This piece originally appeared in Inside Value. Click here to find out more.
One hundred twenty months ago, many of you joined me in a fateful decision: becoming a charter member to Inside Value. Yes, this month marks our 10-year anniversary. Yes. Wow.
A lot of water has passed under the bridge: 192 recommendations, 56,000 discussion board posts, the financial crisis. We've evolved from a 2004-esque print issue to real-time alerts and personalized updates. In that time, we've seen the Internet move from scratching the surface of its promise to denting it, and practically every food become available bacon-infused -- and long may bacon mania last.
For all the drama, late nights, and bacon-wrapped cupcakes, though, the ethos and mission of Inside Value has never wavered. Our mission is to deliver you winning investment advice by uncovering strong, well run businesses selling for prices that discount their bright futures.
I'm pleased to report Inside Value has had a good run. The service has outperformed 98% of the investment newsletters tracked by Hulbert's Financial Digest since our inception and bested the market heading into and out of the Great Recession. And for those of you who have followed our advice move for move since we launched, you'd have earned a 12.5% annualized return, compared with 7.9% from the S&P 500 index. The chart below shows the growth of $10,000 invested following IV move for move, compared with an investment in the iShares SPDR S&P 500 ETF (NYSEMKT: SPY) or Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B).
We didn't get here by swinging for the fences. Instead, we take a lot of pitches and only swing at ones in our sweet spot. We don't mind missing out on high flyers because, unlike in baseball, there are no called strikes in investing. We avoid industries where our feet dangle over the edge of our circles of competence (biotech, fashion, etc.) and others where capital goes to die (retail, mining, airlines, restaurants, etc.).
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That disciplined approach played out as we'd have hoped. Fifty-nine percent of Inside Value's recommendations have beaten the market, which is solid considering a recent study highlighted that only 36% of stocks outperform the market. Our returns have also been consistent: We're on track to best the Wilshire 5000 for the sixth consecutive calendar year.
If it sounds like we're patting ourselves pretty hard on the back, know that we are our own biggest critics. It also isn't like we invented value investing or the concept of being greedy when others are fearful. We're standing on the shoulders of giants -- Ben Graham, Warren Buffett, and Charlie Munger -- and we've fallen and skinned our knees countless times. It's great that 59% of our recommendations have beaten the market, but we can learn heaps from the 41% of stocks we overestimated.
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We do our best to learn from our mistakes, though, and glean insights from original thinkers like Peter Lynch, John Malone, and Tom and David Gardner, who round out our thinking. I don't lose sleep wondering whether Graham would judge me for recommending Google (NASDAQ:GOOGL) (NASDAQ:GOOG). Unlike most value investors, we've learned to place every bit as much weight on business quality as we do price, if not more. It's the strategy that works for us.
The next 10 years
But enough talk about ghosts of our past. And let's also take it as a given that while we'll continue to aim to grow and learn from our mistakes, we'll continue running with the same philosophy. What will change is what strategies we implement to roll with the times. These days, the two most dominant themes affecting our returns for the next 10 years are the current market valuation and interest rates.
We've had a hard time finding new ideas over the past year. The S&P 500 is selling for almost 19 times earnings, about 25% above the long-term average of 15. Warren Buffett's favorite macro valuation measure, total market capitalization to GNP, is floating near high-water marks and about 19% above a price Buffett has said he would consider fair. And on a more granular level, most of our recommendations -- companies we know very well -- have coasted up to near their fair values.
I'm not calling for a 20%-ish correction -- only charlatans and the self-deluded make calls like that -- but every data point I can muster suggests that this five-year bull market we've all been riding has front-loaded our returns, borrowing from our future ones.
The math is pretty straightforward. Let's say the S&P 500 grows its earnings at a 7% annualized clip over the coming decade. Let's also say the price investors are willing to pay for a dollar of its earnings (the price-to-earnings ratio) drifts from its perch at 19 back to a more normal 15. Such a scenario makes for annualized nominal returns of less than 5% for investors -- a far cry from the historical 10% average and a country mile from the S&P 500's 30% return in 2013.
Don't get me wrong: There is a lot for American investors to be excited about. The economy is accelerating, we're home to the world's most innovative companies, and the domestic energy boom is strengthening our finances and rekindling American manufacturing. We investors also aren't obliged to blindly invest in an index, and we can pivot so we can profit from the biggest headwind facing stock prices: rising interest rates.
The Fed's zero interest rate policy has created some predictable yet powerful effects. Low rates helped a crippled housing market get back on its feet and enabled small business owners to borrow to invest. The nation avoided the catastrophic effects of deflation and, while this might feel like a distant memory, that river of cheap money might have been the difference between survival and failure for hundreds more American banks.
The wrinkle is that low rates have pushed retirees and other yield-hungry investors to bid up the prices of stocks and high-yield bonds. When interest rates do climb back to normalcy, lower-risk investments like government bonds and money market accounts will look a lot more attractive to investors, and billions upon billions of dollars will slosh from equities and junk bonds back into safer waters.
When will rates rise? Having been wrongly calling for rising rates for about five years, I may be worse at guessing than you. Still, the time seems nigh. The 10-year Treasury rate historically gravitates toward the level of GDP growth, which clocked in near a nominal 6% last quarter, almost 4 percentage points above 10-year yield. Job growth is also accelerating, the tapering off of quantitative easing has almost ended, and the Fed is well aware that its hyper-aggressive tactics have hammered savers.
The Inside Value scorecard is more than ready for when rates rise, though. We've invested in numerous companies that will make more money on higher interest rates, ranging from Automatic Data Processing (NASDAQ:ADP) to Progressive (NYSE:PGR) to TD Ameritrade (NYSE:AMTD). I can't predict what exactly will happen when the cheap money tides flow out, but I'm confident we won't be the swimmers left standing naked.
The market's high valuation has also led us to ratchet back our risk and tighten our focus. We've sold off companies that we don't think can grow into their valuations and doubled down on the few that we think offer both great long-term prospects and a compelling valuation. It's been a painstaking process and it's never easy to let go of a company you've owned for years, but we've never felt better about the business quality of our crop of active recommendations.
Thank you, thank you, thank you
I love my job. As if educating, amusing, and enriching isn't rewarding enough, I get to work with talented, devoted Fools like Philip Durell, Scott Hall, Ron Gross, Mike Olsen, and our editor, Nathan Willis. I've also been privileged to serve tens of thousands of hardworking people like you, each with their own hopes and dreams. Sending your kids to school. That dream vacation you've always promised your wife. A comfortable retirement.
I can't say enough how much it means to our team that you've entrusted us to join you on that road to financial freedom. I hope we've lived up to your expectations and, no matter what lies on the road in front of us, know that we'll keep doing our best for you.
Joe Magyer owns shares of Accenture, Automatic Data Processing, Berkshire Hathaway, Google (A shares), Google (C shares), MasterCard, Progressive, TD Ameritrade, and Visa. The Motley Fool recommends Accenture, Automatic Data Processing, Berkshire Hathaway, Brookfield Infrastructure Partners, Google (A shares), Google (C shares), MasterCard, Progressive, TD Ameritrade, UnitedHealth Group, and Visa. The Motley Fool owns shares of Berkshire Hathaway, Google (A shares), Google (C shares), MasterCard, TD Ameritrade, and Visa.
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