Does the Yale Asset Allocation Model Still Work?

David Swensen has been head of Yale's investment activities for a number of years.  It is fair to say, I think, that his approach to asset allocation has dramatically changed the way the most large pension and endowment funds are managed.

Years ago, after a considerable amount of study of historic returns, Swensen came to the conclusion that investors were overpaying for liquidity that in all likelihood they would never need. 

Specifically, Swensen pointed out that the historic returns in areas such as private equity and hedge funds had been considerably higher than those in the publicly traded markets, yet endowments largely shunned these area because they typically were difficult to sell.

So Swensen moved Yale's endowment heavily into alternative asset classes (as high as 85% of the total value), and the initial returns were terrific.

Fellow portfolio manager (and regular RG reader) Rich Sipley passed along an  article on Yale's approach to asset allocation. The piece highlights the spectacular early returns that Yale achieved:

The Yale Model became the focus of much attention on account of its performance during the tech bubble.  From July 2000 through June 2003, while the S&P 500 fell 33 percent, Yale’s endowment actually gained 20 percent.  Yale’s portfolio continued to perform well until 2008 (returns of 19.4 percent in fiscal 2004, 22.3 percent in fiscal 2005, 22.9 percent in fiscal 2006, 28.0 percent in fiscal 2007 and 4.5 percent in fiscal 2008 – through June 30, 2008).

http://rpseawright.wordpress.com/2013/03/22/is-the-yale-model-past-it/

As the article notes, the tremendous success of Swensen's approach inspired a wide variety of endowments to mimic his approach. Indeed, working with Swensen at Yale became almost a rite of passage for any chief investment officer at prestigious institutions like MIT.

More recently, returns from the Swensen approach have not proved to be as strong as in prior periods.  Indeed, the article notes that a simple 60/40 stock/bond allocation has outperformed many endowment funds that followed the Yale model:

A simple 60/40 portfolio invested 60 percent in an S&P 500 index fund and 40 percent in a fund tracking the Barclays Aggregate bond index would have gained 12.6 percent annually over the last three years and 2.8 percent over the last five years, as compared with 10.2 percent and 1.1 percent, respectively, for the average endowment.  Yale did somewhat better than the average endowment with three-year returns averaging 11.83 percent and five-year returns averaging 3.08 percent. 

What's going on here?

The authors suggest that perhaps too many institutions are investing in the same asset classes, which is dragging down overall returns.  In addition, as they parse through the numbers:

The bottom line here is that Yale’s success has been driven largely by private equity – mostly venture capital – returns.  Outside of private equity, the research suggests that Yale appeared to underperform appropriate risk-adjusted benchmarks.

Interesting stuff.

Book Review: The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success

In his most recent annual letter to shareholders, Warren Buffett recommended several books.  I picked up one of his suggestions earlier this month, and thought it was worth a mention.

Written by William Thorndike, The Outsiders goes through a variety of case studies of highly successful companies whose managements excelled at something that is often overlooked when evaluating companies: capital management.

Thorndike points out that managements have little control over how the market values their stock. He notes that former General Electric chairman Jack Welch is usually cited as one of the top CEO's in recent history, yet Welch's reputation was significantly helped by the fact that his tenure coincided with the greatest bull market in American history (1982 - 1999).

When Jack Welch retired in 2000, the shares of GE were valued at a P/E of 50x, which was a premium to the market at that time.  However, Welch's predecessor Reginald Jones had actually produced better per share earnings growth, but because stocks carried such low multiples throughout much of his tenure Jones never achieved the notoriety as Welch did.

Thorndike makes a thorough examination of eight different management teams who excelled at capital management.

Besides Buffett, included in this group were Tom Murphy at Capital Cities Broadcasting; Henry Singleton at Teledyne; Bill Anders at General Dynamics; John Malone at TCI; Katharine Graham at the Washington Post; Bill Stiritz at Ralston Purina; and Dick Smith at General Cinema.

Good capital management is deceptively simple.  Thorndike writes that CEO's really only need to do two things to be successful: "run their operations efficiently and deploy the cash generated by those operations".  The latter can be hugely important in the success or failure of any company, since large and expensive mistakes can be fatal to a company's existence.

The CEO's of the eight companies he profiles were fixated on growing per share value. If their stock was trading at a cheap enough level in the public markets, they would not hesitate to aggressively buy back shares (over the course of his career  Henry Singleton bought back 90% of Teledyne's shares).  They were relentlessly focused on costs, and kept corporate overhead to an absolute minimum.

At the same time, if a business segment offered promise, they would hesitate to invest significant capital.  The book mentions that Tom Murphy of Capital Cities:

...did not simply cut its way to high margins, however. It also emphasized investing in its businesses for long term growth. Murphy and {CFO} Burke realized that the key drivers of profitability in most of their businesses were revenue growth and advertising market share, and were prepared to invest in their properties to ensure leadership in local markets.

Throughout the book Thorndike notes that successful capital allocators are prepared to think in a fashion considerably different than most of their peers, and were often considered outsiders.  Most CEO's focus on earnings per share, but this group focused instead on cash flow:

As a result, the outsiders (who often had complicated balance sheets, active acquisition programs, and high debt levels) believed the key to long-term value creation was to optimize free cash flow, and this emphasis on cash informed all aspects of how they ran their companies - from the way they paid for acquisitions and managed their balance sheets to their accounting policies and compensation systems.

