By: Duane Roberts

Add-Value Approach

As we start a new year, investors remain justifiably nervous. Markets have been extremely tumultuous since 2008, with early tremors rumbling through the market in 2007. Almost five years after the first signs of the financial crisis, many investors are weary, and still find it tempting to avoid many asset classes and companies.

The events of the past few years highlight the benefits of including non-financial factors in security analysis. A decade ago, the Enron scandal (and others) taught us prudence in evaluating things such as corporate governance, accounting and auditing practices, and compensation and incentives when considering the investment merit of companies. Looking back on the events that led to the current crisis, it is clear that these factors continue to be important when considering which companies and management teams to entrust with our investment dollars. Companies and management teams that behave responsibly in a broad context tend to be safer and perhaps more rewarding long-term investments.

Investors have turned to advisors and companies that directly address their weak confidence in the market and economy due in part to uncertainty regarding political, governance, social and environmental issues.  According to the Social Investment Forum Foundation, “from the start of 2007 to the opening of 2010, a three-year period when broad market indices such as the S&P 500 declined and the broader universe of professionally managed assets increased less than 1 percent, assets involved in sustainable and socially responsible investing increased more than 13 percent.”

Advisors and investors alike successfully incorporate portfolio management, like The Epiphany Mutual Fund Family (http://epiphanyfunds.com/), that was formed with the intention of placing shareholder concerns and values on the same level of importance as monetary return on their dollars. For example, The Epiphany Fund Family generally excludes companies that do not reasonably safeguard the environment, support and protect families, and promote the dignity of life. After the exclusion-free company list is created funds are screened for a variety of human rights and workforce criteria, successes and failures in environmental evaluation and corporate governance issues including the relationship between the board and the CEO and C-Level compensation structures.

This approach in screening companies using factors that negatively affect the internal company structure of a corporation aids the Epiphany Fund Family in focusing on holistically healthy companies. They are the companies that are more likely to survive in current economic conditions and over decades to come.

Current Economic Concerns

At the start of 2012, markets are still suffering a global debt crisis. The causes of the current dilemma are numerous, global, and go back many years (if not decades). Many individuals, institutions and governments are faced with debt burdens that may be insurmountable. Finding solutions to these debt problems will not be easy, but until permanent solutions are implemented the markets will be sailing into significant headwinds.

A byproduct of the turmoil over the past four to five years has been an increase in market volatility. Volatility spiked to extreme levels in 2008, and while it has moderated in fits and starts since, volatility remains high. This creates a stressful environment for investors and often distracts from the value (and risk) assessments that should drive investment decisions.

Market professionals and active traders focus on the VIX as a measure of volatility. VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility. While off its peak in 2009 and a smaller peak in 2010, the VIX remains elevated. Individual investors may more likely be affected by the magnitude of daily price movements, and daily price swings are alarmingly high. In 2005 and 2006, the S&P 500 index moved more than 2% in only 2 days over the two-year period, and both of those moves were to the upside. Daily changes of more than 1% occurred less than 12% of the time. In 2007, the index moved by 1% or more almost 26% of trading days, and 18 days saw moves over 2% (12 of which were down). Markets really got wild in 2008 when 53% of trading days experienced S&P moves greater than 1%, and the index moved 3% or more in 1 of every 6 days. Things became slightly less volatile in 2009, with a larger decline in 2010. In 2011, 1% changes have taken place on 42% of trading days, and 3% moves registered on 6% of trading days.  2011 saw the frequency of big moves increase.

Everyone is painfully aware of the loss in asset values suffered by equity investors between October 2007 and March 2009. While the S&P 500 index remains below its October 9, 2007 peak, thankfully through the end of 2011 the index has risen 85.9% from the March 9, 2009 low. But as another measure of the volatility of the markets, the cumulative magnitude of daily price moves on the S&P 500 index since March 9, 2009 is 690%. Said another way, we’ve experienced daily price movements of 690% to achieve less than 84% of net change from the 2009 low. (The 685% would be even larger if we considered intra-day movements.) During 2011 we experienced 261% of daily price changes in the S&P 500, an average of over 1% per trading day, to end the year exactly where we started. Is it any wonder investors are spooked by the current volatile environment?

