TMF: The Value Trust has been the only fund to consistently beat the S&P 500 over the past 13 years. Why does the S&P crush most managers?
Gay: When we observe how it is that the market represented by the S&P generates the returns that it does that beat most active managers, you can identify their [the S&P's] strategy the same way you would identify any portfolio manager's strategy. You ask the two basic questions: How do they pick the stocks, and how do they put their portfolio together?
When you try to understand how the S&P picks stocks, they decide based on fairly transparent rules. Is the company of an adequate market size that it is representative in some industry that's important in the U.S. economy? Does the company have adequate trading liquidity, so at least 50% of the free-float must be held in public hands? There's not a lot of fundamental analysis that goes into when a name goes into or out of the S&P 500, and it's pretty transparent, because every time they make a change, they put out a press release. Yet this strategy beats 75% to 80% of active managers.
Part of the reason why we believe we've been so fortunate to have such a consistent track record of beating the market over a long period of time is we have tried to identify what the value-added rules are that the S&P uses that most active managers don't use, that enables it to generate returns that beat most active managers. And so there are three simple things that we observe that most active managers don't do and we try to do.
The first is an avoidance of macroeconomic forecasting. The S&P committee doesn't sit back and say, "Well, based on Greenspan's comments two weeks ago, it looks like they may raise interest rates in the next meeting. So let's lower our financial services weighting." Or, "Based on what oil prices are doing, let's adjust our energy weighting. Energy has done really well this year and last year, and maybe we need to cut it back." They're not making short-term changes in the index's weighting based on what they're observing in the market. Yet many active managers do that. They change their portfolio based on some forecast. What we try to do is observe what the Fed is saying, observe what really smart economists and strategists are saying, and try to understand from a valuation standpoint what that will mean for the companies that we own and the companies we're looking to invest, but not come up with our own forecast of when Greenspan will raise rates and how that will affect the financials we own. We want to understand that, but we're not going to change a portfolio based on some set forecast.
The second observation is that the market represented by the S&P 500 is very long-term oriented and has fairly low turnover. If you just look at the number of names that go into or out of the index, it's 5% to 10% a year. Most active portfolio managers have turnover rates of 100%, 150%. That one fact alone can cause a pretty big discrepancy in your fees and your performance, because you're operating in the most efficient part of the market. You don't have a long-term orientation. And although the S&P has this portfolio of 500 securities, it's pretty concentrated. The top 20% of the names make up about 60% or 65% of the market cap of the index. So a very small, focused part of the portfolio is responsible for its returns.
And then the final point is that the S&P 500 is not constrained by the type of limitations that are often place on active managers. So it doesn't have to have a limit on the number of weights that it has in certain stocks. It doesn't have a limit on the industry concentration. It doesn't have to stay in the value box or the growth box. There are no performance pressures on the S&P to cause it window dress the way you often may observe many active managers. There's a lot of activity at the end of a difficult performance, because they want to get out the under-performing names in the portfolio.
TMF: So implementing those "value-added rules" has led to your success?
Gay: We believe it has been a critical competitive advantage to identify these things that we've observed in the market and incorporate them into our own investment process. We're certainly not always right, and we don't beat the market all the time. We feel very fortunate that Value Trust has produced this consistent track record on a calendar-year basis. But there's nothing about what we do that is geared toward a calendar-year return. It's a fortunate accident of the calendar that has happened, that from December to December every year for the past 13 years, we beat the market. If you look at our returns January to January or February to February or March to March, it's highly unlikely that we beat the market 13 years in a row.
What we strive to do is position our portfolio in a way that has the highest level of potential return over a three-to-five-year basis on a risk-adjusted basis. So we don't look at who's going to win the election or not and decide how that's going to influence stock. We observe what we think is going on. We definitely pay attention to the polls. We have economists visit us all the time. Nancy Lazar from ISI visited us last week to share with us her views on the business cycle, which seemed reasonable. I can promise you that at the research meetings that we have every week, it better be the case that everyone's read Greenspan's comments. We read Paul McCully at PIMCO pretty carefully.
So we definitely observe what's going on, but we don't internally forecast it and change the portfolio because of it. Our average turnover rate tends to be about 25% a year. I don't think the numbers have been calculated through the end of June, but I know through the end of March, the 12-month turnover rate was running around 5% or 6%, which is pretty low -- certainly relative to most money managers.
We also construct very focused portfolios. On average, we have only 30 to 50 names in Value Trust at any one time. The average concentration is about 2.5% to 3%. The result will be a lot of volatility. We're underperforming the market, unfortunately, here today. But there's nothing about the strategy that will change, whether we beat the market this year or not. We're at least smart enough to recognize that the process that we've employed for 22 years has produced long-term, consistent returns, better than the market. That's been in lots of different economic environments, lots of different interest rate environments, inflations environments, different political administrations, different fiscal and monetary policy regimes.
I think probably the fact that we've had this 22-year string of out-performance is the biggest testament that it's the process that's enabled us to beat the market. It's not just that value's in vogue, so we do well. We really have what we believe is a step-by-step approach to finding mispriced securities and building a portfolio that will do well regardless of what's going on in the macroeconomic environment.
Read Matt Logan's complete interview with Mary Chris Gay:
- Lessons From the Value Trust
- Pay Up for Growth
- Beat the S&P 500
- Golden Rule of Investing
- Value in a Diverse Team
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