BHPW Newsletter Q4 2024
MARKET OVERVIEW
Stocks ended the fourth quarter of 2024 on a surprisingly mixed note. While markets initially cheered the U.S. election results, optimism quickly faded once investors began grappling with the repercussions of the new administration’s policies – namely, a stronger dollar, higher interest rates, and potential tariff disruptions. This led to a late-quarter reversal, with the MSCI ACWI index of global equities finishing the period down -1.0%
US stocks outperformed again, delivering a +2.4% return, with the gains remaining heavily concentrated in a small number of names. Meanwhile, international stocks languished, declining -7.6%, as investors braced for the worst case of rumored tariff proposals. This echoes challenges faced during the last Trump presidency as well – and underscores a key risk factor to watch over the coming years. More on this later.
Fixed income also experienced headwinds this period, with the Global Aggregate bond index falling -5.1%. Rising rates were the main culprit, as the 10-year Treasury yield climbed from 3.7% to 4.6% over this three-month span. Interestingly, even though the Federal Reserve has cut short-term interest rates by 1.0% since September, long-term rates have actually risen by nearly an equivalent amount. This is highly unusual, as the chart below illustrates, and reflects renewed concerns about inflation.
Still, despite the choppy ending, 2024 was a strong year for the stock market overall. The MSCI ACWI index returned +17.5%, led by the robust gains in U.S. stocks and Technology. This was offset by more modest returns in international equities, which rose just +6%, and lower returns in less remarkable sectors like Materials, Healthcare, and Real Estate.
Meanwhile, bond markets struggled on a full-year basis due to the aforementioned rise in rates, with most indices ending the period either slightly positive or negative. Shorter-duration, higher-credit-risk securities generally outperformed, while longer-maturity assets faced heavy pressure.
BHPW PERFORMANCE
Our portfolios performed well in this environment. In equities, we meaningfully outperformed the global equity benchmark, despite being underweight in U.S. stocks and Technology – two of the year’s strongest factors. We more than made up for this through strong stock selection, with several of our top-performing names coming from overlooked and underappreciated corners of the market. Notable examples include a U.S. utility (Vistra Energy), a Japanese conglomerate (Hitachi), a Brazilian aircraft manufacturer (Embraer), and a Taiwanese chip manufacturer (Taiwan Semiconductor), with each delivering returns over +90%.
In fixed income, we also delivered strong full-year results, with returns surpassing +4.4%. This was achieved while maintaining pristine credit quality and some duration – an approach that hurt us in the short term but, we believe, will prove invaluable in the event of a market downturn. Some of our best performers in this area came from “special situations,” such as bond funds purchased at discounts and later sold at full value through tender offers or redemptions.
In a world where more and more dollars flow into passive strategies, we remain optimistic about our ability to uncover unique opportunities like these with strong performance potential.
DIVERSIFICATION DILEMMAS
It wasn’t all smooth sailing. We often remind our clients that in a typical year, only about two-thirds of our equities are likely to be “working” – that is, generating positive returns. Last year, we exceeded that benchmark with approximately 75% of our holdings finishing in the green. Inevitably though, this means that one in four of our names finished “out of favor” – and some significantly so.
While the “winners” last year were diverse, spanning a wide range of sectors and geographies, our underperformers largely fell into three key areas: Europe, Consumer Staples, and Healthcare. This clustering is typical in our experience but predicting in advance which themes will underperform has always been extraordinarily challenging. To avoid just some of the pitfalls of our 2024 portfolio, one would have needed to foresee a Trump presidency, the nomination of an anti-vaccine health official, and the assassination of a health insurance executive – and then attempt to reposition an entire portfolio accordingly.
The reality is that most investors struggle to forecast Mr. Market’s mood swings accurately. And while we’ve always been drawn to the idea of pitching a “perfect game,” over the years, we’ve come to understand that building a portfolio where everything is “working” at once isn’t just unlikely – it’s probably undesirable as well. As a former colleague once said, “If everything in your portfolio is going up, you’re probably not truly diversified.”
A quick look at the annual S&P 500 sector returns below underscores how rare it is to have a diversified portfolio that’s “working” across the board, year after year. Nearly every year sees at least one sector finish in the red:
Source: Morningstar
In nearly every year, at least one sector finishes in negative territory
REBOUND-READY
While underperformers are inevitable, there are steps we can take to minimize their downside and maximize their recovery prospects. Our approach boils down to two key philosophies: 1) buy cheap, focusing on margin of safety; and 2) invest in companies highly likely to grow net profit over the next five years.
We believe last year’s detractors performed well on both fronts. For example, the average decline on our “out-of-favor” names was only around -12%. Moreover, as a group, those companies actually grew their earnings per share by about +3% for the year. These fundamentals position us well for an eventual shift in sentiment.
LOOKING BEYOND THE TOP 2%
Over the very long run, the best-performing individual stocks converge to a maximum return of approximately +15% per year:
Source: thriventfunds.com
Top-performing stocks show annualized returns converging near 15% over time
That’s a solid result compared to the market’s historical average. However, we’ve often found that too much focus is placed on this roughly 2% of names that outperform the market significantly. Not enough attention is paid to the 25% of stocks that lose substantial money over prolonged periods.
