Since 2010, U.S. stock funds have been trounced by equity indices such as the S&P 500 Index. It’s gotten so bad that around 88% of active U.S. domestic fund managers lag behind their benchmarks, according to fund researcher Morningstar.
The upshot: Money is flooding out of managed funds into “passive” exchange traded funds (ETFs) that track major indices. Last year, the SPDR ETF SPY, -0.07% an S&P 500 SPX, -0.07% tracker, had inflows of $25 billion, taking its asset base up to $238 billion. Two other S&P 500 trackers, the Vanguard S&P 500 Index Fund VOO, -0.05% and the iShares Core S&P 500 ETF IVV, -0.06% had combined inflows of over $24 billion.
That creates a self-fulfilling prophecy that compounds the problem for active managers. When investors buy S&P 500 ETFs, the ETF buys all of the underlying stocks, naturally driving up their prices. That boosts the performance of those stocks relative to non-index stocks — like the ones that active managers might own. And this attracts more money to index ETFs and away from active managers.
This dynamic sets up a clever way to place a contrarian bet against the ETF boom, points out George Putnam, a contrarian thinker and successful value investor who writes the Turnaround Letter, a value-stock newsletter that has performed consistently well.
The contrarian angle here: Shop for value among the stocks that are cheaper because they are “left behind.” Stocks outside the S&P 500 may naturally carry lower valuations because they haven’t been driven up by the crowds flocking to S&P 500 ETFs.
There’s potentially another big benefit here. If the ETF fad wanes because active managers start outperforming again, these “left behind” stocks will hold up better. That’s because they won’t get hit by the downdraft created when the crowd exits S&P 500 ETFs.
With help from DoubleLine Capital founder and CEO Jeffrey Gundlach, I’ll explain, below, why active managers are a lot more likely to outperform than you might think — itself an intriguing contrarian idea from a contrarian who has a stellar record at betting against the crowd.
But first, here are three of the five “left behind” names that Putnam highlighted in the May issue of his Turnaround Letter.
Typically, you have to be wealthy to invest with private-equity firms that put money directly into private companies and real estate deals. Not so with BlackstoneBX, +0.10% which manages big private-equity funds like Blackstone Capital Partners and Blackstone Energy Partners. All you have to do is buy Blackstone stock. Blackstone has over $368 billion in assets under management. It makes money from recurring fees and performance fees, and by collecting a share of the capital gains earned on its investments.
Those investments have been doing well. Revenue rose 108% in the most recent quarter to $1.94 billion. Net income tripled to $1 billion. Blackstone pays a 7.6% dividend. Despite those positives, Blackstone trades for only 10.8 times this year’s expected earnings, an attractive valuation in Putnam’s view.
Las Vegas Sands
This company runs upscale casinos and hotels in Macao on the southern coast of China across the water from Hong Kong. China’s crackdown on corruption and bribery a few years ago crimped the flow of cash available to gamblers in China, and this hurt Las Vegas Sands LVS, -0.33%
By now those trends are reversing, and gamblers are returning to the tables in Macao. The company’s casinos and hotels in Las Vegas are doing well, too. First-quarter sales overall advanced 14% to $3.1 billion, and net income jumped 50% to $480 million. “After a challenging period, the Macao market is growing again, and its growth rate has been accelerating for three consecutive quarters,” CEO Sheldon Adelson said in the first-quarter conference call.
Despite this improvement, Las Vegas Sands stock, at $59, still trades about 30% below 2014 highs. The stock sells for around 23 times 2017 expected earnings, well below the 26.8 price-to-earnings (P/E) multiple on Wynn Resorts WYNN, +2.00%Wynn probably carries a higher valuation in part because it is an S&P 500 Index member, Putnam said. A cash-flow machine, Las Vegas Sands pays a 4.6% dividend yield.
Norwegian Cruise Line
I suggested this Norwegian cruise company in my stock newsletter, Brush Up on Stocks, during a selloff in early October 2016 at around $37.50. It’s now up 37% to $51.50, compared with an 11% gain for the S&P 500. But it still looks relatively cheap, according to Putnam.
In part because of its “left behind” discount, Norwegian Cruise Line NCLH, -1.48% has a P/E of 13.8 times this year’s earnings, compared with 16.4 at Carnival CruiseCCL, +0.59% and 14.2 at Royal Caribbean RCL, -0.23% Putnam says. Both are S&P 500 members.
Norwegian Cruise Line is the smallest of the three cruise liners that dominate the North American market. That brings advantages. One is that the company has more room to boost earnings by adding ships. Norwegian also has a younger fleet, which means its ships are more attractive and more cost-efficient. What’s more, these three companies are part of an oligopoly, and they seem to be in a friendly standoff on pricing.
(On the next page, read about how active fund managers may get their revenge.)
The revenge of active managers
Will active managers really ever start outperforming indices again? This would help “left behind” companies banished from the S&P 500. Putnam thinks they will. So does DoubleLine Capital’s Gundlach, who has made a lot of contrarian calls that seemed out of left field at the time, but then turned out to be true.
Last week, Gundlach made the case that active managers would come back to the fore — and maybe soon — at the 22nd Annual Sohn Investment Conference. He cited three reasons.
1. “Passive” investing is crushing active managers now. But that hasn’t always been the case. Active managers regularly outperformed for long stretches of time, during 2006-2011, 2001-2005, 1992-1995 and 1981-1985. As with most stock market trends, there’s cyclicality to this contest. This will continue — putting active managers back in the lead — and maybe soon, because this trend is getting long in the tooth. Active managers have been lagging behind passive indices for around six years, about the longest amount of time this normally lasts.
2. Since 1988, active managers have beaten the indices whenever emerging markets (EM) outperform the S&P 500. EM have trailed the S&P 500 since 2010. But that trend recently reversed itself, and Gundlach thinks it will continue because U.S. stocks are twice as expensive. They have typically traded closer to parity since 2005.
If he’s right, this bodes well for U.S. active stock fund managers, since they normally beat the indices when emerging markets beat the S&P 500. (He suggested at the Sohn conference: Go long emerging markets. Short the S&P 500. And use leverage to amplify returns.)
Many investors shun EM now because they fear that more Federal Reserve interest-rate hikes will drive the dollar higher. Emerging markets normally lag behind when the dollar is strong. But history doesn’t support this concern. During three of the past five Fed tightening cycles, the dollar declined. “I’m not bearish on the dollar but I am not a dollar bull,” says Gundlach.
3. “Passive” investing is really just a myth, points out Gundlach. Indices like the S&P 500 are regularly tweaked by committees that manage them. Two conclusions flow from this. One is that institutional clients of big money management shops knee deep in index funds might figure this out at some point and pressure managers to get active and do more work. The other is that index fund management committees might add the wrong stocks, giving active managers an edge.
At the time of publication, Michael Brush had no positions in any stocks mentioned in this column. Brush has suggested NCLH, CCL and RCL in his stock newsletter, Brush Up on Stocks. Brush is a Manhattan-based financial writer who has covered business for the New York Times and The Economist group, and he attended Columbia Business School in the Knight-Bagehot program.[“Source-marketwatch”]