2016 Annual Shareholder Letter
By Mark Oelschlager, CFA
Co-Chief Investment Officer & Portfolio Manager
November 30, 2016
Dear Fellow Shareholder:
It is important for us as investors to understand what is happening in the market and not just with individual companies. Figuring out why something is happening from a broad perspective can help us set the direction of our portfolios. There are two trends that have distorted the market recently, and while these have been in place for a while, their impact reached a zenith in mid-2016. One trend is low interest rates. Because yield-driven investors (retirees would be one example) are not getting much return in the bond market, they have moved into the higher-dividend-yielding parts of the equity market to try to earn dependable income on their savings. The second trend is a hyper-focus on safety or preservation of principal. The financial crisis and severe market decline in 2008 and early 2009 understandably spooked people and caused them to constantly look around the corner for the next crisis; it seems that a couple times a year some sort of crisis in Europe, China or elsewhere causes the US market to dip, only to rebound. Assets flooded into “low-volatility,” “smart beta,” and other “alternative” products that supposedly offered a better mousetrap. There is a lot of overlap between those plays that potentially offer yield and safety (for example, utilities and consumer staples offer both), so the two trends have at times become indistinguishable. An emphasis on yield and safety may sound like a good thing, and in a vacuum there is nothing wrong with it, but as with any other investing idea, it can be taken to extremes.
Two compelling statistics from Empirical Research Partners:
- In 2007 less than 1% of the market was in stocks that were highly correlated (60% or more) with the performance of the Treasury bond market. In October 2016 that number hit 17%.
- If we take the price/earnings ratio for the cohort of the stock market that is most correlated with Treasury bonds and compare it to the P/E of the cohort of the stock market that is least correlated with Treasurys, that measure hit a 33-year high in 2016.
The first statistic tells us that the bond market is having a strong influence on the action in the stock market. The second statistic tells us how it has distorted the valuations, inflating the perceived safety/yield plays. This has led us to largely avoid the bond surrogates (perceived safety/yield) and to focus on the anti-bond surrogates, such as the financial stocks.
For the first half of 2016 financials lagged, as the bond proxies pushed higher, helped by the news that the United Kingdom had voted to exit the European Union (a decision commonly referred to as “Brexit”). This represented the peak of the yield/stability trade, as it became consensus that interest rates were likely going to stay low for a very long time and that central banks around the globe would continue to force nominal interest rates into negative territory. Bank stocks were labeled “dead money.” But as often happens, things changed. Brexit started looking less scary and global monetary authorities began rethinking their positon that lower interest rates are always good for an economy. In addition, wage growth in the US continued to accelerate, and other measures of inflation crept higher. All of this drove bank stocks higher. From early July through the end of October, the KBW Bank Index returned over 19% while the rest of the S&P 500 declined. This trend then got a turbo boost in early November when Donald Trump was elected President of the US. This latter move by bank stocks benefited our portfolios a great deal but will not be reflected in the fiscal year numbers that concluded in October.
A side effect of the intense focus on loss aversion in the market is that it reduces the time horizon of those that employ it. Hyper-sensitivity to the next decline creates an itchy trigger finger and a shoot-first, ask-questions-later mentality. A falling stock price leads to clients demanding their advisors “do something” to protect their wealth. Of course all of this short-termism exacerbates the swings in the individual stocks, which creates greater mis-pricings, which creates opportunities for investors that are focused on the long-term. Our friends at Empirical characterized it as the equity yield curve steepening, meaning that there is an increasing gap between the expected return of those that focus on the long-term and the expected return of those that focus on the short-term. This was heartening to us since, as long-term investors, we prefer to do our work at the long end of the curve.
