How Parsec Monitors Investment Securities

Parsec invests in a variety of securities for its clients.  These may include mutual funds, exchange traded funds or ETFs, and individual stocks, among others.  All of these investments can and do experience significant price pullbacks from time to time.  While Parsec’s Investment Policy Committee (IPC) focuses on investments it can hold for the long-term and performs significant research before adding any new positions, price declines still happen.  In this email we’ll discuss how the IPC monitors investment securities and we’ll share with you our process for when a stock or fund doesn’t perform as expected.

Investment security returns are driven by a number of factors.  For individual stocks, earnings growth, competitive environment, and exogenous events can significantly affect price performance.  For mutual funds and ETFs, the general capital market environment as well as portfolio management departures or changes at the parent company can influence both fund flows and price changes.  At Parsec, in addition to reviewing all covered securities at regularly-scheduled meetings, the Investment Policy Committee continually monitors client investments for these types of factors in between our ongoing investment reviews.

We do this by reading sell-side research reports, company government filings, and the news.  Likewise, the financial software we use alerts us to any new developments on our covered securities and helps us manage the large volume of news flow in order to focus on the most important stories of the day.  When a significant event does happen that negatively affects a security, we research the development by listening to a company’s conference call, reading industry reports, and conducting our own due diligence.  We review our thesis on the fund or stock and determine if and how the latest events could affect the security’s long-term prospects going forward.  In order to gauge an investment’s upside potential we adjust our growth assumptions to reflect the new information and evaluate the security’s risk/reward profile in light of its new price level.

Oftentimes when a major story surfaces there is minimal information on which to make a decision.  At the same time, the market has a tendency to overreact to news events.  For these reasons, Parsec’s Investment Policy Committee may intentionally wait before taking action when a stock or fund experiences a significant negative development.  Although it may appear that we are not responding to the event in question, we are in fact working diligently behind the scenes to gather as much data as possible while reviewing our thesis and assumptions.  This can be a frustrating time for clients who would, understandably, prefer us to take immediate action.  However, we have found that taking a wait-and-see approach allows us to collect more information and answer important questions before making an uninformed or premature decision.

Waiting for the dust to settle while collecting additional information also allows us to better understand how a development could affect a stock or fund’s long-term prospects.  If we determine that a company or fund can recover from an adverse event and the security has fallen significantly in price, it’s often an attractive buying opportunity.

However, on other occasions it may be clear that it’s time to sell a position.  This can happen when an investigation surrounding a security is new but affects multiple divisions or aspects of the underlying company’s or fund’s operations.  Another example may include an environmental disaster or a significant product recall that could take years to resolve.  In these instances the best action may involve taking a modest loss now in order to avoid a much larger loss in the months or years to follow.

While our bias towards higher-quality stocks and funds may mean we’re more likely to hold a security or even add to positions following a negative news event, we are closely monitoring client investments and performing in-depth due diligence as new developments arise.  Our intention is to make objective and thoughtful decisions that will benefit clients and their portfolios over the long-term.

Thank you,

The Parsec Team

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(Tax loss) Harvest Season is Almost Here!

The kids are back in school, the leaves are changing colors, and pumpkin spice lattes – the age-old harbingers of harvest season – are everywhere. At Parsec, we are preparing for the harvest…of tax losses.

Every year, beginning in late October/early November, Parsec’s portfolio managers will scour clients’ taxable accounts for meaningful losses, which we can use to offset realized gains created from trading throughout the year. These tax-efficient trading strategies provide value to clients by minimizing their tax burden while keeping the portfolio aligned with their financial planning goals.

You might see trades from one security into another one that is similar, but not exactly the same – we do this so that you can recognize a loss while maintaining exposure to the same industry or sector, yet avoid incurring a wash sale. According to IRS publication 550, “a wash sale occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale, you buy substantially identical stock or securities,” either in the same account or in another household account, including IRAs and Roth IRAs. Stocks of different companies in the same industry are not considered “substantially identical,” nor are ETFs that track the same sector but are managed by different companies (like a Vanguard Emerging Markets ETF vs. an iShares Emerging Markets ETF).

Sometimes it makes sense to place a loss-harvesting trade and leave the proceeds in cash for 31 days, then repurchase the same security. We may do this for clients who have cash needs during the holiday season, with the intention of placing rebalancing trades in January when there is no more need for liquidity. When liquidity is not an issue, however, we prefer to keep the funds fully invested in another high-quality name. We may later choose to reverse the trade, once the wash sale period has expired, or we may leave the trade in place if we think it is appropriate and suits the clients’ needs.

