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Earnings Review - Wednesday, May 05 2021

It’s obvious:Corporate earnings drive stock prices.  So, how do things look on that front?  At the time of this letter, we are about halfway through 1Q 2021 earnings reports.  In short, earnings are surpassing even the best-case scenario from only a few months ago.  Coming into 2021, there was some question whether this year’s earnings could surpass the $160/share for the S&P 500 seen in 2019.  Events so far this year - and amplified this quarter - have completely erased any concern in that regard.  2021 S&P 500 earnings estimates now hover around $180/share and are likely headed higher.  For 1Q in particular, earnings are exceeding expectations by nearly 25% in the aggregate.  Look no further than Apple and Facebook, the first and fourth largest companies in the S&P 500.  March quarter earnings for both companies exceeded expectations by a whopping 41% - and those were good old-fashioned GAAP earnings to boot.  Beyond Apple and Facebook, much of the overall outperformance is being driven by cyclical companies levered to the strong economic recovery now in its early stages.  Our portfolio is well positioned to take advantage of all of this.  Back in our February letter, we wrote that $25o in earnings for the S&P 500 could be possible in the medium term.  Based on results so far this year, that may come as soon as late next year. 

What’s driving this performance? It’s simple:  strong economic growth drives strong revenue growth.   In the short run, companies can’t add costs (employees, new equipment, etc.) nearly as fast as they can add revenue.  This creates powerful operating leverage resulting in very strong earnings.  This won’t last forever as costs eventually catch up with revenues.  But for now, corporate earnings will continue to surprise to the upside.

Dirty Harry vs Blanche Dubois - Wednesday, May 05 2021

Investing vs Speculating:  I have always thought it useful to distinguish between investment and speculation.  This distinction is not to make a value judgement that one activity is morally superior to the other, or that it is easier to make money in one activity compared to the other.  In well-functioning markets, both have their place.  Both can, in the right hands, make money.  Instead, I do think it is useful to be clear about which one you are currently doing.  It’s a bad idea for your net worth to speculate and fool yourself into thinking that you are making an investment.

Making a clear distinction between investing and speculating rests on having a good working definition of the two.  This is mine:  Investing is judging the value of an asset for its own intrinsic ability to generate future cash flows for its owners.  Speculating is judging that others are likely to pay more for an asset in the future than I paid today.  In its purest sense, investing is a solitary endeavor.  It doesn’t necessarily require the opinions of others to align with your own as a way to make money - though sometimes that can be helpful.  Instead, the investment just needs to perform as you expect (or better).  Successfully speculating, on the other hand, requires that public opinion swing your way in the future.  It’s the very thing, and perhaps the only thing, you are betting on.

Dirty Harry:Knowing whether you are investing or speculating should go hand in hand with knowing your own skill set.  Just as the bad guy’s car explodes at the end of the movie “Magnum Force,” Clint Eastwood put it best - “A man’s got to know his limitations.”  So true.  This is mine.  I am not a very good speculator.  So I try to avoid it.  If I don’t have some reasonable basis for deploying capital other than “people are really going to like this stock a lot more in the near future than they do today,” I try very hard to keep my hands off the buy ticket.  Plenty of people are wired the opposite way and are successful speculators.  I’m just not one of them.

The Next Big Thing: Cryptocurrencies in general, and Bitcoin in particular, are interesting case studies of the distinction between investing and speculating.  At latest count, there are about 4,000 different cryptocurrencies, and the total value of all of them exceeds $2 trillion, roughly the same value as Apple. About half of the $2 trillion total value of all cryptocurrencies is Bitcoin itself.  At first glance, Bitcoin seems like it could be a form of investment.  There is, by design, a limited supply of Bitcoins.  Therefore, it has built in scarcity.  There is ample institutional sponsorship of bitcoin as a suitable investment.  There are publicly traded futures and options contracts.  In short, Bitcoin has all the trappings of other publicly traded investments.

Blanche Dubois: However, as best I can tell, Bitcoin doesn’t generate an intrinsic return like a typical investment does.  Unlike a company, for example, it doesn’t generate cash flow, pay a dividend, or have a contractual interest rate.  In that respect, it is similar to gold.  It has value simply because other people deem it to have value.  Most of that value seems to revolve around investors’ collective fears -  fear that traditional currencies will lose value due to inflation, fear of not having enough portfolio diversification, fear of missing out on the Next Big Thing.  But those fear-based attributes could, in theory, be attached to anything.  It could be gold in the past, bitcoin today, or something entirely different in the future.  Those “special attributes” aren’t necessarily particular to Bitcoin.  The difference is that when enough people agree that any particular thing has this particular set of desirable attributes, then POOF, it becomes imbued with those attributes.  So, the value of Bitcoin in that sense is like Blanche Dubois in “A Streetcar Named Desire:” its value rests on the kindness of strangers.  In other words, the value of Bitcoin is the textbook definition of speculation.  Because people are fickle, that is an inherently unstable source of value.  As I stated above, there is nothing morally inferior about speculation.  Some can practice it successfully.  I’m just not one of them.  And, we should not say that one “invests” in Bitcoin.  It isn’t an investment in any sense of the word I am familiar with.  At heart, if you own Bitcoin you are hoping that someone comes along and is willing to pay more for it than you did - and they might, or, they might not.  Bitcoin may become truly The Next Big Thing and current bitcoin speculators will make a lot of money.  Alternatively, governments may decide they do not want private currencies competing with their official legal tender.  In that case, Bitcoin may become worthless.  Both seem about equally likely to me.  I am just not prepared to bet on either outcome.

Final note:  The paragraph above focuses on Bitcoin.  I realize there are thousands of different crypto-assets, each differing from Bitcoin in various ways.  But the overall distinction between investment and speculation still applies to them all - the foundation of value in all of them is that other people deem them to have value.  Tennessee Williams would be overwhelmed.  Rather than one Blanche Dubois, there are thousands.  Better get another streetcar.

