Note: Pat Dorsey is the former director of equity research at Morningstar. He is now the president of Sanibel Captiva Investment Advisers.
Jason Stipp: I'm Jason Stipp for Morningstar. Some notable investors made big mistakes in 2011, but what were some of investors' biggest miscues and what should be on their radar for 2012. Pat Dorsey, president of Sanibel Captiva Investment Advisors has some ideas about that. He's here to share those with me today.
Thanks for joining me, Pat.
Pat Dorsey: Always happy to be here, Jason.
Stipp: So, it's pretty easy to look back of course at the end of the year and see what were some of the biggest mistakes the year before. But I think some important lessons can be garnered from this. I think that there were a lot of areas that people expected to do poorly, people expected to do well at this time last year. What were some of the most notable things that were on your radar?
Dorsey: Well, I think Treasuries obviously. I mean Treasuries just had an absolute blowout year. Yet I think if you survey most people at the beginning of this year and said, "Gee, you want to own U.S. Treasuries at, you know, a pretty low yield?" The response would likely be, "It's not what I want to own right now." But they've had a phenomenal year. The lesson there is that the best house in a bad neighborhood does pretty well. The U.S. is the least risky of many sovereign economies right now. So you've seen this sort of flight to quality. Also, things can often go on longer than you think.
Think back to the Internet bubble or the housing bubble. If you had sort of said, "I think those homes are getting a little pricey or those Internet stocks are getting a little pricey," at a reasonable level, they probably doubled or tripled from there. The same thing can be said for Treasuries. Saying a year or two ago, that I'm not getting paid for the risk I'm taking on, well, that was probably accurate, and probably over a longer-term horizon, that was the right decision. But acting rationally over the long-term horizon, can hurt over a short-term one.
Stipp: Realistically speaking though, if I've got this portfolio, and I can sit there and say, "Well, Treasuries maybe don't look like the greatest place to be right now, but I also see they benefit from a flight to quality," how do I make those two things come together for a portfolio plan? What should I do with Treasuries?
Dorsey: Well, think about how much longer they will benefit, and obviously don't take the past year's performance and project that out into the future. Just because bonds have had an awesome 12-year run as interest rates have declined, it doesn't mean that that same thing will be the case for the next 10 to 12 years. You always want to be looking forward instead of looking backward, and when you consider that many very well-capitalized U.S. equities--many of which had balance sheets stronger arguably on a debt/capital ratio than the U.S. government--are yielding 3.0% and 3.5% and increasing that payment at above the rate of inflation, then on relative basis Treasuries don't look so hot.
Stipp: So you mentioned the U.S. government and some of its problems and also we do know that the fundamentals in emerging markets have looked a lot better for a while. Emerging markets I'd say, if you sat here a year ago, that story still sounds great today about the fundamentals, and it sounded great last year. But if you invested in emerging markets and dumped a bunch of money in there, in January, you're not too much of a happy camper right now.
Dorsey: There's an old quote from Uncle Warren (Buffett) in Omaha that you pay a high price for a cheery consensus, and a year ago the consensus around emerging markets was quite cheery. They were growing very fast, their middle class was rising in purchasing power, and their sovereign balance sheets were very good. But all of that wonderful happiness was priced in. I would argue now I think now at 11-ish times earnings in the MSCI Emerging Market Index, there's a lot less happiness priced into emerging markets. So your forward-looking returns are likely to be materially better than they were in the past year.
In a way it's quite interesting to see that you're continuing to see mutual fund inflows into emerging markets, despite the really nasty year they've had. I actually find that quite fascinating, because typically what you see is when an asset class performances poorly over a year or two, you see fund flows coming out, not going in. So that's a bit counterintuitive to me. But again, the question is always, "What are you getting paid for the risk that you were taking?" Right now, you're getting paid pretty reasonably to take on the certainly higher risk of investing in emerging markets. You're getting better growth, but you're only paying 11 times earnings for it.Read Full Transcript
Stipp: It could be that investors are looking at their options, and even now that emerging markets have not done well for them this year, they might not see a whole lot of hope for some of the developed markets. For better or for worse, maybe at least they think that they'll get something out of emerging markets coming up.
Another area, Pat, that people were very pessimistic about this time last year was municipal bonds, and I think that if you sold out of all of your munis last year, you also probably won't be too much of a happy camper right now?
Dorsey: Exactly. So, I'll tell you a little story. So there's a trade group of basically family offices; these are offices that manage money for ultra-high-net-worth individuals, $500 million and up for one family. They did a survey that was published earlier in 2011. The survey was taken, of course, in late 2010. The survey asked "What asset class are you moving the most out of?" Municipal bonds was the answer. This was right after Meredith Whitney went on "60 Minutes" and roiled the municipal-bond market. And I think it's a wonderful reminder that headlines are headlines, but reality is reality. And that the muni market tends to be relatively thin, but it's 70% owned by retail investors, so it flops around a whole lot.
But trying the analogies that were made, and I think you and I talked about this at one point between say the muni market and subprime, just don't hold up. The City of Cleveland can't up stakes and move. There's no jingle mail if you're a municipality, which is a little bit different in terms of the degree to which you really want to make your creditors happy and keep paying those bonds off. So that was an area where you basically saw the headlines run way, way ahead of reality, and investors who took advantage of that sell-off in muni bonds have really reaped the benefits, locking in some very, very attractive taxable equivalent yields and then seeing the spreads, the difference between munis and Treasuries compress and the prices of bonds rise as a result.
Stipp: So lastly, Pat, I don't know if we know the end of the story on this, but one thing that we wonder if investors are making a mistake with is their departure from, especially domestic equity funds. We're seeing continued outflows from those funds. Fixed income used to do relatively well in comparison. Is this going to be a mistake that we look back a year from now and say investors shouldn't really have been doing all of this trade into bonds from stocks?
Dorsey: Yeah, I think it's going to wind up being a huge mistake. It's what I call "recency bias" on an absolutely massive scale because essentially you've had 10 years of pretty nasty returns for equities relative to bonds. So, unfortunately people are taking money out of the equities and putting money into bonds. Of course, 10 years ago, it was the reverse, right. In the late 1990s, stocks had a wonderful run. People were plowing money into stocks and you couldn't sell a bond if you gave it away. It's essentially people saying what has worked and that's where I will go and instead of again looking forward.
When you see, for example, Johnson & Johnson's 10-year bonds yielding less than the firm's equity, that's a signal that there's probably more value in the equity markets. So I would certainly encourage people who are continuing to move out of U.S. equities in favor of bonds--again, if you're 90 years old and you need the safety of bonds, you don't have a long time horizon, it's a different story--but I would certainly encourage people to think hard about the relative risk of a bond at say AA investment bond at say 2.5% and the corresponding equity at 3%, especially when again the equity will be raising its dividend over time in all likelihood whereas that fixed debt bond payment is, of course, fixed, hence fixed income.
Stipp: Well, Pat, it's not always the easiest thing to look back at our mistakes, but it certainly can be profitable if you study those hopefully for better returns in the future. Thanks for joining me today.
Dorsey: Thanks, Jason.
Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.