Sarah DerGarabedian, CFA
Director of Portfolio Management

 

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Value Stocks May be Poised to Outperform

Since Parsec’s founding in 1980, we’ve touted the benefits of long-only equity investing.  This includes owning individual stocks, mutual funds, and exchange traded funds (ETFs).  We’ve also maintained the same investment style over the last thirty-seven years.  Regarding funds, Parsec’s investment policy committee (IPC) focuses on low fees, higher-quality holdings, and managers with long track records of outperformance.  When researching individual stocks, we take a value approach, favoring higher-quality companies that trade at a discount to history or peers.

While history shows that value stocks have outperformed growth stocks over most market periods, in recent years growth stocks have delivered higher returns.  In this email we’ll discuss what we mean by value versus growth investing and why we believe value stocks are poised to outperform going forward.

Different stock investors define “value investing” differently.  However, most agree on a few basic principles.  In general, value investors prefer stocks that trade at discounts to their intrinsic values.  Often this happens when a stock’s valuation falls below its long-term historical average or that of its peers.  Another tenet of value investing is margin of safety.  This means selecting stocks that can deliver healthy total returns even if current growth assumptions fall short of expectations.  While we consider ourselves value investors, we will add select growth stocks to the Parsec buy list when expectations look reasonable and a company has a competitive advantage.  In other words, when we think a stock has a reasonable margin of safety.

In addition to a value-based stock selection approach, Parsec’s investment philosophy also has a quality bias.  This means we prefer companies with strong cash flows, consistent earnings growth, a long history of dividends, and above average returns on invested capital.  We also favor companies with strong balance sheets that can withstand different market environments and even gain market share during difficult economic periods.

Looking back over the market’s history, value stocks have outperformed growth stocks by an average of 4.4% annually from 1926 to 2016 (Bank of America/Merrill Lynch).  More recently from 1990 to 2015, value stocks outperformed growth stocks by just 0.43% annually.  The spread has since reversed and in the last ten years value stocks have lagged growth stocks by 3% annually through the second quarter of 2017*.

The shift in leadership from value to growth stocks coincided with the start and continuation of the Federal Reserve’s massive monetary accommodation programs known collectively as quantitative easing (QE I, II, and III).  Those programs put additional downward pressure on interest rates.  In the face of low or no yields and the slowest economic expansion after a deep recession in over 120 years, investors demonstrated a preference for growth stocks over value stocks.  They were willing to pay up for companies delivering higher growth in a world where growth had become scarce.  Throughout the last ten years value stocks have occasionally outperformed, but usually in tandem with a steepening Treasury yield curve and thus improving growth expectations.

Because asset prices and interest rates are inversely correlated, very low interest rates over the last decade have led to above-average asset valuation levels.  This has been even more pronounced among growth stocks as investors have been willing to pay a premium to own them in a slow growth environment.  As a result, typically higher-priced growth stocks are even more expensive today.

Sticking to our value- and quality-biased investment approach has admittedly been a headwind in recent years.  However, we believe higher-quality stocks trading at a discount are poised to outperform.  Growth stocks currently trading at premium valuation levels will have further to fall in the event of a market downturn.  As well, low interest rates have prompted corporations to take out record debt levels.  As rates begin to rise, higher-quality companies or those with strong balance sheets and robust cash flows will be better able to service their debt levels, even during an economic downturn.  While maintaining our investment approach through the current environment has been challenging, we feel confident that investing in higher-quality companies trading at discounted valuations will reward clients over the long-term.

*References the Russell 3000 Growth Index and the Russell 3000 Value Index

The Parsec Team

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Mid-Year Market Update

Now that we’re half-way through 2017, it’s time to take a look at market and economic trends year-to-date. The big picture view is that asset classes across the board have delivered strong returns through June. This is despite interest rate hikes by the Federal Reserve’s Federal Open Market Committee (FOMC). In fact, Treasury yields have actually fallen in the face of two interest rate increases this year, pushing bond prices higher. International stocks and bonds have also risen in 2017, boosted by stabilizing global growth rates, depressed yields world-wide, and improving corporate earnings.

Looking a little more closely at the U.S., stocks continued their upward trajectory early in the year following the post-Presidential election results in November. While the new administration has not made much traction in passing new legislation, relatively healthy economic data – including good jobs growth, higher wages, and a strong housing market – have supported stocks. At the time of this writing (June 15, 2017), the S&P 500 Index is up 8.5% on a price-basis and up 9.7% on a total return basis (which includes dividends).

Technology stocks have led U.S. equity markets this year. Within the S&P 500 Index, the sector is up over 17% year-to-date given healthy earnings growth expectations for the group. The more tech-heavy NASDAQ Index is up a whopping 14% this year, almost 6% ahead of the S&P 500 Index. However, we’ve started to see some signs of weakness among tech stalwarts recently and are watching the group closely. On the flip side, energy and telecom stocks have lagged the index, with price declines of 13% and 9%, respectively. Of note, energy and telecom stocks were two of the three best-performing sectors in the S&P 500 Index last year, with prices returns of +24% and +18%, respectively. This marked turnaround in performance provides a cautionary tale on the pitfalls of market timing: last year’s leaders may well become this year’s laggards. In general we’ve found that it’s difficult, if not impossible to predict which sectors or industries will outperform in any given year. As a result, we recommend maintaining a diversified portfolio through all market cycles and rebalancing regularly.