What About the Feds? - Tuesday, April 06 2021

Why it matters:  In the prior section, we told a bullish tale about the consumer.  After a long grind through the 2010s, the consumer balance sheet has emerged in good shape, ready to power stronger economic growth.  On the other side of the coin, however, lies the federal government’s balance sheet.  In many ways, the federal balance sheet is the mirror image of the consumer balance sheet.  As consumer debt fell over the last decade, federal debt rose sharply, fueled by a combination of stimulus programs (the financial crisis and COVID) as well as tax cuts.  If current projections hold, sometime in the next year, U.S. Government debt will surpass 100% of GDP - a level only seen at the height of WWII.  By comparison, federal debt stood at 34% of GDP in 2007 just prior to the financial crisis.  Could this deterioration of federal finances lead to trouble down the road?  Could the good news coming from the consumer get derailed by the federal debt burden?

It’s an interesting question:  Let’s consider the US experience following WWII, the last time federal debt was this high.  In 1946, federal debt stood at 106% of GDP.  By 2000, federal debt had declined to 33% of GDP.  So we must have run big surpluses in a large number of those intervening years, right?  Wrong.  In that 54-year period, the US ran a surplus in only 10 of those years, the largest of which was in 1948.  All the other surpluses were quite small.  In the other 44 years, we ran deficits, some quite substantial.  As a result, the total debt outstanding in 1946 was $271 billion.  In 2000, it grew to $5.6 trillion, over 20 times greater.  The answer to the puzzle of deficits and rising debt on the one hand and falling debt to GDP on the other is growth.  Simply put, the economy grew faster than the debt outstanding.  Or, as an economist would put it g*, the economy’s potential rate of growth was greater than r*, the cost of borrowing.  We outgrew our debts, and our post war debt problems.

Same story, new day:  Today, we find ourselves in the same circumstance.  Our potential rate of GDP growth, which may accelerate given strong consumer finances, exceeds the cost of our debt by a wide margin.  From here, the key is to maintain strong economic growth.  Our betting is that we will.  And with that, any federal debt worries will prove premature.

Climate Change? - Monday, April 05 2021

Don’t worry: We’re not discussing THAT kind of climate change.  We’re not experts in climate science and reading our opinion wouldn’t be worth your time.

Yes, but: We do, on the other hand, have some thoughts on the long-term investment climate and how that might be changing.  Normally, our investment perspective is “micro.”  We spend a lot of time analyzing companies, products, end markets, strategies, management incentives to name but a few of the items that occupy our time.  Lately, we’ve been doing work on whether Abbvie’s JAK inhibitor Rinvoq will have trouble getting approved for use in psoriatic arthritis and atopic dematitis.  That’s about as micro as you get.

But we don’t entirely ignore the macro.  No thinking investor really can.  For us, we think of macro like the we think of the weather.  We are still going to go about our business, but it would be very helpful to know whether we should bring an umbrella or sunglasses.  The rest of this note should be taken in that spirit. 

Big picture: Big events tend to go hand in hand with a change in the investment climate.  A case in point: in September 2009, immediately following the global financial crisis, PIMCO’s Bill Gross penned a note titled “On the Course to a New Normal.”  The note received a huge amount of press and the phrase “The New Normal” became enshrined in in the financial lexicon.  What is The New Normal?  As Gross wrote in his note: “we are headed into what we call The New Normal, which is a period of time in which economies grow very slowly as opposed to growing like weeds….in which the consumer stops shopping until he drops and starts saving to the grave.”  The reason, according to Gross, was DDR - deleveraging, deglobalization and reregulation.  

The New Normal: Despite his well-publicized personal and professional blow-ups some years later, the following decade proved that Gross’s New Normal was mostly right.  The global economy did grow more slowly in the ten years following the financial crisis than it did in the 50 years leading up to it.  The following numbers prove the point.  In the developed world, consumer spending drives economic growth.  In the US, consumer spending - or Personal Consumption Expenditures (PCE) as it is called by economists - comprises nearly 70% of GDP.  In the 50+ year period spanning from the end of WW II to 2006, PCE grew an average of 3.5% per year in real terms.  That was the “normal” we all were used to before the financial crisis.  In the decade following the financial crisis, things changed.  In the most recent 10 year period following the financial crisis but prior to the pandemic, PCE grew at an average annual rate of 2.3% (real) per year - a 34% reduction in the rate of growth in consumer spending.  In some sense, we all derive satisfaction from spending money and acquiring new goods and services - “utility” to econ nerds.  So, if there is a reason why the 2010s felt bad to the average consumer, which perhaps led to our current fractious political environment, it was that we collectively did a lot less of that which made us feel good.  

What Happened?  On the three factors that Gross cited as being responsible for the new normal- deleveraging, deglobalization, and reregulation - by far the most important was deleveraging.  After all,the main cause of the financial crisis was too much debt.  In 1970, consumer debt outstanding in the US was 44% of GDP.  By 2007, that ratio stood at 97% of GDP.  The story was the same throughout the developed world.  Taking Germany, Japan and the UK as a whole, consumer debt-to-GDP rose from 32% of GDP in 1970 to 79% in 2007.  Clearly, this trend of ever rising consumer debt was unstainable.  As economist Herbert Stein quipped in 1986, “if something cannot go on forever, it will stop.”  And it stopped with a vengeance 2008.  Then something interesting happened.  We actually paid back some of our collective debts - for the first time everAs Gross put it, we went from “shop till you drop” to “save till the grave.”  From 2010 to 2019, consumer debt to GDP in the US declined from 97% to 75%.  A similar pattern occurred in the rest of the developed world.  Collectively, in Germany, the UK and Japan, consumer debt-to-GDP declined from 79% to 66%.  So, taking the very long-term view, in the 50 years prior to the financial crisis, we out-consumed our incomes financed by ever rising levels of borrowing.  In the 10 years following the financial crisis, we under-consumed our incomes as debt repayment took priority over spending. 

