Hylland Capital Mid-Year 2018 Letter to Clients
Below is a portion of our mid-year 2018 letter for clients.
Since we manage each client's portfolio separately, any comments on performance or individual holding for a client is omitted.
We are halfway through another year already, let’s recap a few significant events so far that have impacted your investments with Hylland Capital Management over the last 7 months:
- The U.S. stock market has seen very good returns so far this year, up 4% as I type this, but not after some excitement:
U.S. markets saw a 10% correction in early February, including two days in which the Dow Jones Industrial Average made headlines by falling more than 1,000 points on two separate occasions. February 5th and 8th, 2018 hold the record for the two largest point losses in the Dow’s history. By now, this seems nothing but a distant memory as the markets have quickly recovered.
- International stock markets are not faring as well. International diversification, which has helped portfolio performance over the last couple years, has hurt performance relative to U.S. stock market performance so far this year. China’s stock market, in particular, is down 25% from their peak in January.
- Short term interest rates are rising very fast. In the last 2 years, the interest rate you can receive for a 3 month treasury bill has risen from 0.25% to 2%. This has led to higher borrowing costs for companies, higher mortgage rates, and expected higher future returns for bonds.
Most importantly - What does all of this mean for you?
Expectations Going Forward
By many historical standards, we are well overdue for some less than pleasant stock market performance in the future.
Over the last 60 years, the U.S. stock market has averaged a negative performing year about one in every four years. The S&P 500 index has had one negative year in the last 15, when factoring in dividends.
Over those 15 years the price of the U.S. stock market is up about 213%, while the profits for those companies are up just 68%. And while earnings are expected to grow, even in the most optimistic of scenarios, it is easy to see that the U.S. stock market is getting more expensive than its underlying value, which is the earnings that companies produce.
One simple way to measure the “value” you are getting when purchasing a stock is to look at a P/E, or Price-to-Earnings ratio. For a single stock, this means simply dividing the company’s value by its annual earnings. For example, Exxon Mobil is worth about $348 billion today, and it has earned $20.4 billion over the last year, giving it a P/E ratio of about 17. ($348 billion $20.4 billion = 17).
We can measure the P/E ratio of the value of the market as a whole as well. Today, the U.S. market trades at a P/E ratio of about 24, up from 14 just six years ago.
In our last letter, we put the P/E ratio in perspective by imagining a business owner who is paying money to buy a business that earns $100,000 per year. Assuming this business trades at the same P/E multiple as the U.S. stock market; six years ago our business owner could have purchased that business for $1.4 million (a 14 P/E ratio). Today that same business that earns $100,000 can only be purchased for $2.4 million (a 24 ratio).
That begins to illustrate the problems with an expensive stock market. We begin to get much less return on our investment as prices increase. Today, we must invest 71% more dollars to buy the same amount of earnings as six years ago.
So what is our course of action with the potential for low future returns?
Our Greatest Asset
Our first tool for fighting the potential for low future returns is to recognize that time is our best friend, and greatest asset, in this scenario.
If you have 20+ years left of savings and investing - market declines, even major ones, mean very little to your long term net worth.
I looked back at the 19 worst single day declines in U.S. stock market history (October 19th 1987 being the worst, with a single day decline of 22% for the Dow – which would be equivalent to a 5,600 point drop in the Dow today!) to see what an investor’s performance would have been if they invested the day before each of these 19 worst days in stock market history.
On average, if you had the worst timing of any investor that ever lived, and invested the day before each of these worst declines in history, you averaged a 184% total return over the next 20 years. Or a 5.36% compounded annual return. (There is a table at the end of this letter showing these numbers)
Every investor worries in a market like we have today that they will invest “at the top”. But over long periods of time, even bad timing can produce decent long term returns. This fear should not stop you from investing today if you are able.
Better yet, as long as we maintain a disciplined approach, you will be continuously saving and investing in the future. So if the stock market declines sharply, you can invest more money at much cheaper prices! In the end, young savers and investors should hope for market declines to invest at lower prices. This goes against many people’s mindsets, but long term returns are much more important than returns over any given month or year, and the highest long term returns come from buying at lower prices.
Your Portfolio at Hylland Capital
Of course, there is no way to predict when the next significant market decline will come. And being too safe with our investment portfolios can actually do more harm in the long run by missing out on potential gains.
For example, if “Black Monday”, October 19th 1987 hit today, and U.S. stock markets fell 22%, the stock market would go back to where it was in early 2017. If fears of Brexit, the presidential election, China, trade, or anything else caused you to get out of the markets in late 2016 or earlier, you would need a day worse than Black Monday just to get back to break even. Despite the market’s elevated levels, staying entirely out of the market is a poor decision.
Here is how we are managing the two parts of your portfolio with today’s environment:
International diversification, specifically allocation to emerging markets, was our best friend for much of 2016 and early 2017. That has not been the case so far since February.
But their decline will be a blessing for long term investors. Today emerging market stock markets are as cheap as they have been in a decade compared to American companies. We are investing money today in emerging markets that have a P/E Ratio of under 12, half the price of the U.S. market. I don’t think it is a stretch to believe that there is a potential for emerging markets to have twice the return of U.S. stocks in the future.
We will always hold U.S. stocks in our client portfolios, but expect a higher concentration of foreign stocks if current trends continue.
Rising interest rates have created a scenario where bond funds, typically noted for their low volatility and stability, are facing some of their biggest losses in years. Long term bond funds are down 6% on the year so far.
