Hylland Capital End of Year 2017 Letter to Clients
Below is a portion of our end of year letter to clients for 2017. Omitted is any personal information that would be included before this section such as client name, account balance, performance, mention of individual holdings, etc. We manage each client's account individually, and therefore each client's performance is unique.
2017 was a historic year for the stock market. Let’s look at some of the highlights:
- Including dividends, the S&P 500 index was up 21.83%, the 15th best annual performance in history.
- Stock market volatility reached an all-time low in 2017. It was one of the quietest years in stock market history with only 8 days that saw a 1% or larger move in the price of the S&P 500.
However, it is important to remember: These numbers make the headlines, but mean very little to your long-term success as an investor.
As much as the investment world focuses on the performance of a single year, what is truly important is long-term returns. Making 30% one year means nothing if you lose 30% the following year. Charlie Munger (Warren Buffett’s right-hand man at Berkshire Hathaway) says:
"It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent. There must be some wisdom in the folk saying: 'It's the strong swimmers who drown.'"
The stock market has handsomely rewarded long-term investors who have simply avoided stupid mistakes. Since the S&P 500 index was created 60 years ago, the index has gone from about $41 to $2,620, an annual compounded return of about 7.1%.
7% may not sound like much in comparison to 2017’s performance. But even at 7%, money begins to compound rapidly. For example, the final total of $100,000 invested with various growth rates and durations is shown below:
This amazing power of compounding interest is evident if we look back to our nation’s most famous purchase. In 1803, President Jefferson struck a deal to buy more than 828,000 squares miles of land from Napoleon of France. The Louisiana Purchase doubled the area of the United States for a cost of $15 million, which after financing cost a total of $23 million. Jefferson faced outrage over the deal, but the House’s attempt to halt the purchase fell 2 votes short, 57-59. Today, I don’t think many would argue that Jefferson made a wise decision with this purchase.
Using data from a paper by William Larson of the Bureau of Economic Analysis in 2009 and adjusting for inflation, we can estimate that the raw (undeveloped) land purchased in the Louisiana Purchase is worth around $1.7 trillion today.
Turning $23 million into $1.7 trillion sounds quite impressive! Was President Jefferson history’s best investor?
Not by a long shot.
Had President Jefferson instead found an investment for that $23 million that yielded just 6%, about the rate that stocks have historically appreciated, Jefferson’s $23 million would be worth more than $6.3 trillion today, about equal to the annual economic output of 40 states.
Moral of the story, if you know anyone considering buying a large portion of the world’s property, recommend they talk to us at Hylland Capital first!
Fast forward a couple hundred years since Jefferson’s time… The recent declines in early 2018 have made headlines as a stock market that was calm for so long finally woke up. February 5th and 8th both saw 1,000+ point declines in the Dow. February 5th took the record as largest point decline in market history. Newsworthy? Maybe.
On a percentage basis, February 5th‘s decline of 4.6% did not even crack the top 200 worst declines in history.
As the Dow goes higher, 4 digit declines should hardly be considered unusual. What has been unusual is the low volatility over the last few years. 4% moves have occurred often, and if history is any guide expect 1,000 point declines at least twice every year. That is not a market in turmoil, it is normal.
With today’s elevated stock market levels, what would constitute an actual “bad day” in the stock market? October 1987 saw a single-day 22.6% decline in the stock market. Today, that would equate to a more than 5,500 point drop.
By the way, despite the record-setting drop in October 1987, the stock market finished the year up more than 5%.
So it is important to not let short term moves in the stock market affect our long term plans. Even the 1987 crash, the worst single-day decline in history, is just a minor blip to a long-term investor today:
Investing Going Forward
We focus a lot on historical returns. Understanding stock market history provides a basis for setting realistic expectations and quantifying potential risks. But blindly basing investment decisions on past performance is not a good strategy either.
For example, consider the chart below, which graphs the long term returns of 4 vastly different investment options. Based on historical returns, what appeals most to you?
This chart comes from a talk MIT economics professor Andrew Lo did for Google employees early this year. In general, the “black investment” is the most popular choice, with a few high-risk investors willing to take the “blue investment”. The chart represents more than 30 years of history, seemingly enough data to base an investment decision on, right?
It turns out, the investment that is most often preferred was a fund managed by Bernie Madoff, who was arrested in 2008 for what would become history’s largest Ponzi scheme. Investors, who were attracted to the fund’s history of stable returns quickly realized that past performance is no guarantee of future returns.
Although Madoff’s example may be a bit extreme, we see a similar pattern playing out in once great stocks failing to repeat their past accomplishments. Coca-Cola, once a great long-term performer, has significantly underperformed the S&P 500 over the last 10 years. General Electric, once a company idolized for its long-term returns, has seen its stock fall to levels not seen since 1996 and the depths of the 2008 financial crisis.