Unprecedented:  It is worth pausing to note that the recent decade of shrinking consumer debt has never happened before.  Throughout the modern history of the developed world up to the financial crisis, money became ever easier to borrow, and consumers obligingly took on more leverage.  It is also worth noting the relative speeds of the leverage up-cycle versus the down-cycle.  On average, consumer debt-to-GDP rose about 1% per year leading up to the financial crisis.  In the 10 years following the financial crisis, consumer debt to GDP fell more than twice as fast as it rose - about 2.2% per year.  This simple fact doesn’t get nearly the attention it deserves.  Yes, factors like offshoring production, low productivity, regulatory overreach, stagnant wages, low educational attainment all play a role in the stagnant 2010s, but a supporting role at best.  Some of them, indeed, are better understood as symptoms of slow growth rather than causes.  We should apply Occam’s Razor here.  Rather than look for complex, multi-pronged theories or nefarious actors (Mexico took our jobs!), the simplest explanation works best.  In my opinion, deleveraging outweighs every other factor in explaining why the 2010s felt blah.    We borrowed too much and it took a decade to work our way out.  Cassius put it best - “the fault, dear Brutus, lies not within our stars, but in ourselves.”

Stock vs Flow:  Up to this point, our “consumer deleveraging driving slow economic growth” story has been told by examining debt to GDP ratios.  But, in doing so, we are comparing the total amount of something, consumer debt in this case, to the annual flow of something, national income or GDP.  Analytically, it often makes the most sense to compare a flow to a flow or a stock to a stock.  In the case of consumer debt, we can compare the cost of servicing that debt to consumer income - both numbers are annual flows. Here, due to the decline in interest rates, the consumer deleveraging story is even stronger, especially so in the case of mortgage debt.  At the peak in 2007, our collective mortgage payments stood at 7.2% of our disposable personal income, the highest on record by far.  Today, that number stands at 3.7%, a decline of nearly 50%, and the lowest on record by far.

The NEW New Normal: If the financial crisis brought on The New Normal, could the end of pandemic herald another major change in the investment climate?  The evidence suggests that it could.  The OLD New Normal was defined by slow economic growth weighed down by consumers devoting an increased share of their income to repairing their balance sheets wrecked after decades of living it up on growing amounts of borrowed money.  As a result, to the average person, the 2010s felt terrible.  Today, the consumer balance sheet is in MUCH better shape.  This doesn’t mean that consumers won’t continue to de-lever; they might.  However, it does seem very likely that the PACE of deleveraging will slow significantly and possibly even reverse.  What’s more, as terrible as the pandemic was to live through, as a result of government stimulus programs, consumer balance sheets are exiting the COVID period in better shape than they entered it.  As the world begins to reopen, consumer spending may once again power the economy to surprisingly robust levels of growth - and that may make the 2010s feel less like The New Normal and more like a severe debt hangover.  Like any hangover, it feels awful in the middle of it, but it eventually ends - and that ending may be now.

Investment Implications: The defining feature of the investment landscape in the 2010s was historically low interest rates everywhere in the world.  To a great extent, the low interest rates environment reflects the sluggish economic growth of the period.  Interest rates, in some sense, are just a “conversion factor” between money today and money in the future.  In a slow growth environment, when there isn’t much need for money today, the “opportunity cost” of turning it into money tomorrow is low.  But in an environment of faster growth - like the one we may be entering driven by a financially healthy consumer - today’s opportunities may be compelling.  Thus, interest rates should rise from the historically low levels seen in recent years.  In our view, a higher interest rate regime should result in a more level playing field between growth stocks and value stocks.  As we have written in the recent past, we are not fans of narrow, style-based investing.  It limits a manager’s investment universe to canned lists defined by consultants using outdated and inflexible rules.  Our investing framework ignores style and focuses on stocks, regardless of their label, that trade at significant discounts to our estimate of intrinsic value.  However, there can be times when it makes sense to make an explicit style bet.  This is one of those times.  Value stocks have almost never been this cheap relative to growth stocks.  How do interest rates factor into this?  It’s simply a matter of discount rates.  More of the value of a growth stock occurs in the distant future.  When interest rates are extremely low, that distant future value will be worth more today than when interest rates are high.  That’s just math, nothing more.   A more “normal” rate environment (i.e. higher) spurred on by more “normal” economic growth will help narrow the historically large value discount.  Our portfolio is positioned to take advantage of that.

Where Are We? - Friday, March 05 2021

Big picture: We are coming up on the one year anniversary of COVID market panic.  In the 23 trading days from February 20 to March 23, 2020, the S&P 500 fell 34%.  Since March 23 of last year, the S&P 500 has returned 73.09%.  As we wrote in our monthly letter from that panic period: “At turning points, it often pays to “buy bad news” in advance of better news to come.  Waiting until the coast is clear can be quite costly to long term portfolio performance.”  We followed our own advice to the letter.  How did we do?  Since the COVID bottom on March 23, 2020, our portfolio has returned 99.97% (gross).  Let’s round it to a double.  A good result in our view.  

Now, the COVID vaccine rollout is accelerating, policymakers remain EXTREMELY accommodating, and good times seem right around the corner.  Is it time to “sell good news?”  Our answer: No.  Our argument to support this answer is below.  But first, a brief - and surprising - digression into the history of Christianity to set the stage.

