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5 Ways To Beat The Market: Part II Revisited

In a series of articles in December 2014, I highlighted five buy-and-hold strategies that have historically outperformed the S&P 500 (SPY). Stock ownership by U.S. households is low and falling even as the barriers to entering the market have been greatly reduced. Investors should understand simple and easy to implement strategies that have been shown to outperform the market over long time intervals. The second of five strategies I will revisit in this series of articles is the “value factor” that has seen stocks with these characteristics outperform the broader market. In a series of articles in December 2014, I demonstrated five buy-and-hold strategies – size, value, low volatility, dividend growth, and equal weighting, that have historically outperformed the S&P 500 (NYSEARCA: SPY ). I covered an update to the size factor published on Wednesday. In that series, I demonstrated that while technological barriers and costs to market access have been falling, the number of households that own stocks in non-retirement accounts has been falling as well. Less that 14% of U.S. households directly own stocks, which is less than half of the amount of households that own dogs or cats , and less than half of the proportion of households that own guns . The percentage of households that directly own stocks is even less than the percentage of households that have Netflix or Hulu . The strategies I discussed in this series are low cost ways of getting broadly diversified domestic equity exposure with factor tilts that have generated long-run structural alpha. I want to keep these investor topics in front of the Seeking Alpha readership, so I will re-visit these principles with a discussion of the first half returns of these strategies in a series of five articles over the next five days. Reprisals of these articles will allow me to continually update the long-run returns of these strategies for the readership. Value In the first article in this series, I described the “size factor”, or why small-cap stocks tend to outperform large-cap stocks over long time intervals. The size factor is captured in the Fama-French Three Factor Model that helped earn Eugene Fama the Nobel Prize in Economics in 2013. Another of these factors is the “value factor.” The researchers noted that low market-to-book stocks tended to outperform high market-book stocks. Adding the “size factor” and value factor” to the Capital Asset Pricing Model better describes the stock market performance than beta alone. Since we are trying to beat the general market, it makes intuitive sense that alpha would be found in a value factor that was used as a supplement to better describe overall returns. Our second way to beat the market, as proxied by the S&P 500, is then to simply buy value stocks. Below I have tabled the average returns of the S&P 500 Pure Value Index, and show the returns of this index graphed against the S&P 500. For more information on this style-concentrated index, please see the linked microsite . This index is replicated through the Guggenheim S&P 500 Pure Value ETF (NYSEARCA: RPV ) with an expense ratio of 0.35%. The S&P 500 Pure Value Index identifies constituents by measures of high levels of book value, earnings, and sales to the share price. In the five strategies I am detailing to “beat the market”, I will be using trailing 20 years of data, which is the longest time interval that encapsulated all of the relevant indices used in the analysis. (click to enlarge) Source: Bloomberg; Standard and Poor’s Source: Bloomberg; Standard and Poor’s Why has value investing worked historically? Why has the S&P 500 Pure Value Index outperformed over this long sample period? Value investing has been extolled since the days of Benjamin Graham, and put into most visible practice by his pupil, Warren Buffett. Value investing necessitates understanding the difference between a stock that is valued too low by the market, and a stock that is a “value trap” because changes in the business or its industry have created a structural headwind. Value investors then need to have the fortitude to hold their investment when investor sentiment runs counter to their investment themes. On average, individual investors do not have these attributes. In data from “How America Saves”, the fund giant Vanguard has published a wealth of data on defined contribution plans under its management. The table below shows participant contributions in Vanguard’s defined contribution plans over the trailing ten years. Investors should on average be taking a long-term view towards their retirement assets; however, investors owned their lowest percentage of equities in 2009 as markets rebounded from the 2008 downturn, missing a 26.5% total return for the S&P 500 and a tremendous 55.2% return for the S&P 500 Pure Value Index. Source: Vanguard – an updated version of their analysis is linked . In the four years that the S&P 500 produced a negative return in our twenty-year dataset, the value index produced a higher return in the following year. In the Vanguard