Solving For Inflation Plus Five Percent: 1 + 1 ≠ 7%

Solving For Inflation Plus Five Percent: 1 + 1 ≠ 7%

As yields have declined and equity valuations have climbed, consensus expectations for future capital market returns have dissipated. As such, the minimum essential hurdle most asset owners must exceed has become a perilous mountain trek.

From today’s base camp, the mountain sometimes known as “Inflation plus 5%” looks almost insurmountable. Even Sir Edmund Hillary might balk at such an outlandish expedition.

This article focuses on the public equities portion of an overall asset allocation. It refrains from a discussion of fixed income, credit and alternative investment allocations.

When constructing public-equity exposure, modern-day asset owners have typically relied on benchmark-driven, relative-return implementation methods. Such as:

  • Actively managed public-equity strategies that promise the return of the benchmark plus a suitable margin (alpha) over said benchmark.
  • Passively managed public-equity strategies that promise the return of the benchmark.

Tautologically, the ex post absolute return that an asset owner will ultimately receive from the public-equity component of his/her asset allocation, is derived without ex ante regard for the asset owner’s minimum return requirements or liabilities.

An unpalatable recipe
This phenomenon is an unpalatable recipe when public-equity benchmark returns are expected to be de minimis—and forecast to be less than “inflation plus 5%.”

Today, if consensus thinking expects the future returns of public-equity benchmarks to be insufficient relative to “inflation plus 5%”, then standard passive and active equity strategies will fail to deliver the necessary results, and public equities will be an untenable anchor in the asset owner’s overall portfolio. As the saying goes, “You can’t eat relative returns.”

The capital markets have generally experienced a tailwind since the early 1980s. In August 1982, T-bill yields were in the mid-teens and a long-dead bull market in equities sprung to life. With a few notable exceptions, since then interest rates have trended lower and publicly traded equities have trended higher. About that time the investment industry began to steadily—if not arbitrarily—carve up and segment portfolio management into a smorgasbord of impressive sounding sub-options (large-cap, mid-cap, smid-cap, small-cap, micro-cap, growth, value, international, global, emerging markets, frontier markets, etc.). These subcategories somehow calcified into rigid asset classes, to which many CIOs feel beholden.

Liabilities not benchmarks
Until then, balanced managers had been the original unconstrained absolute return investors, decades before Absolute Return and Unconstrained Investing became Defined Terms with Upper-Case lettering. Balanced managers had the investment freedom to deploy public-equity capital broadly and judiciously as they determined where attractive opportunities could be found. Back then portfolio managers strived to compound their investors’ capital at reasonable rates to help them fund their liabilities. There was no obeisance to an arbitrary benchmark and no kissing of the ring of style-box orthodoxy.

The eventual introduction of style-boxes, peer groups, various new indexes and new investment products further segmented the public-equity universe by market capitalization, geography, and/or style (growth, value, GARP). The technological innovation of easily accessible database peer group comparisons first on your desktop and then on your handheld device further hastened the trend of segmenting the public-equity universe into sub-segments. Finally, the industry’s imposition of “fully invested” strictures and the introduction of “long/short” and “long-only” terminology obscured the simple virtues of, and tempered the appetite for, old school investing. Unwittingly, these industry innovations ultimately reduced the opportunity set and restricted the active management of long-only public-equity portfolios.

By adopting a style-box, benchmark-sensitive public-equity approach, asset owners disconnected their public-equity assets from liabilities—one being tied to relative returns and one absolute. Asset owners locked their public-equity allocations into a relative game, while relegating absolute returns to higher fee, Upper-Case worthy alternatives and hedge funds, but the nature of asset owners’ liabilities has not changed.

Solving a math problem
With yields near all-time lows and with equity valuations stretching (arguably distorting) the returns of various benchmarks, the future returns from benchmark-driven public-equity strategies are widely expected to be subdued. Yet public equities are an essential component of any asset allocation—often comprising 30-50%.

The math problem facing asset owners is how to maximize the return potential from their public-equity sleeve without increasing the risk profile of the sleeve and overall portfolio.