Our Nicene Creed:  Much of what we recognize today as mainstream Christianity dates from the Council of Nicaea in the year 325.  Most Christian practice prior to 325 was a widely varied set of conflicting, sometimes contradictory, mystical beliefs.  Constantine, the first Roman Emperor to adopt Christianity, convened a meeting of the Wise Men of the Church in the ancient city of Nicaea (in what is now Turkey), in an attempt to sort things out.  The result of that meeting was a set of principles that became the foundation of modern, mainstream Christian belief and practice.  That set of principles is codified in The Nicene Creed, a short set of statements each beginning with "We believe….” 

Like early Christianity, investing also can be a morass of conflicting, sometimes contradictory, and occasionally mystical beliefs.  For example, each spring, we are treated to a variety of articles in the financial press discussing “sell in May and go away ” - an investment shibboleth with no factual, historical, or logical basis other than to fill what would be otherwise empty space in the media.  To sort through this mess, we, too, have a set of beliefs that guide our investing practice.  To be sure, we would never claim our investment beliefs represent some sort of universal truth.  Instead, we merely state we have found them, at least in our experience, to be useful, successful, and grounded in how markets and the economy seem to work.  Therefore, we believe:

  • Good businesses, managed by talented people, are the foundation of real wealth creation.  Our job is to find those businesses and acquire shares in them at reasonable prices.  Ideally, if the business and management remain strong, our holding period would be “forever.”  Forever means the tax man never cometh.
  • Economic cycles give rise to both tailwinds and headwinds in our search for good businesses selling at reasonable prices.  A rising economic cycle helps make what we own more valuable, but makes finding new investments a bit more difficult.  A recession does the opposite.  Therefore, knowing our place in the cycle can guide us in managing the size of our holdings of those good businesses we seek.
  • Stock market cycles are not the same as economic cycles. Markets often gyrate with zero impact on, or relationship to, the underlying business environment.  Yale economist Robert Shiller won a Nobel Prize in part for his observation that the stock market is 10 times more volatile than the underlying business economy it is supposed to reflect.  Though they are often frustrating to live through, market gyrations without economic consequence are often great times to invest.  Successful active management would be nearly impossible without them.
  • Finally, economic cycles don’t arise out of thin air.  In a sense, we create them ourselves.  Greed can result in economic excess.  Excesses lead to downturns.  Remember all those excess spec houses built in 2005?  A good time for investment caution and the aftermath that housing excess wasn’t pretty.  Fear, on the other hand, can result in economic slack that allows the cycle to start anew, an especially good time to put money to work.  The depths of the Financial Crisis in early 2009, with millions out of work and home foreclosures skyrocketing, was a case in point.  Therefore, knowing the general degree of economic slack - or excess - is perhaps the most  important variable we monitor in managing the size of our holdings.

Slack-o-Meter: The two very best indicators of economic slack are housing and employment.  This makes intuitive sense.  Our jobs and the place we live constitute a huge proportion of our economic output.  So, where do we stand?

  • Housing:  In 2007, UCLA economist Ed Leamer wrote an influential paper - "Housing IS the Business Cycle.”  Leamer argued that housing punches far above its weight in the economy, especially at turning points.  As Leamer put it in a talk given at The Fed’s Jackson Hole Conference that year: “Housing is the most important sector in economic recessions and any attempt to control the business cycle needs to focus especially on residential investment.”   As Leamer spoke that year, residential investment had reached nearly 7% of GDP - the highest level on record save for a few brief moments following WWII.  This was obvious excess.  In the following few years, this excess ignited the Great Financial Crisis which resulted in the S&P 500 getting cut in half.  Where are we today in housing’s contribution to the economy?  Slightly below the post-WWII average.  Despite some recent pandemic driven froth in certain markets, the aggregate data says there is little excess in the housing market, broadly speaking.  Therefore, there is little threat today of a housing-led downturn.  Housing’s contribution to economic growth today looks much like it did in the 1990’s - normal.
  • Employment: The Bureau of Labor Statistics produces a huge volume of data about the labor market all sliced in different ways depending upon who is counted as working, unemployed, or "not in the labor force.”  In our experience, the best signal that comes out of this mass of data is the “employment-to-population-ratio.”  That number takes all people in a given age cohort who are currently employed as a proportion of the total number of people in that age cohort.  It leaves aside all the inside baseball that economists get into regarding whether certain people who have quit looking for a job should be counted.  Our preferred measure is simple.  If you have a job, you are counted, if not, not.  In the prime working age cohort of those aged 25 to 54, 76.4% held jobs at the end of January 2021.  Pre-pandemic, in January 2020,that measure stood at 80.5%.  In the late 1990’s, this measure reached 82%.  Using this measure, history shows that there is PLENTY of labor market slack.  In historical terms, the current reading on the employment to population ratio is equivalent to levels last seen in early 2014.  From that point, the economic upturn had 6 more years to run.  Were it not for COVID, it would have run even longer.

The bottom line: Markets have indeed come a long way since the depths of  the COVID Panic last March.  We make no claim to know what markets will do over the next month or two.  Remember, markets can move 5-10% up or down for any reason, or for no reason.  We do, however, claim the current economic upturn has a long runway ahead of it.  Over the long term, that keeps us bullish.

Earnings Update - Friday, March 05 2021

Why it matters:  To state the obvious: stock prices (over the long term) follow earnings.  Therefore, understanding, the trajectory of earnings is critical to understanding the potential success of any investment we might consider.  The same principle applies for the overall stock market.  The path of corporate earnings matters - a lot.

We have just come through the bulk of corporate earnings reports for the 4th quarter of 2020.  How did “Corporate America” do?  MUCH better than expected - about 15% better in the aggregate.  This bodes well for earnings in the coming year.

What's next: Over the coming year or two, where could earnings go?  To answer that question, let’s consider some quick back-of-the envelope math.  In general, corporate earnings growth is related to the growth in the overall economy.  To be sure, thedistribution of that earnings growth can change from cycle to cycle, but on the whole, the general relationship between the two holds. 

