Low-Cost Stock Index Funds: Quality ‘Business Conglomerates’ for Solid, Low-Risk Long-Term Returns

Apr 25, 2023 | ETFs, Feature, Investments, Mutual-Funds, Newsletter

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Regular AAC (Asset Allocation Composite), SAA and TAA portfolios are always rebalanced on the first trading day of a month. the next re-balance will be on Monday May 1, 2023. 

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

Low-Cost Stock Index Funds: Quality ‘Business Conglomerates’ for Solid, Low-Risk Long-Term Returns

As an average investor, we are often advised that stock investments have the potential to yield good returns in the long term. However, we have also observed that many so-called ‘investors’ have suffered significant losses in the stock market, with few achieving desirable returns.

With the emergence of index funds, such as the popular Vanguard index funds, a new approach to stock investing has been introduced. The concept is simple: invest in stock index funds, such as Vanguard’s Total Stock Index Fund (VTI) or the S&P 500 index fund (SPY, VOO or VFINX). The main advantage of index funds is their diversification, as they invest in hundreds or even thousands of company stocks. However, few investors truly understand why some index funds (though not all) are considered good investments in terms of returns and risk.

This newsletter examines stock index fund investing as a means of investing in high-quality business conglomerates represented by an index fund. Essentially, stock index fund investments are viewed as business investments. These ‘businesses’ can be viewed as ‘conglomerates’ that consist of hundred businesses represented by their underling holdings. We further discuss why investing in some ultra-low-cost stock index funds, such as the S&P 500 index fund or the Morningstar Wide Moat Fund (MOAT), can offer compelling low-risk returns over the long term.

Stock investments as business investments

Business investments essentially involve investing in companies that are expected to generate good profits. Savvy business investors do not rely solely on a public company’s stock price as an accurate valuation of its underlying business, especially not in the short term. In stock exchanges like the New York Stock Exchange or Nasdaq, thousands of stocks are traded daily and their prices can fluctuate significantly due to short-term speculation and noise. Daily stock prices are definitely not a reliable reflection of a company’s business value. For instance, it is difficult to comprehend how a company’s worth can be appraised at 20% lower on one day, only to be valued 50% higher the next day!

However, in the long term, a company’s stock price tends to converge towards its underlying business value. If a company’s stock price remains undervalued compared to its underlying business for an extended period, major shareholders or market forces may step in to purchase its underlying shares. Alternatively, some business owners may decide to purchase the entire business and operate it privately to generate profits from the underlying business (so called going private). In fact, this is precisely what a private company owner would do – operate a private company and derive profits from its business, without much concern about its appraisal value by third parties or external individuals.

Many people wrongly characterize Warren Buffett as a stock investor, but in reality, he considers himself a business investor and owner of Berkshire Hathaway. Buffett has repeatedly tried to correct this misconception.

Ignore short term prices and focus on long term business performance.

A business investor in the public stock market treats investments as if they were private companies whose stock prices or business values are not subjected to daily trading or assessment by random participants. Instead, they focus on the underlying business performance.

Warren Buffett once remarked that some people immediately understand this value investor mindset, where investors prioritize business investing over stock investing or stock price speculation, while others may take much longer to grasp this concept. In fact, some may never be able to understand this as they are too afraid and swayed by the stock market prices shown daily or every second. Popular financial media only make this matter worse by reporting 24/7 on stock price rise and fall, creating sensation to attract viewership. 

What are ‘good’ businesses?

Suppose you are enthusiastic and daring enough to venture into business investing, which types of businesses should you choose? For many non-business people, this can be a daunting task. However, we can intuitively outline a few simple criteria:

  • Firstly, the business should be profitable and generate returns that outpace inflation. If it fails to do so, we can consider investing in indexed bonds or fixed income and be done with it. A fair and efficient capital market such as the ones in the US or Europe will eventually reward good businesses by enabling them to earn returns better than inflation. Otherwise, in such a market, some businesses will be forced out and leaving the remaining to be able to make better profits. 
  • Secondly, the business should be stable and unlikely to go bankrupt. This is the most crucial requirement, as capital preservation is paramount. Though stock prices can fluctuate wildly when held, what matters most is that the underlying business is functional, growing and profitable over the long term. It is important to note that short-term volatility is normal and businesses may lose money for a few quarters or years.
  • Finally, the business should have competent managers, operate with transparency towards shareholders, and undergo regular auditing and vetting.

Of course, there are other factors one can add to the list. The above list is just some key ones for non business people to get some ideas. 

Stock index funds viewed as collective business conglomerates

Fortunately, for average investors, there is a reasonable way to approach this business investing practice: investing in a ‘good’ stock index fund. The essence of this approach is to view a stock index fund as a business conglomerate. For example, an S&P 500 index fund SPY, VOO or VFINX could be viewed as a conglomerate or a holding company that consists of the 500 companies in the fund’s holdings. This holding company derives profits from these 500 businesses, much like a conglomerate such as Berkshire Hathaway (BRK/B or BRK/A). In October 24, 2022: S&P 500: A Solid ‘Business’ In A Volatile Time, we looked at S&P 500 index more closely and cited the following observations if it’s viewed as a ‘business’:

  • Never lost money in any single year since 1871
  • Has grown its earnings at 6% above inflation annually (or 9%-10% annually in nominal term). This is significant as it not only preserves your purchase power, it also increases your wealth at some non trivial rate (your real purchase power is roughly doubled every 12 years).
  • It’s very unlikely to be bankrupt as the revenue of this ‘business’ represents more than half of the US GDP. So unless the US as a nation experiences a huge upheaval, this is perhaps one of the safest businesses in the world.
  • It’s less affected by many individual companies’ business as it’s so diversified.
  • Its annual rebalance (the index rebalance) means this business is regularly restructured. In fact, such a rebalance has proved to be very effective as it prunes bad business and promotes good businesses.