data, retirement plan participants, who should be taking a long-term view towards their investments, were less likely to own equities after 2008. Value investing is a discipline, and the average investor is not suited to follow this approach, which may be why a low-cost, rules-based exchange-traded fund with a value bent like may be a good solution for some investors. While a value-based strategy has historically outperformed, you can see from the data table below that the value-based index lagged in the first half of 2015. Source: Bloomberg, Standard and Poor’s This 249bp first half underperformance relative to the S&P 500 was the last first half underperformance since 2012. In that year, value stocks rebounded by generating a nearly 18% return in the second half versus a 6% return for the broader market. Value stocks have only produced negative returns over the first six months of four calendar years in the dataset, 1994, 2000, 2008, and 2015. Two of those periods (2000 and 2008) preceded economic recessions and one year 1994 – featured sharply higher interest rates. As I wrote in my 10 Themes Shaping Markets in the Back Half of 2015 , with stock prices near all-time highs and bond prices still elevated from low interest rates despite the first half sell-off, forward returns in asset markets will continue to be subnormal. For long-term investors with a buy-and-hold approach, the value factor has generated alpha over long-time intervals. I will be publishing updated results for three additional proven buy-and-hold strategies that can be replicated through low cost indices over the next three days. Disclaimer My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon. Disclosure: I am/we are long SPY. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Beta: The World’s #1 Passive Fund

Summary I own Vanguard’s Total Stock Market Portfolio in their 529. Here is why I own it and why everyone should consider it. You can make a tax-advantaged contribution at a significant scale. #1 Passive Fund in the World I have always mixed active investing ideas with some amount of passive market exposure. Passive exposure is cheap, simple, and tax-efficient. It also provides me with a little insurance against the results of my active ideas. My #1 favorite place to get market exposure with these benefits is Vanguard’s Total Stock Market Portfolio (MUTF: VTSMX ) within Vanguard’s 529. It has done well since inception: It is up over 50% since I discussed it as a long idea: Management Vanguard claims that, We hire top investment professionals with the experience and expertise you’d expect from Vanguard. But this is an unmanaged fund, so as long as they can keep the books straight, they could also, hire psychotic crack fiends with the experience and expertise I’d expect from San Quentin. for all that I would care. Service Their service is fine. You get 25 free trades per year if you keep over $1 million and you get 500 free trades per year if you keep over $10 million at Vanguard. They are quite generous about this status as they count the entire family’s balance towards the requisite total. In addition to the free trades, they also give you the name and phone number of a competent representative who typically can solve problems associated with such accounts. 529s A 529 savings plan is an investment account intended for college and other higher-education costs. They are sponsored by individual states and offer various tax benefits. Earnings are deferred from federal taxes. Withdrawals for qualified higher-education expenses are also tax-free. You can make up to five years’ worth of contributions at one time without triggering gift tax. The uses are pretty generous – you can use the money for tuition, room and board, books, and other expenses. Why Nevada? Nevada is one of the few remaining states without any income tax. If you have flexibility as to where you live, these are probably states worth considering. Of the bunch, Wyoming is my favorite. If one lives in Wyoming close enough to Montana to shop there, you can pay Wyoming’s zero percent income tax and Montana’s zero percent sales tax. As for Nevada, since they lack a state income tax, they cannot lure Nevadans to their 529 with promises of avoiding state income tax. Instead, they have offered every other type of inducement. Their contribution limit of $370,000 is high. Funds are removed from your estate and are exempt from creditors’ claims. They are lenient about any requirement to withdraw funds. Why Vanguard? Compared to the alternative in Nevada, Vanguard’s 529 allows you to invest in Vanguard funds. The alternative fund costs from 0.29-0.89%, while the expense ratio on my favorite Vanguard fund is 0.21%. Vanguard’s minimum initial contribution is $3,000 instead of $250, but the whole idea with this investment is to make a large investment and to hold it for a very long time. There are no enrollment fees for either Vanguard or the one alternative to Vanguard in Nevada. Why the Total Stock Market Portfolio? While this fund is highly correlated with the S&P 500 (NYSEARCA: SPY ), it is somewhat more diversified. It includes smaller capitalization