Emerson's "Building Blocks" of a Balanced Portfolio
How does Emerson balance investment opportunities and risk?
By Paul Tryon, CFA, Director of Investments
Through the headwinds and tailwinds of the global financial markets Emerson has steadfastly used four investment cornerstones to identify opportunities and manage risk. We believe these principles will reward investors who maintain a long-term investment focus.
Two important aspects of portfolio theory are limiting downside risk and shortening time to recovery following a decline. Portfolios with as few as two assets (stocks and bonds) can limit risk and shorten recovery after a decline compared to single asset portfolios. For example, an all equity portfolio of domestic shares lost 51% of its value from October 2007 through March of 2009 (“downside risk”) and four and a half years later is still 15% down from its previous high (“time to recovery”). A 60% stock and 40% bond portfolio had downside risk of 32% over the same time period. However, the more diversified portfolio recovered to its previous high by December 2010, demonstrating a shorter time to a more pronounced recovery.
Diversification can improve upon dual asset (traditional stock and bond) portfolios by altering the risk/reward relationship. Emerson’s balanced portfolios contain international shares and bonds, commodities, real estate, and small cap stocks. These strategies provide less correlated returns to domestic equity and bonds, which can offer added protection in down markets and additional return in stronger markets.
However when a severe period of stress, like in the recent financial crisis of 2008, drives the correlations of diverse assets together, income provides the next level of portfolio protection.
Securities which generate dependable and recurring income from interest and dividends can offer downside protection beyond diversification alone. In volatile markets, price appreciation and can be difficult to achieve, which makes income a substantial component of a portfolio’s return. As a result, high yielding securities, stocks or bonds, become more attractive to investors, limiting some of the downside. Dividends and coupons also remain important components in more normal markets. In fact, dividend payments have comprised over 50% of stocks’ total return since the 1930’s.
At today’s low interest rates, investors worry about inflation which could erode purchasing power. Securities with dividend growth rates above inflation, and high yielding fixed-income securities are well positioned to offset inflation risk. Typical Emerson balanced portfolios currently yield over 3.2%, as most asset classes – including our commodity investment - have a meaningful income component, while our dividend specific strategy enjoys income currently growing above 10% annually.
Well diversified and high yielding portfolios can also be improved by sound macroeconomic analysis.
The economic cycle is the basis for macroeconomic analysis; industries and asset classes perform differently given changes in the economy. In general, the cycle encompasses four stages: peak, trough, expansion and contraction, but these stages can also be subdivided into sub-periods such as recovery (early expansion). Profits of cyclical businesses, like technology companies, are very sensitive to economic growth or contraction, while non-cyclical companies, like grocery stores, may profit despite these fluctuations. Stock markets anticipate changes in the economy and investors value shares of cyclical and non-cyclical industries based on expectations of future growth. The same is true with certain asset classes, such as small cap stocks and large cap stocks. Therefore, anticipating changes to the economy, such as contraction to recovery, or recovery to expansion, and changing sector allocation or the mix of asset classes, can improve performance.
This year Emerson’s domestic portfolios have demonstrated positive relative performance from macroeconomic analysis by anticipating a moderately expanding economy and emphasizing large cap, non-cyclical, and late-stage companies in our domestic stock portfolios.
After taking diversification, income and macroeconomic analysis into account, the final component of our investment management framework is “big ideas.”
Big ideas can generate returns in even the most challenging markets. Emerson looks to uncover big ideas in a simple framework: fundamentally sound, underappreciated companies with catalysts. Fundamentally sound companies have a “big moat,” or a series of competitive advantages that allow them to generate high profit margins for long periods. The market may undervalue these businesses as they face industry headwinds or new competitive challenges, but so long as we have identified catalysts (product innovations, new markets, new intellectual property) that have not been reflected in the stock price, we can find a “big idea” opportunity.
Some of Emerson’s big ideas this year have come from industries that face headwinds. But where a leader has emerged, such as in healthcare insurance, outdoor clothing, coffee and debit cards. To be fair, not all of our ideas have worked, but big ideas are an important and essential part of Emerson’s investment framework.
Over the last decade, achieving both capital preservation and growth in portfolios has been elusive at best. Poor returns in the equity market, low yields in bonds and increased volatility stemming from two economic recessions and a financial crisis have made some investors wonder if their goals are simply too optimistic in today’s world. At Emerson, we believe growth and capital preservation along with dependable income are reasonable and achievable – especially from today’s current valuation levels. But investment success needs a sound process including diversification, income, macroeconomic analysis and big ideas to stand up to the challenges of a global market.