The Days of “Every Investor Wins a Trophy” May be Ending
by A. Scott White, CFP®, ChFC®, CLU®
President, Scott White Advisors
When a company needs to justify its existence only by growing faster than the hypothetical risk-free rate of return (often defined as the interest rate on U.S. Treasury Bills), then over the past 10 years, with yields on T-Bills hovering near historic lows, that company didn’t have to do much to become a relevant investment and avoid sell offs in its stock. Therefore, an investor over the past 10 years hasn’t had to do much studying to find an investment capable of beating the T-Bill rate. In fact, the past 10 years was a great time to do no analysis on identifying worthy investments and simply buy low-cost passive investments designed to try to track the market. Every investor has been a winner—just like many players in youth sports teams today have grown up with every player expecting a trophy, whether their team wins or not.
In recent editions of The Navigator, I’ve written about the high valuations of many companies, the impact of central bank manipulation of interest rates, and the general investor complacency that tends to occur when there is little volatility and markets appear to only go up. You may recall that in the Spring 2018 article “Price and Quality No Longer Matter,” I mentioned that this type of environment often rewards unsustainable business practices.
A company with a rising stock price has an easier time borrowing money, because when estimating how much debt a company can take on, lenders will often compare the amount of debt a company has outstanding to the market value of the company. Therefore, a rising stock price allows a company to borrow more money. In addition, once the loan is complete the company can invest that money in the growth of company top-line revenue (earnings before expenses), despite showing little to no profits. This added growth, in turn, can drive up the company’s stock price when stock traders are not paying attention to the business’s fundamentals, making it easier for the company to borrow even more money.
We need look no further than October 2018 when the Netflix stock price gained 12% the day after it announced strong subscriber growth in international markets, despite a previous earnings report that showed earnings growth had been slowing.1 Stock traders weren’t focusing on Netflix’s meager profits, and yet the very next week Netflix announced it was borrowing another $2 billion.2 Now don’t get me wrong—I enjoy watching Netflix programing and hope to continue enjoying it for a long time. But it is hard for me to believe its business survival means it is a worthy investment call. To me, any purchase of Netflix’s stock is much more a speculative call in hoping the company can grow enough to start returning some of its profits to shareholders instead of movie stars in the face of increasing competition from the likes of Disney, Apple and Time Warner.3 Over the years I have learned that hope is rarely a sound investment strategy for an investor.
As with life, all good things come to an end. Rising interest rates make the cost of servicing debt more expensive, which can be particularly painful for any company with scarce profi ts to start with. Add in increasing trade tariffs and slowing economic growth, and more companies can expect further earnings contractions. This can lead to their stock price decreasing, thus making it harder to borrow because the company becomes worth less money. If it is more difficult to borrow, then it can be even harder to fund the company’s previous growth—and its stock price can go down more. Thus, a downward spiral begins, and this is certainly not an environment a long-term investor wants to participate in.
As 2019 begins, we witnessed the recent rise in interest rates, the imposition of trade tariffs, and the speculation of slowing global growth, resulting in lower earnings forecasts for many companies. This, of course, led to increased volatility in the stock market at the end of 2018 and losses not seen in the prior 10 years.4 Perhaps now quality and price may matter again—as they always do.
At Scott White Advisors, when we take on a new client we do not begin with an investment strategy. Instead, we begin by evaluating the family’s complete financial situation, and then we develop a written financial plan to meet those goals. After that, we design our client’s portfolio built on meeting those goals—with a sound investment strategy that does not speculate on things that may or may not happen. We develop a written Investment Policy Statement to assist us in not making emotional decisions at inappropriate times. Your needs and circumstances will always determine your family’s asset allocation in an investment portfolio. We don’t rely on a risk/reward questionnaire that can produce different results depending on the ebb and fl ow of investors’ emotional states about the stock market’s rise and fall.
At Scott White Advisors we utilize professional investment managers whose only job is to evaluate a stock’s fundamental businesses before making any investment. We work diligently to identify investment managers who seek out the world’s most profitable businesses, with management teams working for the shareholders—not corporate insiders. These investment managers look for businesses not carrying too much debt and seek to invest in those businesses at reasonable prices. At Scott White Advisors, we understand these are the underpinnings we can control and we avoid building investment portfolios on events that may or may not happen.
We understand that in life, not everyone wins a trophy. We know that some don’t enjoy a worry-free retirement with the confidence in knowing their family fortune won’t be squandered away in passing on to the next generation. We help our clients realize their family’s financial goals, with the sound underpinning of their Investment Policy Statement.