As investors delve into Q1 corporate earnings reports in the US and Canada, the S&P 500 index continues to trade at historically elevated valuation levels on expectations of a soft-landing scenario. However, mixed macroeconomic data points suggest mounting risks to the current positive narrative and imply that we could be in the latter stages of the current economic expansion. These late cycle risks could derail soft-landing expectations currently underpinning equity valuations.

What should long-term equity investors do in the face of these late cycle risks?  What does history tell us about risk?  Academic literature often defines risk as the volatility of share price returns – which can be measured by terms like Beta (measure of systematic risk) and standard deviation (measure of total risk). For many individual investors however, risk is the likelihood of permanent impairment of their capital. 

In his book Stocks for the Long Run (6th edition), Jeremy Siegel examines the historical relationship between the maximum and minimum real holding period returns between US stocks, Bonds and T-bills (i.e. cash) from 1802-2021.  The notion of risk (i.e. loss of capital), truly comes to the fore in the following chart:

_{Source: Stocks for the Long Run (6th Edition)}

The basic observations which can be drawn from Siegel’s data may be surprising to some but should be noted by all equity investors:

1) The risk of loss decreases as the holding period increases. Stocks are undoubtedly a riskier proposition for investors with a shorter time horizon given the wider range of potential outcomes for shorter holding periods.  Although investors may realize meaningful positive returns on a 1- and 2-year basis, the potential to suffer substantial losses also exists over this timeframe.  Nonetheless, the range of potential outcomes for stocks (including the risk of outsized loss) begins to decline noticeably, and at a faster rate than bonds and T-bills, as the holding period increases.  In fact, when an investor’s holding period reaches 20 and 30 years, stocks exhibit lower absolute risk of loss relative to shorter holding periods, as well as when compared to alternatives such as bonds and T-bills.

2) Stocks have never delivered negative real returns for holding periods of 20 years or more. Historical data suggests that equities are not expected to generate capital losses, as shown in the previous chart, over most multi-decade holding periods.  Furthermore, the preservation of purchasing power provided by stocks cannot be understated over longer timeframes given the positive real returns generated by the asset class.  

3) Over 20- and 30-year periods, stocks have always outperformed bonds and T-bills.  For investors with a long-term investment horizon, the lower risk option has been to remain invested in stocks.  As such, investors who engage in dynamic or tactical asset allocation, based on economic scenarios, or stages of an economic cycle, could potentially be altering the positive risk/return characteristics offered by their current equity allocation. 

Several conclusions can be drawn from this analysis, but a few key takeaways should be noted from the perspective of a long-term investor.   First – the process of value creation takes time.  Over longer holding periods – it is the power of compounding inherent in stocks (i.e. the incremental annual earnings growth on top of an ever-expanding base) which drives capital appreciation and ultimately reduces the risk of permanent capital impairment.  Second, stocks have generally been one of the better alternatives to preserve purchasing power over the long term.  This should resonate with most investors in the current environment given today’s elevated inflationary backdrop.  Lastly, the opportunity cost of holding bonds and cash at the expense of equities is relatively high for investors with a 20+ year time horizon with no immediate liquidity needs. 

However, one important caveat is the need to recognize that individual investor circumstances are distinct, often with differing needs and objectives. For example, significant exposure to stocks may be inappropriate for investors with a shorter time horizon, as equities can become an increasingly riskier proposition as investment time horizon decreases. As investors approach retirement or enter a period in their lives where liquidity needs increase, the willingness or ability to withstand losses (which could be significant over a shorter timeframe) declines.  As such, the relevance of bonds and cash within an overall asset allocation framework cannot be ignored, particularly in the latter stages of an investor’s life cycle or for investors with near-term liquidity needs.

What about Bottom-Up Investing?

Siegel’s analysis considers risk from a top-down perspective by analyzing asset class returns through time over a range of holding periods.  However, in addition to using holding period as a potential risk reducing tool, investors can further reduce risk by employing a repeatable and rigorous investment process.  Stock specific risk can be garnered from a franchise’s underlying fundamental characteristics (earnings and cashflow generation, returns on invested capital, balance sheet strength to name a few), as well as its fundamental outlook and valuation.  A franchise’s fundamental value drivers, assessed through proper due diligence and homework, can reduce portfolio risk while also ensuring that investors receive adequate compensation for a given level of risk, in the form of expected return. 

QV’s time-tested risk managed investing framework recognizes the long-term compounding and wealth creation potential inherent in equities.  Risk is ultimately a function of underlying franchise quality and valuation.  Equity investing at QV seeks to construct diversified portfolios of high-quality franchises trading at discount to intrinsic value with an appropriate margin of safety.  The asset allocation i.e. proportion of a client’s portfolio allocated to equities, considers time horizon and risk tolerance.  The strong long-term track record of QV’s core equity strategies is a testament to the repeatability of this process and the discipline that our investment teams use in applying a risk-managed approach across market cycles and investment regimes.

_{Source: QV Investors. As of March 31, 2024}