Many investors have been ruined by basing investment decisions solely on past performance. A long run of numbers, no matter how large, multiplied by zero is still zero. Our job is to make sure we avoid those zeros so that your money can continue to compound for you.
Investing Going Forward
Your investment portfolios consist of two primary asset classes, stocks (equities) and bonds, with each facing unique challenges today:
Your Equity Portfolio
Stocks have seen an incredible run since the 2009 financial crisis. The S&P 500 is up more than 360%, including dividends, since the March 2009 lows.
How high can stocks continue to climb? To help answer, consider the following example:
If you wanted to buy a business on your street corner that produced a profit of $100,000 per year, what should you pay?
Thinking about this question is no different than how we can begin to value stocks today. The S&P 500 index, which is at a price of $2,650, has earned about $107 over the last year. Investors today are buying the S&P 500 at a “24 multiple”, or about 24 times the annual earnings.
Back to our local business earning $100,000, that means paying about $2.4 million. Is that a good deal?
It’s high. Historically the stock market has sold at a multiple closer to 15, meaning the S&P 500 would be around 1,605 with today’s earnings and a “normal” multiple. This doesn’t mean the stock market has to crash - earnings could rise as well to lower that ratio. But it should put investors on guard to expect lower returns going forward if we do not see significant earnings growth.
We could also say our $2.4 million gas station investment has an “earnings yield” of 4.2% per year ($100,000 ÷ $2.4 million). With that same calculation, the S&P 500’s earnings yield is 4.0% today, well below a historical average around 7%.
This earnings yield helps us compare the value between stocks and bonds. As bond yields rise higher, bonds become more attractive relative to stocks.
Today, a 10-year U.S. Treasury bond yields close to 3%. Corporate bonds, yield between 3.4% to 6% depending on their credit strength. We are getting close to a level where we are not being rewarded for taking risks investing in stocks. This is a level we will continue to be watching carefully.
We are already getting more selective in our equity allocation. We are overweight International markets, which are much cheaper. And we will continue to overweight certain sectors that remain more reasonably priced compared to the broader market. But in general, we believe U.S. stocks will have a hard time repeating the last 10 years of performance.
Your Bond Portfolio
However, the rising interest rates we have experienced also hurt your bond investments. With today’s higher rates, if you are looking to sell a treasury bond you purchased a couple years ago that yielded 2%, nobody wants it because they can buy other bonds that yield 3%. This means you would likely lose money if you try and sell that 2% bond today.
Needless to say, the biggest risk to the bond portion of our portfolios is rising interest rates and inflation.
Usually, we would expect longer term bonds to have a higher yield to compensate for the risks of higher rates and inflation in the future. However, today that is barely the case:
If a 2-year treasury bond yields 2%, and a 10-year treasury bond that yields 5%, we would obviously be rewarded for taking the risk of investing in the longer-term bond. But today, that spread is becoming almost nonexistent. A 2-year bond yields 2.2%, and a 10-year bond yields 2.7%, a very small difference.
This makes long term bonds much less attractive because we are not being rewarded for taking a risk in holding longer duration bonds.
So many of our bond holdings have been moved into shorter duration bonds. If interest rates rise, we will be able to move investments into higher yielding investments sooner. If interest rates stay the same, we are getting a nearly identical return, without having to “lock up” our money for decades at a time. If interest rates fall, our bond holdings rise in value, and stock investments become cheaper relative to bonds.
How should we prepare for a period of potentially low returns? Start by focusing on things that are within our control.
An investor who is committed to saving more can come out ahead even if they experience low returns. Consider 3 different investors:
The “red investor” has phenomenal returns of 15% per year (a level that only a handful of investors have achieved for 25 years), but only saves $100 per month. The “blue investor” achieves above average returns and saves a bit more, $400 per month. The “green investor” has dismal returns relative to his counterparts but saves aggressively. Who comes out in the end?
Your savings rate has a much higher impact on your future nest egg than your returns. Use that to your advantage!
If you are curious, you can play with these numbers yourself with our interactive compound interest rate calculator on our website: http://www.hyllandcapital.com/blog/compound-interest-rate-calculator
Lastly, I think it is important to know that I “eat my own cooking” at Hylland Capital. I have nearly my entire savings in the same exact holdings that make up the portfolios of clients in Hylland Capital, though allocations may vary (such as a higher allocation to stocks compared to older clients), you and I hold the exact same stocks and funds.
I make no promises to what the future holds, but I can guarantee that we share the same fate.
As always, please do not hesitate to reach out whenever you have questions or concerns.
Thank you for another wonderful year at Hylland Capital Management (our fastest growing ever!)