Some good new from a friend

Turner Investments

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Navigating the forest A common metaphor for explaining human shortsightedness is a person can’t see the forest for the trees. Growth-stock investors can be as susceptible to not seeing the forest as anyone.

It’s easy for growth investors, for better or worse, to get fixated on the trees. For instance, they may be keen on assessing fundamental criteria such as how Apple Pay, the new iPhone app that enables consumers to make purchases in stores, will affect Apple’s revenue and earnings. Or they may try to gauge the attractiveness of the price/earnings ratios of fast-growing companies benefiting from two key business phenomena of our times, the rise of social networking and cloud computing. Cases in point: Facebook, whose shares trade at 39 times next year’s earnings, and Workday, trading at 15 times projected sales for the next 12 months.

Others may attempt to pull back from the trees somewhat and examine broader quantitative measures such as the S&P 500 Index companies’ earnings growth, which is still impressive at 9% year over year, or valuations, which we believe remain reasonable if not exactly table-pounding cheap at 15 times projected earnings for 2015. Or they may scrutinize the duration of the current bull market, which as of November 2014 is approaching 69 months, versus the historical average of 60 months. Or they might seek to look at the magnitude of gains generated by this bull market: the S&P 500 Index has returned more than 190% cumulatively from when the upswing began on March 9, 2009 to November 17, 2014, compared with the historical average of 185%, according to the CFA Institute.

Bull alive and well?
Such perspectives might provide some comfort that this bull market could have a ways to go yet. But then growth investors, being the tree huggers they are, might be tempted to shorten their sights and contemplate such microeconomic issues as whether 3-D printing will revolutionize manufacturing and thus be a bonanza for a major player like Stratasys. We hasten to emphasize that in growth-stock investing, not all tree hugging (or gazing) is bad. Far from it. It’s just that focusing only on the trees won’t furnish a bigger picture as to where the stock market may be headed.

Since we didn’t foresee the extent of the 2008-2009 bear market, we thought at one point it might be a good analytical exercise to imagine our acquiring the investment equivalent of a sophisticated military tool – the drone – so that we could zoom over the stock-market forest to see what we could possibly be missing.

We reasoned that an investment drone might give us the ideal vantage point to determine which way the market is moving – in a bullish or bearish trend. But then our research indicated that a drone would only further muddle things; it would introduce additional criteria of marginal usefulness to our efforts to deduce the market’s direction. Criteria such as stocks that are trading above their 200-day moving average, the global demand for stocks, the supply of U.S. stocks, merger-and-acquisition activity as a percentage of the gross domestic product, and so on. Alas, we realized the list of potential criteria could simply go on and on, like modern-day presidential campaigns.

Who’s that on CNBC?
Then there are subjective criteria – most prominently, market forecasts. For every one opinion by market strategists who make a handsome living divining the course of the stock market, there are scores of indicators to support (or not support) their predictions. Being right once can make a strategist’s career. Being wrong often merely results in a strategist being invited less often to appear on CNBC.

But here’s the good news: we have come to realize that there’s a better way to discern the prospects of the stock-market forest. In our judgment, it’s more simple and reliable than any other fundamental, quantitative, or subjective criteria: credit-market analysis.

Brian Reynolds, the chief market strategist at Rosenblatt Securities, has been in the forefront of analyzing credit data perceptively. He has concluded that the credit market’s direction parallels that of the stock market. Typically the credit market enjoys a boom for an extended period (to the benefit of stocks) but ultimately goes bust (to the detriment of stocks).

Investors apply leverage
As Brian Reynolds has documented, in today’s world of paltry and declining interest rates, institutional investors covet certain desired rates of investment returns for their portfolios. For instance, pension plans typically want investment returns of 7.5% annually, and endowments typically seek returns of 4-5% annually. To achieve those kinds of returns, some money managers for institutional investors are compelled to use leverage – lots of it.