Response to the Current Concerns

There are some positive signs for investors who look beyond ephemeral headlines and the overreactions—up and down—they provoke. In the U.S., GDP is growing, albeit slowly. Valuations for many equities are attractive relative to historical levels. Corporate profits are growing, although the growth is decelerating. Healthy and prudently managed corporations haven’t indulged in the same profligacy as many individuals and governments, so corporate cash levels are at historic highs. While much of the early part of the post-recession earnings rebound was fueled by cost cutting (and distortions in the financial sector), companies in many areas of the economy are seeing revenue growth and rising demand. So despite slow economic growth that could persist for several years, many corporations remain attractive from an investor’s perspective.

Part of the appeal of equities arises from unattractiveness of other asset classes, particularly fixed income. The U.S. response to the financial system and its fiscal problems has been a monetary policy that is keeping interest rates low, with the Fed having signaled its intent to keep short-term rates near zero at least into 2013. Under normal circumstances, low interest rates should lead to higher valuation levels in the equity markets. Fear has prevented this from happening and valuations, while bouncing off lows in early 2009, have trended down. This condition could be rational if earnings were expected to contract. Earnings growth is slow, but we are still growing, and while the future is always uncertain we believe the probability of a recession in the near term is low, at least for the U.S. (Specific challenges in a handful of countries could lead to recessions in individual countries or regions outside of the U.S.) This leads us to believe that the equity market in the U.S. is, on average, attractively valued. Out of uncertainty comes opportunity.

One manifestation of the value seen in equities is the dividend yield produced by many stocks. Stock dividends have become quite attractive relative to interest on fixed income securities. In fact, there are numerous high-quality companies whose equity dividend yield exceeds the interest income from their bonds. And dividends are often growing, unlike the fixed income payments from bonds. Equities also offer a hedge against inflation that most bonds cannot provide. Income-oriented investors have started looking to high-yielding stocks as an alternative to fixed income securities. Even on a total return basis, analysts find that dividends are becoming a larger piece of the overall value assessment for stocks.

Future Navigation amongst Market Headwinds

How should investors navigate the current market? As always, diversification and a long-term view should form the basis for any investment plan. While ongoing economic, monetary, fiscal and political challenges remain, and will drive headlines and market volatility, the time to be defensive was 2007 and 2008. Risk aversion has led to too much demand for fixed income, particular U.S. government securities. Inflation fears and concerns about sovereign debt have driven up the price of gold and other commodities (with some easing in the past few months). Equities, on the other hand, have been underappreciated, keeping valuations low.

With attention paid to the aforementioned financial and non-financial areas of analysis, these times of stress often produce areas of opportunity. Controlling fear, prudently investing in a range of asset classes and ongoing rebalancing will be rewarding to investors who can tolerate volatility.

While continued volatility is expected in the market, and hence temper the preference for equities, timing the market is extremely difficult. Rather than waiting for uncertain market lows, investors can take advantage of volatility to rebalance portfolios or to dollar-cost average new purchases. The ride may be bumpy, but five years from now, one should expect that strategic investors will have been rewarded for their fortitude.

Category: Small/Mid Cap Companies

Benchmark: Russell 2500

The Epiphany FFV equity funds share a common investment process. This process combines the FFV Scorecard™ with disciplined portfolio management and value-oriented stock selection.

Initially, the fund uses the screening to determine the eligible investment universe. Within this universe of eligible securities, we apply an investment process that is designed to minimize certain risk measurements while allowing opportunity for outperformance relative to the appropriate benchmark. The process starts with top-down portfolio construction intended to limit risk. The portfolios are sector-neutral relative to the broad market (as measured by the benchmark index), diversified in number of individual holdings and position size, and structured to resemble the broad market in terms of a number of portfolio characteristics which include dividend yield, growth rate, market capitalizations, and others. The securities purchased for the portfolio are selected based their valuation relative to peer companies within each economic sector.

The Epiphany FFV Focused Fund invests in mid-cap and small-cap companies, using the Russell 2500 index as the benchmark. The stocks in this fund differ from those in other FFV Funds primarily in size of the company. Traditionally, this difference has offered the investor diversification.

The Russell 2500 is a broad index featuring 2,500 stocks that cover the small and mid cap market capitalizations. The Russell 2500 is a market cap weighted index that includes the smallest 2,500 companies covered in the Russell 3000 universe of United States-based listed equities. You cannot invest directly in an index.

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