Thanks to COVID, in 2020, the US economy shrank 3.5%.  In 2021, the US economy looks set to grow 6%.  That’s a 9.5% swing from year to year.  The last time we had a cumulative 9.5% swing in GDP was coming out of the Financial Crisis.  From 2009 to 2013, the US economy grew a cumulative 10%.  This time around, we may do it in a year or so, rather than the 4 years it required following the Financial Crisis.  From 2009 to 2013, earnings for the S&P 500 doubled.  Could we see a doubling of S&P 500 earnings over the coming year or two?  That is a distinct possibility.  That would bring $250 in earnings for the S&P 500 squarely into view.  Assuming, the market’s current multiple declines to 18x from its current level of 21x, that would imply a 4500 level for the index, meaningful upside from here.

What is Normal? - Friday, February 05 2021

Distant memories:  The year 2020 seemed like a long decade.  Does anyone recall pre-pandemic normal?  Crowded restaurants?  Packed sports events?  Regular plane travel?  Seems like eons ago.  Somehow, though, we have adapted to this new normal.  Masks, which seemed so odd a year ago, now seem like a standard article of clothing.  Dining outside in cold weather would have been a non-starter a year ago.  Now, we bundle up and ask if the restaurant could move the propane heater a little closer.  If nothing else, we humans are an adaptable species.  Pass the hand sanitizer.

Anchoring to the recent past:  As our memories and habits anchor to the recent past, this new normal seems to have taken over from the old normal in our minds.  Behavioral economists call this "recency bias,” and it is especially prevalent in financial markets.  We have become used to extremely low or even negative interest rates.  We have become accustomed to the idea that the dividend yield on stocks exceeds the yield on government and high grade corporate bonds.  We have become used to sluggish economic growth.  Economic malaise seems like the normal state of affairs.  Growth and optimism seem like foreign concepts.

The real normal:  Despite the immediacy of the recent past, it is worth thinking much longer term to gain a better perspective on what “the real normal” could be.  After all, the recent past, could itself be quite different than the very long term average.  In particular, it is worth taking stock of the past decade and the stark contrast with most of post-WWII history.  The past decade began with a long, slow recovery following a global financial crisis and ended with a pandemic.  Those are breathtaking bookends to what history likely will judge to be an outlier decade.  In the same way, standing in 1980, it would have been a nearly fatal investment mistake to assume that the coming decade would look like the high inflation, high interest rate environment of the 1970s. With that in mind, and, leaving aside for the moment how we get there, suppose we were to find ourselves transported to something that looks like the very long-term normal in financial markets.  What would that imply?  Note: this should not be construed as a forecast.  Instead, this is a “plausibility exercise” for what could happen if conditions were right for a return to the long-term, post-WWII normal.  

  • First, a method for the madness:  There are many different ways to make sense of what stocks are worth, each having its own particular strengths and shortcomings.  In our view, what’s most important in any method of stock valuation is simplicity and logical consistency.  Are we comparing financial  measures that make logical sense to compare and are we doing so in a simple way.  Without those two things we risk “data mining” our way to an answer that supports our pre-existing biases.
  • Stocks vs bonds:For the stock market as a whole, this is our preferred valuation method: comparing the “earnings yield” on stocks to the yield on corporate bonds.  What is the "earnings yield” on stocks?  It’s just the inverse of the P/E ratio - the ratio of earnings to price.  Comparing that to the yield on corporate bonds makes complete logical sense.  Companies produce operating cash flow after tax.  That cash flow is used to service the providers of capital - debt and equity.  Comparing the relative yields on the two different types of capital serviced by the same cash flow should provide solid guidance of how to structure a portfolio.  If bonds look cheap compared to stocks we should pursue the safety of bonds.  If the opposite, we should take risk in the stock market in exchange for higher returns.  Sounds simple, but we have always found this framework to be a reliable long-term guide to correctly calibrate the degree and type of exposure we should take in our portfolio. 

Where are we now?  Comparing the earnings yield on the S&P 500 to the yield on high-grade corporate bonds shows the following:  today, stocks today are one standard deviation cheap compared to their post WWII average relationship to corporate bonds.  To us, this signals a favorable relative environment for stock market investors.  And this is true even after the major gains seen following the pandemic low in March 2020.

What if?  Using our framework comparing the earnings yield on stocks to corporate bond yields, what would happen to markets if that stock/bond relationship reset to its post WWII average?  To answer that question, let’s change each of the three main variables in the comparison - earnings, multiples and bond yields - and see what that implies.

  • P/E Multiple:  To reset our earnings yield/bond yield comparison to its post WWII average, the P/E ratio for the S&P 500 would need to expand to 33x compared to 23x currently.  Using consensus estimated 2021 earnings for the S&P 500 of $173, a 33x multiple would imply an index level of 5700, nearly 50% above today’s level.  
  • Earnings: Alternatively, earnings could fall.  To reset our earnings yield/bond yield comparison to its post WWII average, earnings for the S&P 500 would have to fall to $116 - a 33% decline from current consensus estimates.  An earnings decline of this magnitude would be typical of that found in a severe recession.  Following the pandemic recession of last year, and the degree of global monetary and fiscal support, this hypothetical earnings collapse would be extremely unlikely.
  • Bond Yields:  Finally, bond yields could rise to bring our earnings yield/ bond yield comparison back to its long-term normal. To do this, corporate bond yields would have to rise 135 bps, nearly 50% higher than current levels.  This could happen, but only in an environment of much stronger economic and earnings growth which would serve as a significant offset to higher bond yields.
  • What about consensus?  Roughly speaking, the optimistic end of current published consensus calls for the S&P 500 to end the year at 4400, about 15% higher than the current level.  That same consensus also calls for a modest rise in bond yields of about 50 bps.  Although a 15% return in 2021 sounds like an optimistic outcome, if we plug those consensus numbers into our long term comparison of earnings yields and bonds yields, we find that we move only halfway back to the long-term normal relationship. 