companies. In doing so, it avoids some of the turnover associated with companies entering and exiting the S&P 500. That reconstitution generates trading fees and taxes. Companies included in the S&P 500 trade at a premium, which one has to pay every time one buys an S&P 500 index fund or ETF. Owning a broader based fund avoids such expenses. But whether or not you agree with my rationale, the difference is trivial: Scale This is a tax-advantaged fund 67x your IRA contribution limit. For 2015, the IRA contribution limit is $5,500 ($6,500 for people 50 or older). One might as well fund it, but the scale is small. The 529 limit is $370,000. If you are married, you can each invest $370,000 with oneself as the owner and beneficiary. At that scale, this investment has already been worth over $1.1 million since inception and over $391,000 since I last discussed it. This is an ideal vehicle for long-term tax-free compounding. Withdrawals This investment idea works well regardless of your intention for the proceeds. It works best when invested for at least a generation or longer. However, regardless of your time-horizon, it is more flexible than it first appears. There are at least five great ways to use the proceeds. 1) College for your kids and grandkids First, one can use it for its intended purpose: college, presumably for your kids or grandkids. It is easy to transfer money from one beneficiary to another. You can transfer assets in increments of $70,000 once every five years without any gift tax. Higher education is expensive and getting more expensive. It should be no surprise that we suffer under the highest inflation where there are the most third party payers. The government enters the bid side of a market with no price-sensitivity and it… increases prices: Is the expense more worrisome or is the fact that politicians fail to see the connection between their behavior and prices? In any event, it is likely that you will have higher education bills in your future. 2) College for yourself Secondly, you can spend the money on yourself. Whether or not you have kids or grandkids (or have any inclination to subsidize said kids/grandkids), you can still save the money in a 529 and spend it on… your own bad self. Courses in wine tasting and golf in an idyllic college town would not be terrible. 3) College as philanthropy Thirdly, you can give the money away. Even if you do not want to spend it on either your progeny or yourself, this would make a perfect foundation for your philanthropic educational efforts. Whether or not you will have college bills to pay, someone certainly will. You will be able to help them. 4) Future expanded usage Fourth, it is reasonably likely that the hodgepodge of tax-advantaged accounts will be simplified and consolidated in the future. If this one is consolidated with others intended for retirement or healthcare, then the limitations on usage will have effectively disappeared. Over the next fifty years, this is highly likely. 5) Just pay the penalty… you will still come out ahead Fifth and finally, you can simply pay the penalty. But here is where this idea gets really interesting, in fact dominant as a strategy: the penalty is too small . Federal law imposes a 10% penalty on earnings for non-qualified distributions. While I never plan to pay this penalty, the value of 10% of the earnings on the back end will probably be far less than the value of compounding tax-free in the interim decades. Even if you intend to spend the money on wine, women, and song (and fail to find an anthropology course “Wine, Women & Song 101”), then you can compound tax-free, pay the penalty, and still end up ahead. Scholarship Encouragement If your kids fully expect that you will pay for college, it can be harder to encourage them to find scholarships. There are piles of scholarship dollars everywhere for almost every type of kid. The key is for them to be motivated to find it and get it. If they receive a scholarship, then the penalty for withdrawing money from a 529 is waived. My hope is that my kids attend military academies (also that my daughter elopes). If the plan succeeds, then there are decades ahead of tax-free compounding without any restriction on some withdrawals. In order to interest them, I am offering each kid half of whatever they earn in scholarship money. Conclusion If you max out your 529 contribution and then wait for a long time, you will benefit from tax-free compounding at a significant scale. At the same time, the cost of the limitations on withdrawals is manageable. With that base of passive market exposure, one can turn to active ideas. My best ones are here . Disclosure: I am/we are long VTSMX. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Chris DeMuth Jr is a portfolio manager at Rangeley Capital. Rangeley invests with a margin of safety by buying securities at deep discounts to their intrinsic value and unlocking that value through corporate events. In order to maximize total returns for our investors, we reserve the right to make investment decisions regarding any security without further notification except where such notification is required by law.