Finally, Thorndike describes that the fabulous success that all of his studies achieved had several characteristics in common:

Each ran a highly decentralized organization; made at least one very large acquisition; developed unusual, cash flow-based metric; and bought back a significant amount of stock. None paid meaningful dividends or provided Wall Street guidance.  All received the same combination of derision, wonder and skepticism from their peers and business press. All also enjoyed eye-popping, credulity-straining performance over very long tenures (twenty-plus years on average).

I found this book a terrific read, and well worth any serious investor's time.

Crash, dammit

About 15 years ago, in 1997, the Economist magazine had a cover story they called "Crash, dammit".

Accompanied by a picture of a man falling from a skyscraper, the story in the October 15, 1997, issue described a sense of despair among a group of investors who were convinced that the market was due for a fall - but the market refused to cooperate, and kept moving higher.

Here's an excerpt from that piece:

WHETHER it be as tragedy or farce, the tendency of history to repeat itself is well documented. So it is not surprising that this tenth anniversary of the stockmarket crash of October 1987 finds some investors in a nervous state of mind. As this newspaper noted after that earlier crash, the 1982-87 bull market “was driven further and faster than any before, not just by economic confidence and cash-rich institutional investors but also by deregulation and wider share ownership.” It was, in other words, very like the present bull market. What, if anything, has changed? What has been learnt?

http://www.economist.com/node/102687

There are, in my opinion, some similarities between 1997 and today.

Then, as now, many investors are convinced that markets are moving higher based on irrational government policies and investors blind to the economic trouble that lie ahead.

This bearish group foresees a painful reckoning that almost surely will occur in the very near future.  Like the bears in 1997 - who kept referring to the 1987 market crash - today's bears are reliving the nasty bear market of 2008, telling anyone who will listen that disaster lies right around the corner.

The real problem, it seems to me, is that too many institutional and individual investors exited the publicly-traded markets after 2008, vowing never to return - and now stocks have fully recovered. 

Here's a comment from regular Random Glenings reader (and fellow portfolio manager) Rich Sipley:


Just catching up on my reading and I am looking at a recent strategas report that shows pension fund allocation towards equities has gone from 60% in 2005 to 38% currently.  Fixed income has gone from 27% to 41%.  I understand there are likely some demographic factors at work but it can not explain much of that move.  It looks like 'alternatives' have been the big winner...
 

And so today, with the S&P within a whisker of its all-time high, and equity prices up more than +26% since the beginning of 2012, many are hoping that we will soon see a correction - if only to give them a chance to get more fully invested.

Merrill Lynch's Steve Suttmeir made this observation earlier in the week:


Based on sentiment data from Investors Intelligence (II), 34% of newsletter writers expect a correction and this is near the 34.7% and 35.1% contrarian bullish peaks from early March and mid-November, respectively. With too many investors looking for a correction, the S&P 500 rallied from early March and mid-November and is similarly positioned as we move into late March. In our view, newsletter writers need to capitulate and remove their calls for a market correction in order to get a contrarian bearish sentiment extreme. 

In other words, it seems likely that many are quietly looking at the market's relentless rise and whispering "Crash, dammit!".

Taking the Pulse On Pharmaceutical Stocks

Two years ago, in March 2011, I headed over to the Merrill Lynch offices here in Boston to hear Gregg Gilbert.

After covering the specialty pharmaceutical stocks for nearly a decade, Gregg had just initiated coverage of the major pharmaceutical group. Gregg had started his career at Merrill following stocks like Pfizer; Merck; and Eli Lilly, so was already familiar with the companies.

His message that day was simple:  Buy these stocks.

His comments were along the lines as follows:

When I stopped covering this group in 2000, all of the stocks were trading a P/E multiples in the high 20's or low 30's, and dividend yields were relatively puny - around 1%. Every meeting I attended was crowded - pharmaceutical stocks were popular with both growth and value managers.

Now, 11 years later, no one likes this group.  Most are convinced that major pharmaceutical companies are dinosaurs, with bloated bureaucracies and meager new product pipelines.  Multiples today are in the single digits, and dividend yields are near 4%.  

But I am telling you now:  This is a tremendous opportunity.  While all of my companies have issues, they are just being priced too cheaply. Buy today, and you will be richly rewarded.

Over the years I have probably attended hundreds of analyst meetings, but only rarely have I heard an analyst speak so forcefully (and rationally) about the stocks he follows.

Yesterday I headed back over to Merrill's offices to hear Gregg again.  Like the meeting two years ago, there were few in attendance, although the poor weather yesterday probably had something to do with the small audience.

But there was no denying that Gregg Gilbert had been right on the money two years ago. 

As the above chart shows, major pharmaceutical stocks have been big winners.  Lilly, for example, is up +60% since March 2011, while the S&P 500 is up +20%.  Lilly also paid investors a 5% dividend yield, which even further increases its outperformance over the the last two years.

Yesterday I reminded Gregg of his prescient call on pharma stocks, and he was understandably pleased that I remembered.

So, I asked, what about now? Are the stocks still attractive?

Gregg characterized his views today as "bullish" as opposed to the "wildly bullish" feelings he had earlier. 

The valuation of most of the stocks (except for Bristol Myers, which trades at premium multiple and that he rates a neutral) are closer to the overall market. Dividend yields remain above the market, yet the gap has narrowed considerably due to the strong relative performance of the stocks.

Unlike other pharmaceutical analysts, Gregg does not base his recommendations solely on new product pipelines.  Drug development is still too uncertain, and success rates relatively low, to buy a stock on new drugs. He likes to find companies with innovative R&D and strong managements trading at cheap valuations.

And most pharmaceutical stocks today still fit the bill.