Thu, 4 Oct 2012
A 'price matters' discipline combined with a momentum process can help investors avoid catching falling knives in a down market or leaving money on the table in an up market, says RiverFront Investment Group chairman and CIO Michael Jones.
Scott Burns: The go-anywhere investing decision process.
Hi, there. I'm Scott Burns, Morningstar's director of fund research. Joining me today is Michael Jones, who is a chief investment officer and chairman of the board of the RiverFront Investment Group.
Michael, thanks for being here today.
Michael Jones: My pleasure.
Burns: So, you are participating in Morningstar's ETF Invest Conference and you were just on a panel titled “Where are the go-anywhere managers going?” But I think that kind of precludes a question. You are running a tactical asset-allocation strategy. It's one thing to know where you are going. I think it's actually more informative to think about, well, how do you decide where to go and how do you decide where to position that portfolio? So, maybe you can talk to us a little bit about your investment process.
Jones: Sure. Well, we have over the last 20 years developed a philosophy and a process around a simple concept and that's: The price you pay for something matters. So, we set our expectations of returns downside risks by looking at the price that an asset is trading at. We got 140 years of good market data. What does history tell us about what's our downside risk when we pay this price, what's our upside potential, what are our average returns? Let's do that for large-cap stocks and small-cap and commodities and bonds, and then let's put together a portfolio that optimizes the downside risk that we assume relative to the upside potential for return.
Burns: Now, I think when most people think about go-anywhere strategies, I don't think they are thinking about fundamental valuation and that does sound like what you are talking about. I think most people think that go-anywhere is chasing hot sector and things like that. How does that play into your decision, things like momentum?
Jones: Sure. Well, first of all, when you have a “price matters” discipline, what I want to distinguish it from is the traditional strategic where if you move 5% that might be a big deal. In 1999, when large-cap stocks got 100% overvalued, they dropped out of our portfolio entirely. In 2008, when commodities got to the 40% maximum overvaluation we've never seen, they dropped out of the portfolio entirely.
So, the great thing about the “price matters” discipline is it gives you the conviction to make big moves, but it's not sufficient because stocks got overvalued about 100% in June of 1999 and they kept going up for another nine months. So, you've got to add to it what we call “momentum process.” So, there is “price matters”--that's science--and then there is “momentum”--and that's more art, that's more measuring the shorter-term fluctuations in the market and then adjusting the longer-term strategy for those shorter-term market momentums. You can think of it as: We know we want to sell something--let's hold ourselves back until the market signals that it's ready to return to earth. We want to buy something--let's try to avoid catching the falling knife. Let's wait until the momentum of the market gives us the go-ahead signal.
Burns: I think most investors are familiar with thinking about fundamental valuation on an individual security, whether it's a stock or a bond or a commodity. But in your portfolios, you are looking at really macro bundled ETFs and other indexed products. How does that valuation analysis change? How is it similar from looking at an individual security?
Jones: It is really different because when you are looking across a basket of stocks, when you are looking across large-cap stocks--literally hundreds of different stocks--and you're talking statistics, and you're talking probability, and that, ultimately, I really believe strongly that if you look at the historical experience when you pay this price and you understand that upside/downside, you get good returns over the long run. When you then narrow it down to buy an individual stock, the fact that you pay a low price for Hewlett-Packard doesn't mean that Meg Whitman isn't going to announce this morning that: “You thought we missed before? We are missing even bigger today.”
Burns: Did she do that today by the way?
Jones: It was actually yesterday, yes. But yeah, there is a specific risk in every company and there are companies like Apple, for example. There is not a statistic that you can use to measure what they've done and what they are doing. You put them all together, though, and the price that you pay is going to dominate all of those individual fluctuations, and I think it gives you the best long-term value signal.
Burns: Got it. So, you can still do fundamental valuation?
Jones: There is no--we believe--I think that the old strategic model made a false choice. We can't add value deciding that large-cap growth is overvalued. So, we are just going to put a fixed amount there and then we'll add value picking large-cap growth stocks. That's a false choice.
You can add value by deciding that large-cap growth is overvalued and I want to move the money to small-cap value and I want to move it to bonds and I want--you can add value by shuffling the pie chart and you can add value by picking great stocks within each slice of the pie. And actually I think your long-term returns will be improved and they will be less volatile when you have multiple ways to add value to the portfolio rather than just restricting yourself to one strategy.
Burns: Got it. Well, Michael, thank you for your insight into your process and thanks for joining us at ETF Invest.
Jones: My pleasure. Thanks, Scott.
Burns: I'm Scott Burns with Morningstar. Thanks for watching.