The Big Picture

Summary US markets have surged in recent years. But this pattern has happened before. Foreign markets may present big opportunities. This is a shortened version of the latest Euro Pacific Capital’s Global Investor Newsletter . The past four years or so have been extremely frustrating for investors like me who have structured their portfolios around the belief that the current experiments in central bank stimulus, the anti-business drift in Washington, and America’s mediocre economy and unresolved debt issues would push down the value of the dollar, push up commodity prices, and favor assets in economies with relatively low debt levels and higher GDP growth. But since the beginning of 2011, the Dow Jones Industrial Average has rallied 67% while the rest of the world has been largely stuck in the mud. This dominance is reminiscent of the four years from the end of 1996 to the end of 2000, when the Dow rallied 54% while overseas markets languished. Although past performance is no guarantee of future results, a casual look back at how the U.S. out-performance trend played out the last time it had occurred should give investors much to think about. The late 1990s was the original “Goldilocks” era of U.S. economic history, one in which all the inputs seemed to offer investors the best of all possible worlds. The Clinton Administration and the first Republican-controlled Congress in a generation had implemented policies that lowered taxes, eased business conditions, and encouraged business investment. But, more importantly, the Federal Reserve was led by Alan Greenspan, whose efforts to orchestrate smooth sailing on Wall Street led many to dub Mr. Greenspan “The Maestro.” Towards the end of the 1990’s, Greenspan worked hard to insulate the markets from some of the more negative developments in global finance. These included the Asian Debt Crisis of 1997 and the Russian debt default of 1998. But the most telling policy move of the Greenspan Fed in the late 1990’s was its response to the rapid demise of hedge fund Long term Capital Management (LTCM), whose strategy of heavily leveraged arbitrage backfired spectacularly in 1998. Greenspan engineered a $3.6 billion bailout and forced sale of LTCM to a consortium of Wall Street firms. The intervention was an enormous relief to LTCM shareholders but, more importantly, it provided a precedent that the Fed had Wall Street’s back. Not surprisingly, the 1990s became one of the longest sustained bull markets on record. But in the latter part of the decade the markets really started to climb in an unprecedented trajectory. As the bubble began inflating in earnest Greenspan was reluctant to follow the dictum that the Fed’s job was to remove the punch bowl before the party got out of hand. Instead he argued that the Fed shouldn’t prevent bubbles from forming, but simply to clean up the mess after they burst. But while U.S. markets were taking off, the rest of the world was languishing, or worse: (click to enlarge) Created by EPC using data from Bloomberg All returns are currency-adjusted But then a very funny thing happened. In March 2000, the music stopped and the dotcom bubble finally burst, sending the Nasdaq down nearly 50% by the end of the year, and a staggering 70% by September 2001. When investors got back into the market their values had changed. They now favored low valuations, real revenue growth, understandable business models, high dividends, and low debt. They came to find those features in the non-dollar investments that they had been avoiding. Over the seven years that began at the end of 2000 and lasted until the end of 2007 the S&P 500 inched upwards by just 11%, for an average annual return of only 1.6%. But over that time frame the world index (which includes everything except the U.S.) was up 72%. The emerging markets, which had suffered the most during the four prior years, were up a staggering 273%. See table below: (click to enlarge) Created by EPC using data from Bloomberg All returns are currency-adjusted Not surprisingly, the markets and asset classes that had been decimated by the Asian debt and currency crises, delivered stunning results. South Korea, which was only up 10% in the four years prior, was up 312% from 2001-2007. Brazil, which had fallen by 4%, notched a 407% return, and Indonesia, which had fallen by 50%, skyrocketed by 745%. The period was also a great time for gold and gold stocks. The earlier four years had offered nothing but misery for investors like me who had been convinced that the Greenspan policies would undermine the dollar, shake confidence in fiat currency, and drive investors into gold. Instead, gold fell 26% (to a 20-year low), and shares of gold mining companies fell a stunning 65%. But when the gold market turned in 2001, it turned hard. From 2001 – 2007, the dollar retreated by nearly 18% (FRED, FRB St. Louis), while gold shot up by 206%, and shares of gold miners surged 512%. As it turned out, we weren’t wrong about the impact of the Fed’s easy money, just too early. 