  • Why not explore non-conforming, non-classical, non-traditional, actively managed public-equity strategies that are designed to deliver satisfactory absolute returns which are measured against the asset owner’s minimum return requirements or liabilities.
  • Public-equity strategies that employ a private-equity ethos, with a limited number of public-equity investments, each one individually underwritten with a compelling ex ante expected return – while deliberately disregarding a holding’s weighting in a benchmark.
  • Public-equity strategies whose success is measured by the accuracy of their ex post actual results as compared to their ex ante forecast.

Numerous financial institutions are expecting public-equity benchmarks to deliver mid to low-single digit returns over the coming decade. If these forecasts are even moderately accurate, asset owners will have a challenging time exceeding their minimum hurdle rates and funding their liabilities. Perhaps it’s time to supplement oft-used benchmark-oriented public-equity approaches with long-tenured public-equity strategies that build a portfolio of concentrated investments that strive for spendable absolute returns.

Past performance is not a guarantee of future results.

  1. Equity Quality Return (EQR) Portfolio Forecasted Return is our annualized forecasted return at the beginning of the 10-year period based on ACR’s intrinsic value and return estimates for EQR stocks not including cash. Individual stock 10-year estimated return formula: (1+Required Return) * (Value/Price)^(1/10)-1. A ten-year horizon was chosen to encompass a full market cycle. Selecting a different period would significantly alter the forecasted return. The “Required Return” is the return ACR estimates is fair for the risk taken in each EQR stock. ACR portfolio managers assess risk based on multiple business and financial factors and assign a specific rate which in their judgement is commensurate with security risk. The Intrinsic Value/Price captures ACR’s estimate of undervaluation. Intrinsic value is based on multiple business and financial factors and represents the portfolio manager’s subjective estimate of business value. The portfolio return forecast is the weighted average of individual stock 10-year estimated returns. Forecasted returns do not represent actual trading. The portfolio during the forecast period was different than the portfolio when the forecasted returns were calculated.
  2. EQR Portfolio Actual Gross Return is the EQR Advised / SMA Composite actual pure gross-of-fee total return (including dividends) annualized, including cash over the 10-year period. Gross of fee returns do not reflect the deduction of management fees. Actual client returns will be reduced by management fees. Fees are typically deducted quarterly for clients thus the compounding effect will be to increase the impact of the fees by an amount directly related to the gross account performance. For example, on an account with a 1% management fee, if the gross performance is 10% annually, owned for 10 years, the compounding effect of the management fees will result in a net performance of approximately 8.90% annual return.

 

Important Disclosures
ACR Alpine Capital LLC is an SEC-registered investment adviser. For more information please refer to Form ADV on file with the SEC at www.adviserinfo.sec.gov. Registration with the SEC does not imply any particular level of skill or training.

All statistics highlighted in this research note are sourced from ACR’s analysis unless otherwise noted.

It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the examples discussed. You should consider any strategy’s investment objectives, risks, and charges and expenses carefully before you invest.

This information should not be used as a general guide to investing or as a source of any specific investment recommendations, and makes no implied or expressed recommendations concerning the manner in which an account should or would be handled, as appropriate investment strategies depend upon specific investment guidelines and objectives. This is not an offer to sell or a solicitation to invest.

This information is intended solely to report on investment strategies implemented by Alpine Capital Research (“ACR”). Opinions and estimates offered constitute our judgment as of the date set forth above and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. There are risks associated with purchasing and selling securities and options thereon, including the risk that you could lose money. All material presented is compiled from sources believed to be reliable, but no guarantee is given as to its accuracy.

Please refer to our full composite performance presentation with disclosures published under the Strategies section by clicking here.

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The Equity Quality Return (EQR) Advised Composite consists of equity portfolios managed for non-wrap fee and wrap fee clients, according to the firm’s published investment policy. The composite investment policy includes the objective of providing satisfactory absolute and relative results in the long run, and to preserve capital from permanent loss during periods of economic decline. EQR invests only in publicly traded marketable common stocks.

Returns are presented gross and net of fees and include the reinvestment of all income. The currency used to calculate performance is the U.S. dollar. Past performance is not indicative of future results.

The index benchmark is the S&P 500 Total Return (TR) Index. The S&P 500 TR Index best represents the quality of the composite holdings, is a broad-based stock index including reinvestment of dividends, and is widely regarded as an indication of domestic stock market performance. The S&P 500 TR index is unmanaged and cannot be purchased by investors.

A compliant presentation and/or the list of all composites maintained by the firm is/are available upon request by emailing the following: info@acr-invest.com.