The whole point:  The nearly 70 years of financial history following WWII shows that long standing financial market relationships - stocks vs bonds -  are a long way from normal.  We have become accustomed to these out of whack relationships because of our ingrained habit of anchoring what we perceive to be normal to that which we most recently experienced.  But the long sweep of historical data says otherwise.  While the above analysis could be construed as being wildly bullish, we should remind everyone this is just a “what-if exercise” not a forecast.  Instead, it should serve as a reminder that the current stock/bond relationship imbeds a high degree of caution about the future.  Clearly, some of that caution is warranted.  But here is the whole point:  from the current cautious starting point, more could go right for , :markets than wrong - at least that’s how we read the long sweep of history. 

Portfolio implications:  The “what if” exercise above highlights our belief that for the broader stock market, tailwinds are more likely than headwinds.  But that favorable overall environment provides little specific guidance on how to manage a concentrated, stock-selection-driven equity portfolio.  As we have written in recent months, we spent last spring picking up bargains in the areas of the stock market hardest hit by COVID - banks, energy, and industrials in particular.  Since then, many of these holdings have done very well, which led to our strong performance in 2020.  The question now becomes: is there more to go, or, are we overstaying our welcome?  In general terms, this question revolves around the relative price of cyclical, economically sensitive earnings as compared to the price of stable, non-economically-sensitive earnings. Over the very long term, companies with stable earnings (e.g. consumer staple companies)  trade at an average 15% P/E premium to companies with economically sensitive, cyclical earnings.  In a way, this makes sense: predictability deserves a (slight) premium.  At the pandemic low in March of last year, that “stability premium” expanded to 60%, nearly the highest on record.  Where are we today?  Despite the significant rebound in cyclical stocks since last March, the P/E premium for stable earnings has declined only slightly - to 50% - still well above average.  To us, as the environment continues to normalize, as vaccines are more widely deployed, as the hardest-hit parts of the economy recover, there remains a compelling case to retain the cyclical/value bias in the portfolio.  The long sweep of history says there is a long way to go.

Strange Days - Tuesday, January 05 2021

Understatement of the Year:  2020 was an unusual year.  A year ago, no one, us especially, could have foreseen the events that took place this year.  A deadly pandemic, rapid and effective relief programs from governments and central banks around the world, extreme political division - especially in the US, stock markets at record highs, and scientists who have saved our collective bacon.  A movie script with these events would have been sent back to the writers with a note in red ink saying “Rewrite - too corny, not realistic.”

Making Sense of it All:Often we are asked for our “forecast for the year ahead.”  For some reason, many people seem to think that professional investors, especially ones who have been at it for a long time, must have some special insight into the future.  2020 underscores just how naive a notion that is.  To be clear, it isn’t correct to say we have ZERO thoughts about the economy and markets in the year ahead.  We have them, as outlined at the beginning of this letter, but they are loosely held, and subject to change.  They aren’t the single, fixed North Star by which we steer the portfolio.  As Keynes once quipped “when the facts change, I change my mind - what, sir, do you do?”

  • Keeping an Ear to the Ground:  We spend a lot more time listening to what market prices are telling us, and a lot less time telling the market what we think the right answer should be.  In our letter from March of this year, at the height of pandemic uncertainty and fear, we discussed our preference for “listening” rather than “speaking.”  Market prices imply a forecast about the future.  We listen to that, try to make sense of it, and ask whether that implied forecast is plausible.  To us, that is a much more reliable way to make sense of the investment landscape around us.
  • The Ides of March 2020:The market-implied forecast back in March, especially for those stocks hard hit by the pandemic, told us investors believed that the pandemic would never end; that the future was worth, in some cases, less than zero.  That seemed extremely unlikely to us.  So, we spent most of the spring picking up bargains in the hardest hit cyclical and value oriented sectors of the market.  We had a good year in 2020, not because we were excellent forecasters, but because we listened closely to what markets were telling us at a time of great stress and allocated your (and our) capital accordingly.  

Ear on the New Year:In some sense, listening to markets is a search for anomalies - prices or statistics that imply a future forecast that makes little sense.  What anomalies do we find interesting for the coming year?  There are two.

  • Interest Rates:  To us, one of the strangest features of global markets is the amount of debt that carries negative yields.  At last count, nearly $18 trillion of debt around the world carries a negative nominal yield to maturity - the highest amount on record.  Over the long term, this makes no sense.  As we move beyond the pandemic, will investors continue to guarantee themselves a loss by investing in negative yielding debt, especially after the economy re-accelerates from its pandemic lockdown?  That seems unlikely to us.  If rates indeed do rise, the principal benefit will be to our financial holdings as higher rates boost net interest income.  Financials are currently the largest sector overweight in our portfolio.
  • Political Polarization:  We live in two different political worlds when it comes to views about the future state of the economy.  The long-running University of Michigan consumer sentiment survey bears this out.  Over the three months ending last week, the share of Democrats who expect a continuous economic expansion over the next five years rose from 27% to 54%.  For Republicans, the opposite.  Expectations for continuous economic growth over the coming five years fell from 60% to 32%.  Can this degree of extreme polarization continue?  Can people forever look at the same set of facts and come to completely opposite conclusions?  It seems unlikely to us.  At some point, our expectations about the future MUST square with reality.  Ultimately growth is growth, and recession is recession regardless of who you voted for.  Over the coming year, it seems much more likely to us that political tensions will decline as the economy actually improves.  It’s worth noting that polarized economic views are not the historical norm.  When another controversial president (Reagan) swept into office in 1981, both Republicans AND Democrats became more confident about the future of the economy.  There is a rich body of economic research that highlights the depressing effect that political polarization has on long-term business investment.  If the degree of polarization declines over the coming year, our industrial and capital investment-related holdings should benefit as companies become more confident about the future and loosen their capital spending purse strings.