Another wide disparity arose among growth and value stocks. Year-to-date, growth stocks (as measured by the Russell 3000 Growth Index) are up almost 14% on a price return basis versus a 3% return for value stocks (as measured by the Russell 3000 Value Index). Much of the outperformance by growth stocks stems from strong returns among technology stocks – many of which are growth-oriented and trade at higher valuation levels.

After years of underperforming U.S. stocks, international equities have outperformed year-to-date. In aggregate, developed stocks from Japan, Europe, and Australia are up 14% on a price return basis through June. While this group has lagged U.S. stocks over the past four consecutive years, improving economies in most of these regions, positive consumer sentiment, and accommodative central banks are starting to turn the tide. Likewise, Emerging Markets stocks are up over 17% on a price return basis so far this year. The marked turnaround comes as corporate earnings growth for many of these countries is starting to improve and global growth is stabilizing.

Other interesting observations for 2017 include record-low stock volatility levels, lower yields despite higher interest rates by the FOMC, and an eventful (if unproductive) six-months in Washington.

Looking forward, we see risks and opportunities. The Federal Reserve is set to reduce its bloated balance sheet later this year which could pose a risk to above-average stock valuation levels. Despite the potential for unintended consequences, we view the move as a vote of confidence in the U.S. economy and as a much needed step towards more normalized monetary policy. While a more restrictive Federal Reserve is a headwind to asset prices, interest rates remain very low (with no signs of rising) and the U.S. economy remains on stable footing. These factors, along with improving U.S. corporate earnings growth, bode well for continued stock gains over the long-term.

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March Update – Trading

Trading is an important, albeit often underappreciated part of investment management.  In this email, we’ll share with you our investment philosophy and how it drives our trading approach.  While Parsec uses both funds and individual securities across client accounts, this blog applies more to those portfolios with individual stock holdings.  In general, we use funds for smaller-sized accounts because of the immediate diversity it provides, at a relatively low cost.  We generally use individual securities for larger client portfolios as these portfolios offer economies of scale that can overcome trading costs.  Over the years, we have fine-tuned our trading approach with an eye towards minimizing costs and maximizing efficiency.

As you’ve heard us say time-and-again, Parsec does not engage in market timing.  Instead of trying to determine when one asset class will underperform and another outperform, we select our securities using a bottom-up fundamental research approach.   Using individual equities as an example, this means that we first screen any new stock ideas for attractive financial characteristics and then perform additional due diligence to determine its total return potential over the next several years.  Once a stock is added to a Parsec portfolio, we monitor the company regularly for changes in its competitive environment, its growth drivers, and valuation levels.  However, we do all of this in light of our long-term thesis on the stock, as opposed to the market’s near-term noise.

Taking a long-term investment approach in which we focus on a security’s total return potential often allows us to buy and hold securities for many years.  This keeps our portfolio turnover – a measure of how frequently assets are bought and sold – low, and in turn keeps our trading costs low.  When we do trade we use block trades whenever possible.  By aggregating all of our trades into one large transaction we can better assure that clients receive the same price when a given security is bought or sold.

In addition, our focus on a security’s long-term potential largely circumvents the need for specialized trade orders.  Typically short-term traders, and not long-term investors, utilize limit orders, stop orders, or other types of non-market orders.  These specialized trades often come with additional costs, including higher transaction fees for retail investors and various opportunity costs.

One such opportunity cost can arise when setting short-term price targets.  For example, using a limit order to purchase a security requires an investor to set a price target.  However, without thoroughly researching a security using fundamental analysis, price targets are often based on “a gut feel” or are knee-jerk reactions to an investor’s past experience with an asset.  In effect, unconscious emotions can drive the trading decision and lead to even higher costs.  These can come in the form of missed opportunities, as when a stock declines but doesn’t quite reach an investor’s price target to buy.  In this case if the stock then continues higher an investor may have missed-out on significant upside potential.

Another opportunity cost is possible when a security pays a dividend, but because an investor was waiting for a slightly lower price before buying, he or she inadvertently forfeited the added income.  In some cases the dividend payout might have amounted to more than the savings associated with buying at a lower price.

While there are many types of trades, and some that do add value, in general we’ve found that specialized trade orders often come with more costs than benefits.  This is why Parsec identifies assets using fundamental research and takes the long-term view on a security’s total return potential.  Doing so inherently reduces security turnover in a portfolio and thus trading costs.  It also avoids incurring hidden opportunity costs and, we believe, increases the likelihood of reaching your longer-term financial goals.

Thank you,

The Parsec Team

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