winner as the housing recovery continued; the company continued to expand margins. We also did well with PetSmart (PETM), a stock that we bought. Really, our timing was lucky here because a month after we bought it, there was some involvement from an activist investor, and before the year was out, the company ended up agreeing to sell itself to some private equity firms. And I would say that was probably the biggest theme of all. We had a lot of one-off situations. There were a few themes that we could point to, but also a lot of company-specific factors that drove the outperformance. And that's really what you want to see, because I think it means that you are taking a diversified approach and your picks are working out for a variety of reasons.
Glaser: On the other hand, what holdings did you have that didn't work out so well this year that maybe reduced your performance?
Coffina: So, the two big headwinds we had, I would say, were the stronger U.S. dollar--and that really weighed on some of our global consumer staples firms. For example, we own Unilever (UL), Coca-Cola (KO), Philip Morris International (PM). Those companies had, in general, most or all of their earnings growth wiped out by the stronger U.S. dollar and their stocks tended to underperform. The other headwind was the fall in oil prices late in the year. So, this really hurt our positions in Schlumberger (SLB) and National Oilwell Varco (NOV) two oil-services and equipment names.
On the other hand, it wasn't all bad news in energy. Fortunately, we were able to reposition ourselves to take advantage of a runup in natural gas prices earlier in the year. So, we sold Exelon (EXC) early in the year and that ended up being one of our top performers. It had been a long-term laggard for us. We also sold Cloud Peak Energy (CLD) early in the year. By the end of the year with the decline in oil and gas prices, Cloud Peak was down more than 50%. So, again, we did well by selling early.
Glaser: Looking ahead to this year, then, what trends do you think are going to continue? What are your expectations for this year and also over the long run?
Coffina: So, it's been, generally, a very challenging environment for us. I was very satisfied with our performance last year, but I certainly didn't expect it going into the year. Going into 2014, we thought that stocks were already pretty fully valued. [But we had another] strong year for stocks, and here we are now with stocks even more fully valued. So, there are really very few opportunities out there, especially among the high-quality, wide-moat companies that we tend to favor. So really, it's very slim pickings, and I would say my main message to investors is that you should set your expectations pretty low or you should at least have reasonable expectations--which is to say that the market is very, very unlikely to deliver returns going forward anything like what they've been over the past five years.
The last five years--almost six years now--the bull market was enabled by the very depressed valuations during the financial crisis. But starting from current valuations, stocks simply aren't capable of delivering double-digit or even 20% annualized total returns. Realistically for the market, I think we could expect maybe 6% to 8% over the long run in nominal terms. And from our portfolio holdings, which I think tend to compound their intrinsic value steadily over time, steadily growing earnings, I'd be very satisfied with 8% to 10% total return.
So, I think the outlook is still good for us to outperform the market over a long time horizon. I would never predict that we're going to outperform over any given year; but just owning such very-high-quality companies, reasonably priced companies on the whole, and companies that continue to compound their intrinsic values, I think we can hope for an 8% to 10% total return in the long run. And I think that's likely to beat the market's return, which is likely to be more in the mid-single digits.
Glaser: So, your advice for 2015 is to keep your expectations in check.
Coffina: For 2015 and beyond, I would say. If the market comes down and valuations become more attractive, then we could be more optimistic about future returns. But starting from the current level of valuations, I would say stocks still, of course, look far more attractive than bonds or pretty much any other alternatives that are out there. But I don't think stocks are priced to deliver continued double-digit total returns like we've seen over the last five years. That was really only possible because of the depressed starting valuations that existed during the financial crisis. And historically, I think if you look back at when stocks had been trading at similar valuations to what we see right now, investors have tended to be disappointed over the next five or 10 years.
Glaser: Matt, thanks for the update today.
Coffina: Thanks for having me.
Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.
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