We have been lucky by allocating nearly all of our fixed income investments in short term bonds, which are much less sensitive to a rise in interest rates. The short term bond fund that we primarily use (Ticker symbol SPTS in your account statements) is down 0.36% on the year.
Besides short term bonds, for those with a higher allocation to fixed income, such as those nearing retirement, we have begun to allocate money to convertible preferred shares of companies with very high credit quality, namely large U.S banks.
The big risk to a long term fixed income investor is inflation. Today you can buy a 30 year Treasury bond with an interest rate of 2.9%. If inflation rises above 2.9% in the next 30 years (which seems like a strong possibility), your bond will have a negative real return. You will be stuck either holding that bond for 30 years at a guaranteed small loss, or be forced to sell it at a more significant loss.
One way we believe we can get around this potential “inflation trap” is to be invested in securities that pay a fixed amount of income, but can be converted into shares of the company’s stock under certain conditions. This gives us an “out” to prevent our investments becoming locked in at low interest rates, for long periods of time, in high inflation scenarios.
Finally, to our last bit of news:
Fiduciary Rule and the State of Our Industry
One major piece of legislation that looked ready to change the finance industry was recently scrapped. Known as the “Fiduciary Rule”, the law was going to require that all individuals that give financial advice act as fiduciaries.
What exactly is a fiduciary? The Department of Labor’s definition of a fiduciary financial advisor is one that “acts in the best interests of their clients and put their clients' interests above their own”.
It seems a law requiring advisors serve their clients well should not be required. But with the unfortunate state of our industry, it is – badly.
We have strict laws in this country to prevent doctors from receiving kick-backs for prescribing specific drugs. A single violation to the ‘Anti-Kickback Statute’ can result in a doctor receiving a $25,000 fine and 5 years in prison.
But for many financial advisors, receiving kickbacks is standard operating procedure. Many companies operate solely on the kickbacks they receive by selling clients certain mutual funds or insurance products, whether or not they are the best products for the client.
The fiduciary law was going to force entire companies to change their business models. Merrill Lynch (part of Bank of America) announced in October of 2016 that they would no longer work based on commissions. Edward Jones began mailing documents to clients that they would no longer be commission based. Northwestern Mutual spent hundreds of thousands of dollars lobbying against the rule (Many of their products could not be sold under a fiduciary standard). LPL Financial, Raymond James, and Ameriprise urged their clients to print off pre-filled out letters from their webpage to send to their congressmen arguing against the law.
These companies were not changing because they wanted to do right for their clients. They were changing because if they had to act as a fiduciary, their business models and many of the products they sell would have been ILLEGAL.
But as soon as the law was scrapped in June of this year, these companies immediately announced that they would go back to being commission based. Back to business as usual. Here’s two headlines from the Wall Street Journal, one from 2016 when the bill looked to become law, another just a couple months ago when the law was scrapped:
At Hylland Capital, we were at a tremendous advantage during this potential law change.
It would not affect one thing we do.
We never had to consider changing billing models, getting different certifications, finding new investments for our clients, or disclosing new conflicts of interest. Because we have always complied with all of the fiduciary law’s requirements, before it was ever to become a law.
So tell me: Who really has your best interest in mind? A business whose model can only function by NOT acting as a fiduciary, or one that has always and will always, act as a fiduciary? What does it say about our competitors when they spend millions of dollars lobbying against a law that would simply require their “advisors” (I think we should just refer to them as salesmen) to do what is best for clients?
Our difficulty is getting the word out to consumers. We don’t have the lobbying budget, neighborhood offices on every street corner, or TV ads to help convince others to do what’s right.
We need your help.
If your friends or family are looking for an advisor – make sure they find a fiduciary advisor.
Costs Of High Commission Products
Let’s take a look at how this plays out in the real world:
Walk into an Edward Jones office today and one of the funds you will likely be sold is the “American Mutual Fund” from American Funds, one of the world’s largest mutual fund companies. The fund is a broadly diversified fund holding stocks in popular companies such as Microsoft, Verizon, and Wells Fargo.
You can search for this fund yourself by searching for the ticker symbol: AMRMX
At Hylland Capital, we would likely advise replacing that fund with something like State Street Advisors “Total Market ETF” (look at your most recent TD Ameritrade account statement – you probably own it). The fund’s ticker symbol for those that want to look it up: SPTM.
What does a comparison of these funds look like on a $10,000 investment?
12-b-1 fees are included in the fund’s total Expense Ratio, but I separated them out here just to show you why that Edward Jones salesman prefers to sell you AMRMX instead of SPTM. By selling you on the more expensive American Fund, our salesman pockets 5.75% ($575 per $10,000) right away, so your $10,000 investment drops to $9,425 before you even start investing. On top of that, he gets 0.25% every year for as long as you hold the fund.
In total for year 1, our salesman receives $635 from you. Want to invest another $10,000 next year? That’ll be another $635. Your total fee through Hylland Capital? $73 (0.7% AUM fee + $3 expense ratio)
Dealing with larger sums of money? (As all of you do or inevitably will): With a $100,000 investment, our neighborhood Edward Jones “advisor” takes $6,350 in fees. Hylland Capital’s fee would be $730.
Over time, these added costs really hurt you. Assuming the stock market rises 7% annually, after 20 years an investor who went with the cheaper fund and saved $10,000 per year would have $50,000 more!
This is a screen shot from a calculator that is available on our website. If you want to play around with the numbers yourself just search for “Compound Interest Calculator” on our website or blog.
That is just one real world example of the costs that many unknowing investors will face now with no fiduciary law.