Stock Market Leisure Suit:  Finally, it is worth observing that the stock market has become a decidedly unfashionable place to invest.  Over the last 10 years, literally trillions of dollars of investor capital have left equity mutual funds, hedge funds, and ETF’s and gone into cash, bonds, private equity, private credit, venture capital and real estate.  As we wrote recently, the tech bust and the financial crisis occurring in the space of eight years have given rise to a generation of stock market skeptics.  Indeed, over the past year, several financially savvy friends have remarked to us they are looking to buy second homes simply because “they didn’t trust the stock market” with their idle capital.  While it seems unlikely that this skeptical attitude will undergo a wholesale change in the short space of the coming year, it seems equally unlikely that further trillions will continue to flow out of public equities.  At the margin, removing a negative is a positive.

After reading all of this, you may have the impression we are optimistic about the coming year.  Correct.  We are.  Needless to say, we have no special insight on what happens over the next several months.  Our optimism relates to the long term.  In other words, the usual caveat applies: “markets never travel in straight lines.”

OK, Now What Happens… - Saturday, December 05 2020

Yogi Berra Time: One of my favorite Yogi-isms is “I never make predictions, especially about the future.”  Back in March, at the height of pandemic uncertainty, and as global stock markets were melting down, few would have predicted the series of events that unfolded over the balance of 2020.  We certainly did not.  We did, however, make a couple of observations about what we saw in markets at the time and the opportunities that presented themselves as a result. 

  • Babies and bathwater:  As often happens in periods of high uncertainty, stock market babies get thrown out with the bathwater.  In this case, economically sensitive stocks - so called-value stocks - seemed priced as though the pandemic would never end.  On its face, that made no sense to us.  The pandemic would indeed end.  The only question was when.
  • Biotech to the rescue:  It also seemed reasonable to assume that the underlying technical advances in bio-analysis and bio-synthesis - which have been very large over the past decade - would lead to very rapid advances in COVID therapeutics and vaccines.  Using a 20-year-old timeline for vaccine and therapeutic development made no sense to us.  Thus it seemed reasonable that vaccines and therapeutics would arrive much earlier, and with greater efficacy, than many expected back in March.
  • Simon and Garfunkel:  Finally, having invested through the turbulence of 2008, it seemed likely to us that policy makers would provide enough of a financial “bridge over troubled waters” that the pandemic would not morph into a full-blown financial crisis.  Policy makers may be slow to learn in general.  However, they have learned the lessons of 2008 very well.  Central bankers and legislators don’t often see eye-to-eye, except when it comes to avoiding a financial crisis.  Allowing a financial crisis to spiral out of control is a career-ending move for politicians and policy makers.

In short, while we had no idea what was going to happen and when, the odds did seem stacked in favor of a strong value-tilt in the portfolio - those stocks were historically cheap and policymakers and scientists would have our back.  So that’s what we did, not knowing when, if ever, that tilt would pay off.  Since March, there have been two further positive developments that we did not anticipate at the time; namely:

  • Centrism wins:  The message from the recent election season was mostly a centrist one.  Fears of either socialism or white nationalism  - the worst case on both the left and the right - were taken off the table.  Instead, as we see it, the collective wisdom of voters seems to point toward a desire for less confrontation and a more competent professionalism.  This result is market-friendly in the long run.
  • WFH was our ace in the hole:  “Work from home” proved far more successful than even the most optimistic forecasts at the time.  For the 80% of the economy that could take advantage of this, WFH proved to be a godsend.  For the other 20% of the economy that couldn’t, businesses and their customers proved to be quite adaptable to operating in a pandemic.  All in all, the combination of a good internet connection, Zoom, and creative changes to business practices meant that the economy and corporate earnings performed much better than many anticipated back in March.

All of these factors, sparked by extremely favorable vaccine data several weeks ago, combined to make November 2020 our best performance month ever.  Note:  we didn’t predict this back in March.  Instead, we simply noted that the odds seemed heavily skewed in favor of a value-tilted portfolio.  When and where the payoff would occur, we did not know.  As we noted in our March letter, 60% of the stock market’s entire gain since 1927 - a very considerable number - has come on only 13% of all trading days.  November 2020, much to our pleasant surprise, had a good number of those days.

Crossing the Chasm, But to Where, Exactly?: After a very strong month, the natural question to ask is - what’s next?  We have several observations:

  • No Economic Excess This Time:  In general, most recessions stem from economic excesses.  In the last downturn, excess investment and speculation in residential real estate, coupled with excessive leverage in the financial system, led to a deep hole that needed to be filled.  This led to a slow, grudging recovery.  For most of the early 2010’s, businesses and consumers had to “atone for past sins” rather than invest for growth in the future.  In some sense, this mental model is now the default expectation that we all have for recession recoveries - that they are all disappointingly slow.  This time around, that mental model does not fit the current facts at all.  Rather than excess to work off going into the pandemic recession, we had the opposite - robust savings.  One way to measure this is the Private Sector Financial Balance.  In the GDP accounts, this is “net private savings” less “net domestic investment.”  Think of this as the collective checkbook balance for all businesses and individuals. In the ten years prior to the financial crisis, the private sector financial balance averaged anegative 1.4% of GDP - we were investing a a far greater rate than we could pay for out of current income.  Clearly this had to end.  Contrast that with the ten years since the financial crisis.  The private sector financial balance has averaged apositive 5% of GDP - the highest ten year average since WWII.  Not only did we not have excesses going into the pandemic, we actually had a robust cushion.  No past sins means no atonement necessary in 2021.
  • Pent-up Demand: Not only were there no prior economy-wide excesses going into the pandemic, businesses and individuals actually built more cushion as the pandemic hit.  In the second and third quarters of 2020, the private sector financial balance ballooned to record levels; 24% of GDP in 2Q and and additional 13% of GDP in 3Q.  Those numbers are all-time records by huge margins.  Think of it this way - every cruise not taken, every flight not boarded, every hotel room not booked this year, in a way, still sits in our collective bank accounts.  This robust private checkbook balance will turbocharge economic growth once we begin the process of vaccinating the population and re-opening the most impacted parts of the economy.  While there are clearly those who have been greatly affected by the events of 2020, the collective economy has survived quite well and we will enter 2021 with a financial tailwind.

