Manley Capital Management, LLC
* Capital preservation is critical to investment success
* Markets are cyclical and regress to the mean
* Valuations best determine future returns
Free Markets Capitalism is the best economic system to allocate resources (land, labor and capital). Low taxes, low regulation and a stable currency allow entrepreneurs to compete and innovate. This competition and innovation leads to increased productivity, real GDP growth and increased living standards. As responsible investment managers, our goal is to grow clients' wealth by maintaining a diversified and value-driven investment portfolio, managing risk and preserving capital in bear markets. We strongly believe capital preservation is essential to long-term wealth accumulation.
Since 1960, the stock market has averaged a 32.4% decline every 4.3 years, requiring 48% appreciation to return to breakeven. Capital preservation and avoiding such major drawdowns is critical to long-term wealth accumulation. Also, preserving capital in bear markets yields the necessary cash to exploit the great values available at major market lows.
Regression to the Mean:
Bear markets are inevitable because profitability, growth rates and valuation are cyclical and will “Regress to the Mean” overtime. Competition drives this mean reversion. High returns on investment attract competition and excess capacity, which reduces future levels of profitability. Overtime, a firm's return on investment will equal their cost of capital (the level of profitability will regress to the cost of their capital). While fundamentals are cyclical, many investors driven by human nature (fear and greed) extrapolate current fundamentals into the future, paying too much for peak earnings and pushing valuation levels away from their intrinsic value. When margins and profits regress to the mean, investors are disappointed, stocks decline and a bear market ensues, pushing valuation and profitability levels back to average or below-average levels.
Historically, stocks have provided a return of 9.5% (6.5% real). In our view, the market's long-run expected return and risk/reward are best determined by valuation measures (for example, cyclically adjusted earnings, CAPE, Tobin Q, Book Value, MV/GDP). Because stocks are the present value of future cash flows, and over time the growth rate of those cash flows will regress to the mean, what one pays for that cash flow stream is critical in determining the future long-run return.
Since markets are cyclical and will regress to the mean over time, an asset allocation should not be static (ie.,100% stock or 60% equity/40% bonds); it should be driven by the market's long-run risk/reward that is best determined by valuation measures. As the market cycle matures and the risk-reward deteriorates, portfolios should mitigate risk by increasing asset diversification, reducing equity exposure and limiting portfolio volatility. Conversely, after a bear market, when stocks are inexpensive, profits are depressed and investor expectations are low, portfolios should increase equity concentration and accept greater portfolio volatility.