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We Woke Up on the Wrong Side of the Bed

publication date: Mar 9, 2023
author/source: Brian Nelson, CFA

By Brian Nelson, CFA

Large Cap Growth Still Dominating Small Cap Value

After the ‘value factor’ put up its worst performance in history during 2020, some retracement should have been expected in the subsequent 12-18 months, but large cap growth – our favorite stylistic area – continues to outperform.

Since the publishing of the first edition of Value Trap: Theory of Universal Valuation in December 19, 2018, an ETF that tracks large cap growth (SCHG) has outperformed an ETF that tracks small cap value (IWN) by more than 45 percentage points.

Using data that goes back to before the invention of the computer and television, researchers will tell you that there’s something called a small cap value premium. However, in this day and age, there’s no such thing.

Asset light, net cash rich and strong free cash flow generators remain the place to be, in our view, and that’s the area of large cap growth. We expect this area to continue to trounce small cap value for years and years to come.

Who Cares About Whether Fund Managers Beat Their Benchmarks. Pick the Best Group of Stocks, Right?

We’ve fallen into the trap of the active versus passive debate in the past, too. For example, how many times have you heard that active managers can’t beat their benchmarks or category averages? Right? It has been the party line for indexers for years.

It’s taken me a long time to see through the deception. Here’s the reality: Very few investors should care about active versus passive (index) analysis. For one, I no longer care which fund managers or what percentage of fund managers have beaten their benchmark in a particular category over the past several years.

But why? Well, let’s talk basketball as an example to illustrate the point. Let’s say, Michael Jordan, Kobe Bryant and Lebron James form the same benchmark or are in the same category of ‘basketball player.’ One of these players can probably be considered the GOAT (greatest of all time), for example.

The average of these three players might then be the benchmark (category average) – one of these three players is going to be above average in the GOAT category while another of these three players is going to be below average in the GOAT category.

As you might gather, I really don’t care who is above or below average in the GOAT category – instead, I want this category of ballplayers to be on my team!

The same can be said about investing. One needs to be able to recognize great investment categories to include in their portfolio – and they really shouldn’t care about funds that are above average or below average within the category. Give me Kobe. Give me King James. Give me MJ. Heck – give me all three in my Dream Team portfolio!

Same can be said about investing. I really don’t care which large cap growth fund manager is beating their benchmark or category or how many are doing so. I care about having exposure to large cap growth! From my perspective, it’s far more important to be in the right investment category than what fund managers are doing in that category.

Just one more thing while we're on this topic.

Michael Jordan may very well be the one true GOAT, but that doesn’t mean that Kobe Bryant and Lebron James are poor basketball players, which in this comparison, is what might be implied by fund research on underperforming active managers relative to their benchmark or category averages.

Most would have loved to have Kobe and King James on their team, no matter how they compare to MJ. Sad to say, but most fund research that is structurally against great active managers is doing more harm than good these days.  

Dividends Are Capital Appreciation That Otherwise Would Have Been Achieved Had the Dividend Not Been Paid

Dividends aren’t the only way to achieve income goals.

An entire field of study of portfolio management caters to the needs of retirees that require a certain amount of income each month or year, while preserving their capital (and hopefully) grow it along the way.

As a shareholder of a company, you already own all the assets of the company, which includes the cash on the balance sheet before a dividend is paid. Business owners understand that if they pay themselves a dividend or distribution, they are not wealthier.

The same can be said about the shareholder, which is an owner of a business, too. The business paying them a dividend may be one way to structure their income payments, but it is not the causal driver of wealth (which is increased free cash flow generation).

It’s okay to love dividends – we do, too! – but don’t be confused by them. With the share price of the stock adjusted down by the amount of the dividend on the ex-dividend date, dividends are merely capital appreciation that would have been achieved had the dividend not been paid.

Dividends aren’t magic. With dividends, investors are getting paid with their own money. Business owners understand this – paying themselves a distribution doesn’t make them any wealthier. In fact, it may make them less wealthy given tax consequences.

Go Figure -- Bonds Are Down Again So Far in 2023

Everyone was falling over themselves to pitch the 60/40 stock/bond portfolio to start this year and how there are now alternatives to stocks given rising yields. The latter isn’t untrue, but bonds have done practically nothing so far in 2023--after a terrible 2022.

The Vanguard Long-Term Bond ETF (BLV) is flat on the year, while the iShares Core U.S. Aggregate Bond ETF (AGG) and the Vanguard Total Bond Market ETF (BND) are each down ~1.%. Meanwhile, the S&P 500 (SPY) is up ~5%.

We think people are desperate for the 60/40 stock/bond portfolio to do well, instead of analyzing the situation objectively. Both stocks and bonds should be inversely correlated to the direction of interest rates, and because bonds have fixed future expected coupons, they can face pressure, while stocks can still advance as they can grow their future expected "coupons" (free cash flow).

It’s possible bonds can eek out a positive return in 2023, but stocks for the long haul make a whole lot more sense to us.

REITs are Underperformers and Haven’t Been Reliable Dividend Payers

Though REITs may fit within a diversified portfolio, as theoretically any asset can, they haven’t delivered in the way many retirees have wanted. The Vanguard REIT ETF (VNQ) paid out $3.561 and $3.254 in annual dividends in 2005 and 2006, respectively, and now 15+ years later, the ETF paid out less than those levels during 2022 ($3.2261).

Not only have REITs, in aggregate, grown their dividends a big “nothingburger” since 2005, but their total return over the past several years (2015-2022) has been terrible. Inclusive of dividends received, the VNQ generated a 39.5% total return from 2015-2022, while the S&P 500 (VOO) increased 116.3% over the same time period.

We have no idea why so many absolutely love REITs. We only like a handful of them, and we're aware of the big risks to the group, as REITs have been terrible investments for quite some time now. We think REITs play some role in investing, but it should be a very, very small part. More on why REITs are so risky >>

Concluding Thoughts

Both the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio generated relative outperformance during 2022. The success rates of the Exclusive publication remain fantastic, and the High Yield Dividend Newsletter portfolio remains resilient in the face of rising rates. We put up one of our best set of options ideas recently, and the work we’re doing on ESG continues to deliver. Let us know if you have any questions. We clearly woke up on the wrong side of the bed this morning.


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Brian Nelson owns shares in SPY, SCHG, QQQ, DIA, VOT, BITO, RSP, and IWM. Valuentum owns SPY, SCHG, QQQ, VOO, and DIA. Brian Nelson's household owns shares in HON, DIS, HAS, NKE, DIA, and RSP. Some of the securities written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.        

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1 Comments Posted Leave a comment

Brendan Messenger (Abilene)

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