Historically, S&P 500 has had annual profit margins around 10-12%, a very respectable business (see Yardeni’s S&P profit margin report, for example). Investing in an S&P 500 index fund such as SPY or VOO results in a profit margin for your investment that is similar to the median profit margin among the 500 individual companies. This places your investment in the middle of the spectrum. However, the index ‘company’ offers a more consistent earnings/profit, resulting in higher aggregate earnings growth than the median or average earnings growth of individual companies. Additionally, factoring in investor behavior, it is probable that index investors will achieve higher than average overall returns. While concrete quantitative data is not available, it can be surmised that returns for S&P 500 index investors will likely fall within the top 33 percentile. Again, we emphasize the top 33 percentile is just some subjective guess. 

Granted, S&P 500 index’ price has fluctuated widely in the past. In fact, it has experienced gut wrenching maximum drawdown (from a peak to a subsequent trough) as large as over 60% or so. But in the long term, this ‘good’ business’ stock price eventually reflects its business value and always makes its investors money — growing at about 10% annually for the past 100 plus years. 

Foundation of strategic asset allocation in investments

We view using using quality index funds as our basic building blocks (candidate funds) when constructing an investment portfolio. For a strategic asset allocation portfolio, that means we just simply invest in these funds, along with some high quality bond funds, in a portfolio with weights properly decided to reflect one’s risk tolerance. For example, a balanced investor may simply invest in a 60% stocks and 40% bonds portfolio that exhibits moderate price fluctuation. 

For US stocks, the example good index funds include, in addition to S&P 500 or VTI,  iShares MSCI USA Quality Factor ETF QUAL and VanEck Morningstar Wide Moat ETF MOAT , as discussed in the previous Newsletter.

For international stocks, one can choose ultra low cost index funds such as VEA (Vanguard FTSE Developed Markets ETF) and VWO (Vanguard FTSE Emerging Markets ETF). 

A properly structured strategic asset allocation portfolio utilizing these ‘business conglomerates’ as investments can yield some good returns. 

Market overview

The following chart shows how major assets have performed year to date:

From the above chart, we can see that stocks and bonds are all doing well year to date. This is surprising as businesses are facing some strong headwinds, namely rising interest rates that result in higher borrowing cost and persistent inflation. For now, investors are still betting on a non-hard landing outcome in this inflation (fight) episode. The sentiment is somewhat supported by the latest (as of last Friday) Factset S&P 500 earnings insight: 

  • Earnings Scorecard: For Q1 2023 (with 18% of S&P 500 companies reporting actual results), 76% of S&P 500 companies has reported a positive EPS surprise and 63% of S&P 500 companies have reported a positive revenue surprise.
  • Earnings Decline: For Q1 2023, the blended earnings decline for the S&P 500 is -6.2%. If -6.2% is the actual decline for the quarter, it will mark the largest earnings decline reported by the index since Q2 2020 (-31.6%).
  • Earnings Revisions: On March 31, the estimated earnings decline for Q1 2023 was -6.7%. Six sectors are reporting higher earnings today (compared to Mar. 31) due to positive EPS surprises.
  • Valuation: The forward 12-month P/E ratio for the S&P 500 is 18.2. This P/E ratio is below the 5-year average (18.5) but above the 10-year average (17.3).

Thus far, the reported earnings growth for last quarter has surpassed expectations as of March 31, 2023. Nevertheless, since only a small number of companies have reported earnings at this early stage, investors should brace themselves for potential negative surprises, especially given the strong headwinds mentioned previously. Approximately 82% of companies are yet to report their earnings, which could significantly impact the overall earnings growth trend.

As always, we call for staying the course which is guided by some well defined and sound strategies:

  • For strategic allocation (buy and hold) investors, ignore the current market behavior. Remember, as what we have emphasized numerous times, when you choose and commit to a strategic portfolio, you essentially know and commit that your investment horizon (or the time you need to utilize this capital) is 20 years or preferably much longer given the current high valuation. As we pointed out, if your investments are those diversified (index) funds such as an S&P 500 index fund (VFINX, for example), you know your money is in some solid ‘business’ that eventually (20 years later and preferably many more years later) will deliver some reasonable returns. As long as you are comfortable with this thesis, you should sit tight and forget about the current gyration.
  • For tactical investors, again, you have to ignore the current market noise. Furthermore, you should follow your strategy rigorously, especially in a time like this. Human emotion, both optimistic and pessimistic, and human desire, both greedy and fearful, are your worst enemies. This has been shown to be true time and time again.

Stock valuation has dropped and now valuation is becoming less hostile. However, it is still not cheap by historical standard. For the moment, we believe it’s prudent to be extra cautious. However how serious a correction might be, we have confidence in the US economy in the long term and thus in the stocks in aggregate. We just need to manage through interim losses carefully.

We again would like to emphasize that for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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