The outsized use of leverage has been particularly pronounced in the past five years, when 10-year Treasury yields have struggled to stay above 2.50% and the return potential of bonds has been subpar. Also, the bear market of 2008-2009 burned many investors so badly that they subsequently avoided stocks, thereby impairing the results of those investors’ portfolios. All that has helped to fuel an investment boom in credit (see Display 1).
Display 1: Corporate Bond Issuance ($bil)
Corporate Bond Issuance
Source: Bloomberg. 2014 annualized through 6.30

A credit boom has an array of consequences – at first, favorable consequences, then not-so-favorable consequences.

Of course, low rates make it financially advantageous for companies to issue debt. For instance, in April 2013 Apple floated a then-record $17 billion worth of bonds, with its 10-year issue yielding a meager 2.38%.

The upshot: higher stock prices
Also, the issuing companies often use the new cash to buy back their shares (see Display 2). Or they often raise their dividend payouts. Or they acquire other firms. Most often, they invest in research and development and production plants and equipment. All of this, happily, can lead to the ultimate favorable consequence: companies’ stock prices move higher – potentially much higher (see Display 3).

Display 2: S&P 500 Quarterly Stock Buybacks Actual and Announced, Cumulative in $ Billions

Source: S&P, Bloomberg

Display 3: S&P Composite Index

Source: Robert Shiller, FactSet, JP Morgan Asset Management

Even though stocks have risen sharply over the past five and a half years, we think this bull market can still rage quite a while longer. For one thing, stocks remain much less richly valued than bonds are (see Display 4). For another thing, as long as interest rates remain low and institutional investors’ desire for substantial total returns remains high, the credit boom is likely to persist, thereby aiding the stock market. (Incidentally, contrary to the conventional wisdom, stocks can continue to perform well when interest rates rise – as long as that rise isn’t too dramatic.)

Display 4: Stock vs. Corporate Bond Valuation S&P 500 Earn Yield as % of Junk Yields

Source: Bloomberg, Rosenblatt

Inevitably the time will come when credit investors are hurt by the use of leverage and receive the dreaded margin call from their brokers. When that happens, as in the past, the credit boom is likely to end badly – and is likely to take stocks down as well. But we believe that’s unlikely to happen for a few years at least.

In the meantime, we believe it’s an opportune time to wade into the forest and take a hard look at the trees to identify growth stocks capable of soaring at this advanced stage of the bull market. At the same time, we will keep our ears alert for the alarm sounded by the discerning forest ranger in the lookout station who’s commonly known as the credit market. As we see it, when that forest ranger finally does sound his alarm, savvy stock investors should take note and adopt a more conservative positioning in their portfolios, in anticipation of a market downturn.

But until then, looking at the trees may continue to prove rewarding.

Robert E. Turner, CFA
Chairman and Chief Investment Officer

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The views, opinions, and content presented are for informational purposes only. They are not intended to reflect a current or past recommendation; investment, legal, tax, or accounting advice of any kind; or a solicitation of an offer to buy or sell any securities or investment services. Except as otherwise specified, any companies, sectors, securities, and/or markets discussed are solely for illustrative purposes regarding economic trends and conditions or investment process and may or may not be held by Turner, the Turner Funds, or other investment vehicles or accounts managed by Turner or its affiliates. Past performance is no guarantee of future results.

As of October 31, 2014, Turner held in client accounts 7,465,608 shares of Apple Inc., 5,718,737 shares of Facebook Inc., 7,976,590 shares of Workday Inc., and 2,800,777 shares of Stratasys Ltd.

Turner Investments refers to Turner Investments, L. P., its subsidiaries, and affiliates. Nothing presented should be considered to be an offer to provide any Turner product or service in any jurisdiction that would be unlawful under the securities laws of that jurisdiction.

Turner Investments, founded in 1990 and based in Berwyn, Pennsylvania, manages growth, global/international, and alternative separately-managed accounts and mutual funds for institutions and individuals.

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