The Case for Being Selective

“If you don't know where you are going, you might wind up someplace else.”
—Yogi Berra

Yogi Berra’s words strike a chord with us. It could be that opening day is just around the corner, but the quote fits with today’s markets. The mad dash to passive equity funds leaves us wondering do investors know where they are going? Will they be shocked when they wind up someplace else?  

The questions are even more important with the stratospheric valuations of the most popular indexes, as shown in the table.   

S&P 500 Index Seems Expensive  
  3/24/2017 3/24/2016
Earnings per Share: $89.09 $90.66
Price/Earnings: 26.31x 22.46x
Market/Book Value: 3.17x 2.80x
Earnings Yield: 3.80% 4.45%
Dividend Yield: 2.04% 2.21%

Source: Barron’s and Standard & Poor’s
Generally accepted accounting principles (GAAP)
S&P Dec. 4-quarter’s GAAP earnings as reported and indicated dividends based on 3/24/2017 close.
S&P 500 Price/Earnings ratios based on GAAP earnings as reported. For additional earnings series refer to
Past performance does not guarantee future results.

If conviction is key to intelligent investing, holding-period data is even troubling. Recent analysis shows the average passive investor holds an exchange traded fund (ETF) for a whopping 47 days. For the SPDR S&P 500 ETF (SPY), one of the most popular S&P 500 ETFs, the number is even shorter—just 12 days!

A short-term mentality like this reminds us of tech-stock trading just before the bubble burst.

And similar to the heyday of “New Era Investing”, many true believers are certain things are different this time.

In just the past few months, I’ve received “investment advice” from retired executives and a caddy master alike:

“I’m in an S&P 500 Index fund—I can’t lose,” or “making money in the market is easy—just buy an ETF.”

When pressed about what they own in the index, the response was generally a shrug. Passive funds may be useful in special circumstances but this indifference toward valuations and the quick-money mentality feels more like a game of chance than investing.

The disinterest in fundamentals is even more striking to us given challenges and opportunities that are bubbling up on the horizon.

Here are just a few:

  • Short-term interest rates have moved higher, which could shrink highly leveraged companies’ profit outlook, while providing those with strong balance sheets an advantage.
  • Tax reform is on the agenda. It may not mean much for the top 50 companies in the S&P 500 that pay just 22.5% on average, but we expect it should result in a windfall for smaller companies that can’t exploit loopholes to reduce effective tax rates closer to 35%.
  • Inflation is heating up, meaning companies with unique niches should be better suited to pass along rising costs.
  • Current multiples should lead to a greater emphasis on earnings yield, not just top-line growth—e.g. Amazon, Tesla.

While excessive valuations have raised the bar for many growth/momentum companies in particular, not all news is negative:

  • Housing remains strong.
  • Consumer confidence is at a 16-year high and small businesses are bullish.
  • Employment continues to impress.
  • Government regulations are ripe for a rollback.

Still, in our opinion, the mixture of good and bad points to the importance of selectivity.

As bottom-up investors, we are proud to remain committed to doing the hard work of fundamental analysis. This means continuing to leverage a disciplined process to identify companies that should thrive under the scenarios listed above. Our bottom-up research has helped unearth specialized businesses that have unique product offerings or idiosyncratic drivers and capable management that should help them grow earnings in the quarters and years ahead. We believe this s the best approach for investors to reach their destination and avoid ending up someplace else.

We thank you for your continued trust and confidence.

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Past performance does not guarantee future results.

Investing involves risk, including the potential loss of principal.

There is no guarantee that a particular investment strategy will be successful.

Value investments are subject to the risk that their intrinsic value may not be recognized by the broad market.

The statements and opinions expressed in the articles or appearances are those of the presenter. Any discussion of investments and investment strategies represents the presenters' views as of the date created and are subject to change without notice. The opinions expressed are for general information only and are not intended to provide specific advice or recommendations for any individual. Any forecasts may not prove to be true.

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As of 3/31/2017, Heartland Advisors on behalf of its clients did not hold, Inc., SPDR S&P 500 ETF, and Tesla, Inc. 

SPDR is a short form of Standard & Poor's depositary receipt, an exchange-traded fund (ETF) managed by State Street Global Advisors that tracks the Standard & Poor's 500 Index (S&P 500). Each share of a SPDR contains one-tenth of the S&P index and trades at roughly one-tenth of the dollar-value level of the S&P 500. SPDRs can also refer to the general group of ETFs to which the Standard & Poor's depositary receipt belongs. 

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