July 2014- A Look Into the Growth of Equity Strategies

By The Lerner Group on July 1, 2014

We are now six months into the year, and this is an appropriate time to discuss the rapid changes that are underway in the economy as well as what their effect could be on your personal portfolio. Please keep in mind that we construct every client’s individual portfolio by selecting securities from three different categories. Our building blocks are (1) Equity Income (high yielding equity and preferred stocks), (2) Fixed Income (both municipal and corporate bonds), and (3) Growth Equities (six different equity investment strategies).
The low interest rate and slow growth environment that characterized our economy over the past six months made the high dividend stocks we hold in our Equity Income category attractive investments. Between the first of January and the end of June the S&P Index returned 6.05 percent; the consolidated return of our Equity Income category was 6.57 percent.
The low interest rate and slow growth environment also enabled us to buy investment grade bonds maturing in four to seven years, collect a reasonable interest rate while we held them, and realize a gain if we sold as the bond approached maturity. The consolidated returns of the Municipal bonds and Corporate we hold also dominated the S&P return generating six month returns of 6.41 and 6.25 percent (after fees) respectively.
The Growth Equities presented a more varied picture. Two equity strategies generated higher returns than the S&P. The first strategy buys and holds stocks that report rising earnings, rising sales and rising prices; the second investment strategy lies at the opposite end of the security spectrum. It buys and holds stocks that fell in price by more than 25 percent during the past year and continues to sell at a low, but positive, price to book ratio. These two strategies generated returns of 7.8 and 6.82 percent (after fees) respectively over the last six months.
A third strategy which concentrates on Large-Cap companies rose marginally more than the S&P Index while the returns of Mid-Cap and Small-Cap stocks lagged. Given the economic uncertainty in Europe, the Mid East and Central and South America, it is no surprise that International stocks, the sixth strategy in our All Equity category, rose only 1.16 percent during this period.
Looking forward to the next six months and beyond, we anticipate the return performance of our portfolio categories will change. The economy is becoming more and more vigorous with virtually every passing day. The level of employment is increasing, housing prices are increasing, gross national product and industrial production are expanding, corporate profits are increasing and the S&P index is now at a record high level.
Under these circumstances, we anticipate two unfolding developments are likely to impact your
portfolio’s return in the months that lie ahead and some adjustments should be made to take
advantage of them. These developments are (1) the number of mergers and acquisitions that place
should increase and (2) interest rates should begin to rise. Consider each in turn.
Rising profits and higher stock prices make it easier for larger firms to think seriously about
merging with or acquiring another firm. Most large firms want to continue to grow and expand,
and it is usually both faster and less expensive to acquire an existing firm than it is start a brand
new activity. High current profits tend to make managements optimistic about both their ability
and the future; and the current high share price enables larger firms to grow by issuing new shares
for the acquisition with a minimum impact on their current cash flow.
Smaller and mid-sized firms are willing to merge or be acquired for many different reasons. Some
of them may be personal, but all of them include the fact that the price the smaller cap firm’s
shareholders will receive from the transaction is higher than the current value of their holdings. If
the merger trend continues, and we believe it shall, the returns of small and mid-cap companies
which lagged those of the S&P index could see their rankings begin to increase.
The increase in commodity prices, industrial production, and economic growth now underway
should also lead to a rise in interest rates. Janet Yellen, Chairman of the Federal Reserve System,
has assured investors that she won’t cut back on the supply of credit and abruptly raise rates
“simply because some markets may look bubbly”. However as the demand for credit continues to
be strong and as inflationary forces pick up, interest rates could begin to increase because of the
increase in the demand for credit. The impact of such a rise in rates would be to increase the risk of
holding fixed income securities, and contribute to the flow of funds out of bonds and into equities.
We believe plans should be put in place to take advantage of both developments. Specifically, the
proportion of your portfolio held in Small and Mid-Companies should be increased, and the
commitment to the Fixed Income category of your holdings should be reduced.
We always welcome your comments on our remarks and proposed actions whether they are face to
face, on the telephone, or via e-mail. I assure you that both our and your goals are identical: we
both want to see you preserve and enhance your wealth. Thank you for your continued confidence.