2010 – 2014 In recent years, investors who have looked to avoid the dollar and the high-debt developed economies have encountered many of the same frustrations that they encountered in the late 1990s. Foreign markets, energy, commodities and gold have gone nowhere while the dollar and U.S. markets have surged as they did in 1997-2000. (click to enlarge) Created by EPC using data from Bloomberg All returns are currency-adjusted It is said history may not repeat, but it often rhymes. If so, there may be a financial sonnet brewing. There are reasons to believe that relative returns globally will turn around now much as they did back in 2000. Perhaps even more decisively. Just as they had back in the late 1990’s, investors appear to be ignoring flashing red flags. In its Business and Finance Outlook 2015, the Organization for Economic Cooperation and Development (OECD), a body that could not be characterized as a harbinger of doom, highlighted some of the issues that should be concerning the markets. Reuters provides this summary of the report’s conclusions: Encouraged by years of central bank easing, investors are plowing too much cash into unproductive and increasingly speculative investments while shunning businesses building economic growth. There is a growing divergence between investors rushing into ever riskier assets while companies remain too risk-averse to make investments. Investors are rewarding corporate managers focused on share-buybacks, dividends, mergers and acquisitions rather than those CEOS betting on long-term investment in research and development. While these trends have been occurring around the world, they have become most pronounced in the U.S., making valuations disproportionately high relative to other markets. As we mentioned in a prior newsletter , looking at current valuations through a long term lens provides needed perspective. One of the best ways to do that is with the Cyclically-Adjusted-Price-to-Earnings (CAPE) ratio, which is also known as the Shiller Ratio (named after its developer, the Nobel prize-winning economist Robert Shiller).Using 2014 year-end CAPE ratios that average earnings over a trailing 10-year period, the global valuation imbalances become evident: (click to enlarge) As of the end of 2014, the S&P 500 had a CAPE ratio of well over 27, at least 75% higher than the MSCI World Index of around 15. (High valuations are also on evidence in Japan, where similar monetary stimulus programs are underway). On a country by country basis, the U.S. has a CAPE that is at least 40% higher than Canada, 58% higher than Germany, 68% higher than Australia, 90% higher than New Zealand, Finland and Singapore, and well over 100% higher than South Korea and Norway. Yet these markets, despite the strong domestic economic fundamentals that we feel exist, are rarely mentioned as priority investment targets by the mainstream asset management firms. In addition, U.S. stocks currently offer some of the lowest dividend yields to compensate investors for the higher valuations (see chart above). The current estimated 1.87% annual dividend yield for the S&P 500 is far below the current annual dividend yields of Australia, New Zealand, Finland and Norway. If a dramatic shock occurs as it did in 2000, will investors again turn away from high leverage and high valuations to seek more modestly valued investments? Then, as now, we believe those types of assets can more readily be found in non-dollar markets. Another similarity between then and now is the propensity to confuse an asset bubble for genuine economic growth. The dotcom craze of the 1990s painted a false picture of prosperity that was doomed to end badly once market forces corrected for the mal-investments. When that did occur, and stock prices fell sharply, the Fed responded by blowing up an even bigger bubble in real estate. When that larger bubble burst in 2008, the result was not just recession, but the largest financial crisis since the Great Depression. But once again investors have mistaken a bubble for a recovery, only this time the bubble is much larger and the “recovery” much smaller. The middling 2% GDP growth we are currently experiencing is approximately half of what we saw in the late 1990s. In reality, the Fed has prevented market forces from solving acute structural problems while producing the mother of all bubbles in stocks, bonds, and real estate. A return to monetary normalcy is impossible without pricking those bubbles. Soon the markets will be faced with the unpleasant reality that the U.S. economy may now be so addicted to monetary heroine that another round of quantitative easing will be necessary to keep the bubble from deflating. The current rally in U.S. stocks has gone on for nearly four full years without a 10% correction. Given that high asset prices are one of the pillars that support this weak economy, it is likely that the Fed will unleash another round of QE as soon as the market starts to fall in earnest. The realization that the markets are dependent on Fed life support should seal the dollar’s fate. Once the dollar turns, a process that in my opinion began in April of this year, so too should the fortunes of U.S. markets relative to foreign markets. If I am right, we may be about to embark on what could become the single most substantial period of out-performance of foreign verses domestic markets. While the party in the 1990s ended badly, the festivities currently underway may end in outright disaster. The party-goers may not just awaken with hangovers, but with missing teeth, no memories, and Mike Tyson’s tiger in their hotel room. Read the original article at Euro Pacific Capital. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.