Another trend in this business has been to move money from active managers (ones, such as Oak, who attempt to beat a market benchmark) to passive vehicles that attempt to merely match a benchmark. For many years active managers have seen more money flowing out than coming in. The thinking is that since most managers underperform their benchmark, one is better off attaining an indexed return. We acknowledge that beating the benchmark is not an easy endeavor, but there are managers who do so. Our three largest funds are White Oak, Pin Oak, and Red Oak. Many of you have invested in them, and we thank you. Over the ten years ended October 31, White Oak generated a cumulative return of 118%, while the S&P 500 returned 91%. For the same period, Pin Oak outperformed its benchmark, the Russell 3000, 169% to 92%, and Red Oak beat the S&P 500 Equal Weight Information Technology Index 197% to 143%. All of these returns for our funds are net of expenses. Many academics would attribute these numbers to luck. Without question luck comes into play in short periods of time, given the randomness of the market, just as it does for a baseball player in a limited number of plate appearances. But for ten years, through a full market cycle, and by these margins, we would strongly argue that it is not due to randomness. There is no doubt that our funds will experience a period of underperformance at some point, as do all funds, and it may even last for years. Our goal is to continue to outperform over long periods of time. The Oak funds have bucked the passive trend of late and attracted a strong flow of new money. This is good news not only for Oak but to our long-time shareholders as well, as a growing fund can spread its fixed expenses over a larger base of assets thereby reducing its expense ratio.
Some comments on President-elect Trump. We are encouraged by Mr. Trump’s plan to lower corporate and personal income tax rates and his vow to reduce regulation. This could greatly benefit our economy. On the other hand, his anti-trade campaign rhetoric is concerning and would likely be quite harmful to the US and global economies if carried through. His cabinet appointments may give an indication about how he will govern.
As our funds continue to grind higher it is important to remind you that there will indeed be another correction, and it may even be severe. We don’t know when it will come, nor does anyone else, and when it arrives we won’t flock to cash. We will continue to focus on maximizing returns over a full market cycle by investing in companies that we believe are attractively priced.
We feel fortunate that you have entrusted us to manage your money.
Mark Oelschlager, CFA
Co-Chief Investment Officer and Portfolio Manager
Oak Associates Funds
This manager commentary represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice.
To determine if this fund is an appropriate investment for you, carefully consider the fund’s investment objectives, risk factors, charges and expenses before investing. This and other information can be found in the fund’s prospectus, which may be obtained by calling 1-888-462-5386 or visiting our website at www.oakfunds.com. Please read it carefully before investing.
The performance data quoted represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an Investor’s shares, when redeemed, may be worth more or less than their original cost, and current performance may be lower or higher than the performance quoted. Click here for standardized performance, including performance data current to the most recent month-end.
Investments are subject to market fluctuations and a fund's share price can fall because of weakness in the broad market, a particular industry, or a specific holding.
Correlation is a statistic that measures the degree to which two securities move in relation to each other.
The KBW Bank Index is an economic index consisting of the stocks of 24 banking companies. This index serves as a benchmark of the banking sector. This index trades on the Philadelphia Stock Exchange, where it was created.
The price-earnings ratio (P/E Ratio) is the ratio for valuing a company that measures its current share price relative to its per-share earnings. The price-earnings ratio can be calculated as market value per share divided by earnings per share.
The Russell 3000 Index measures the performance of 3,000 publicly held US companies based on total market capitalization, which represents approximately 98% of the investable US equity market.
The S&P 500 Index is a commonly-recognized, market capitalization weighted index of 500 widely held equity securities, designed to measure broad U.S. equity performance. One cannot invest directly in an index.
The S&P 500 Equal Weight Information Technology Index is an unmanaged equal weighted version of the S&P 500 Information Technology Index that consists of the common stocks of the following industries: internet equipment, computers and peripherals, electronic equipment, office electronics and instruments, semiconductor equipment and products, diversified telecommunication services, and wireless telecommunication services that comprise the Information Technology sector of the S&P 500 Index.
Smart beta defines a set of investment strategies that emphasize the use of alternative index construction rules to traditional market capitalization based indices. Smart beta emphasizes capturing investment factors of market inefficiencies in a rules-based and transparent way.
Oak Associates Funds are distributed by ALPS Distributors, Inc. ALPS Distributors, Inc. and Oak Associates Funds are separate and unaffiliated.
CFA is a registered trademark of the CFA Institute.
The preceding has been provided to you for informational purposes only, and should not be considered tax advice. Please consult your tax advisor for further assistance.