The chart below shows the long-term distribution of individual stock returns versus the broader market. The 50th percentile line (technically, the 58th) represents a return of approximately 9% per year, or zero excess market return. A closer look reveals how portfolio performance can be dramatically improved by simply minimizing exposure to the biggest losers. This often proves more critical than trying to pick the next superstar stock. As a famous football coach once said: “It’s not who makes the most big plays; it’s who makes the fewest bad ones.”
Source: dimensional.com
25% of names experience major compounded losses over 5-year periods (teal line)
THE BHPW APPROACH
We regularly mention that our goal is to build a diversified portfolio of long-term holdings, priced to deliver double-digit returns based on realistic assumptions. What we don’t emphasize enough is what we actively try to avoid: that 25% of stocks that carry a high risk of permanent capital impairment. We do this with the understanding that safeguarding against large declines is critical – because recovering from a -50% loss (requiring a +100% return) is far more challenging than rebounding from a -10% one (requiring just +11%).1
Given that 15% per year is the long-term cap on individual stock results, we believe it’s far more practical to diversify thoughtfully across the opportunities we estimate will return in the 11%-15% range. By moving away from the pursuit of maximizing every last percentage point, we can focus more on qualitative factors – such as our confidence in the investment thesis and the likelihood of positive outcomes. This approach helps us manage risk effectively while still positioning our portfolios to deliver healthy, sustainable performance over the long term.
LOOKING AHEAD
Markets enter 2025 at some of their highest valuations in recent memory, particularly here in the United States. In our last letter, we highlighted how U.S. stocks haven’t reached these levels since the tech bubble. As many will recall, the years that followed were far from celebratory.
Source: S&P Global
S&P 500 P/E ratio, using the highest EPS achieved to date
Two key concerns stand out to us. First, we believe the market’s growth expectations are very optimistic. Current projections anticipate an +11% earnings growth rate over the next few years – well above the long-term average of +6%. With profit margins already elevated and inflationary pressures mounting, we see little reason to expect this rosy outlook to materialize.
The second issue is volatility. A Trump presidency amplifies both idiosyncratic risk – specific to individual companies or industries – and systemic risks across the broader market. As the quote at the beginning of this newsletter states, “With Trump, you’re going to have a lot of uncertainty and headline risk.” This isn’t fully reflected in sentiment yet, as investors seem to have forgotten the pain such unpredictability can inflict – especially when a single tweet can send stocks tumbling by several percent.
REASONS FOR OPTIMISM
It’s not all fear and gloom, though – there are encouraging offsets to our concerns. For example, AI (“artificial intelligence”) holds immense potential, with the capacity to transform industries and usher in a new era of efficiency. It’s poised to become a powerful driver of global progress – though its benefits may not be as immediate or widespread as some forecasts suggest.
Beyond AI, we’re also optimistic about the broader global growth outlook, as we appear to be entering a more business-friendly climate. Enduring growth themes – such as rising energy demand, cloud computing, autonomous transportation, and perhaps even quantum computing – continue to offer compelling investment narratives as well. There will be significant winners over the next ten years for those looking to uncover exceptional opportunities.
CONCLUSION
While the past two years have been strong for equities, history suggests that a “three-peat” is far less common. We wouldn’t be surprised to see markets take a breather, particularly if major geopolitical or economic headwinds arise.
How are we positioning our portfolios for such an environment? First, we remain heavily focused on downside protection, as many areas of this market seem increasingly disconnected from economic reality. We’re often reminded of a famous John Maynard Keynes quote: “When the capital development of a country becomes a by-product of a casino, the job is likely to be ill-done.” This description feels especially fitting in light of recent events.
Second, we continue to seek out fundamentally attractive opportunities, maintaining a willingness to go wherever the market leads us. Two recent examples come from the real estate sector, where we believe we acquired investments with normalized free cash flow yields approaching double digits.
We’re also leaning into diversification, increasing the number of holdings in our stock model to 75. We believe the concentration risk in the S&P 500 is underestimated, with nearly $4,000 of every $10,000 in the index now allocated to just 10 names. We’re comfortable with a broader approach, particularly as we enter a period of elevated company-specific uncertainties.
In bonds, we remain defensively positioned. Compensation for taking credit risk remains near all-time lows, which is why more than 75% of our bond portfolio is allocated to securities with a government guarantee. Despite this conservative posture, we’re still achieving a 5.5% overall yield and a 4.5 duration, positioning us favorably relative to most bond and money market funds. It also provides us the flexibility to capitalize on higher yields when better opportunities emerge.
As demonstrated throughout this letter, our approach prioritizes a high probability of strong returns for our clients over chasing extreme outcomes – whether spectacularly good or bad. We believe this is the right strategy, given that so much of both our clients’ wealth and our own is invested in the same model.
We wish you all a happy and prosperous New Year, and for our clients here in Los Angeles, we hope you and your loved ones are safe following the recent wildfires. Thank you for your continued trust and partnership.
Sincerely,
The BHPW Investment Team
1. In rare situations, we will invest in companies where we forecast a downside case that can be a permanent loss. But, this is only when the upside potential is commiserate with that risk.
Beverly Hills Private Wealth, LLC is a registered investment adviser. This is solely for informational purposes. No advice may be rendered by Beverly Hills Private Wealth, LLC unless a client service agreement is in place. Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Past performance does not guarantee future results. Investing involves risk, including loss of principal. Consult your financial professional before making any investment decision. Other methods may produce different results, and the results for different periods may vary depending upon market conditions and portfolio composition. This newsletter does not represent an offer to buy or sell securities.