What could this mean for the stock market over the next few years?  A few thoughts to consider:

  • Stock prices follow profits: In the three years following the financial crisis, earnings for the S&P 500 grew 80% cumulatively.  Remember this was a slow and grudging recovery - so we should consider this to be the lower bound of possible profits growth this time around.  100 - 120% growth from the 2Q 2020 trough is more likely given the early evidence of a strong earnings recovery already underway (see below).
  • Positive early evidence:The profits figures from the GDP accounts usually provide a good early read of where S&P 500 accounting profits are headed.  The GDP figures strip out the usual accounting tricks that can smooth out the ups and downs of GAAP earnings.  The 3Q GDP profits figure released last week hit an all time high - eclipsing the previous high from Q4 2019.  This record high is a very positive development following the massive hit to profits taken at the height of the pandemic in the first half of this year.  As a point of reference, the profits hit in the first half of 2020 was nearly as large as the hit taken in 2008 - the largest on record.  That profits have rebounded so quickly and to such a large degree bodes well for the future.  A Christmas anecdote:  in a way that should not be entirely surprising, Christmas tree sales typically correlate with economic growth in the 4th quarter.  This year, Christmas tree sales are off to a record start, with sales up nearly 30% over last year (according to an ISI survey) and prices rising 7%.  If any of you own a Christmas tree farm, congratulations!
  • Interest rates are likely to remain low:  Global central banks - the Federal Reserve especially - have altered their monetary policy frameworks to emphasize full employment even at the expense of temporarily overshooting on inflation.  This shift means that rates will rise only after a truly long and durable growth cycle.  Over the next few years, this stance likely will insulate the stock market from any concerns over interest rates holding down P/E multiples.
  • Investor sentiment still subdued: As we wrote last month, many measures of investor sentiment have remained squarely in the bearish camp.  A month ago, the AAII survey of individual investor sentiment had remained in bearish territory for 34 straight weeks - the longest period on record by far.  Institutional investor sentiment also remains downbeat.  The State Street Investor Confidence Index remains well below its average over the last 20 years.  While November’s rally has caused animal spirits to rise a bit, caution still rules.  This means there is plenty of dry powder to fuel future gains. 
  • Framing the potential:  From the end of the financial crisis to the beginning of the pandemic, the S&P 500 traded at an average multiple of 17x earnings.  If we assume 1) a range of possible profit recovery scenarios over the next three years from 80% (similar to that seen in the post financial crisis period) to 120% (based on the strong early profit recovery seen in the GDP accounts) and 2) a 17 multiple of earnings, then the S&P 500 could return between 10 and 30% over the next two to three years.  Remember, we don’t manage our portfolios with explicit target prices for the overall stock market.  It is useful, however, to understand whether the overall environment will prove to be a headwind or a tailwind to our concentrated individual stock positions.  From what we see, a tailwind, perhaps even a strong tailwind, is far more likely than a headwind - at least looking out over the next few years.
  • Value remains cheap:  Despite our value tilt finding some love in the stock market this month, value as a style remains extremely cheap.  Depending on the measure, the “value of value” is currently between the 6th and 17th percentile of its historical valuation range.  As a result, our portfolio retains its value tilt and we remain optimistic about its potential over the next few years.

One word of caution. This is an optimistic scenario - over the long term.  It is important to remember that markets never travel in straight lines and on the path to what we believe will be a good outcome over the next several years lies many twists, turns and unexpected short term bumps.  As always, we will remain prepared to seize on those opportunities as and when they arrive.

Politicians Make Lousy Investors - Thursday, November 05 2020

Big picture:  As this letter goes to press, it is election day in America.  Given that, shouldn’t we toss our hat in the ring and make a prediction?  Perhaps we should tell you how we voted, and encourage you to do the same?  Absolutely not.  This letter is not the place for political opinions, ours or anyone else’s.  In our investing work we try very hard to set aside whatever political opinions we may have and look at the landscape as it actually is.  Too often we find that investors place way too much emphasis on who occupies the Oval Office, or which party controls Congress.  This isn’t to say that politics has ZERO impact on markets.  But it is to underscore that the investment implications of political change are much more complex than simply D vs R.  We have three branches of government, 50 state governments, and dozens of regulatory agencies, all of which help shape the business and investment landscape going forward.  What’s more, good businesses have always shown a remarkable degree of adaptability when faced with political and regulatory change, rendering simple, politically-driven investment themes moot in the long run.  The facts and the data drive what we do, as it should, even if our personal political opinions might sometimes run in the opposite direction.  Political opinion driven investing is a sure pathway toward poor returns.

Case in Point:In late 2016, the commonly held investment wisdom was that a Trump victory would be good for the so-called MAGA sectors.  There would be a domestic industrial renaissance as factories “re-shored” their operations; domestic energy production would flourish; the general regulatory burden would decline, benefitting industries that were seen to suffer under the Obama administration, especially the financial sector.  On November 9th 2016, the day after the last presidential election, Goldman Sachs’ US equity strategist David Kostin wrote a piece titled “The U.S. Equity Implications of a Trump Presidency.”  In it, Kostin counselled investors that cyclical stocks would outperform during a Trump presidency - industrials, energy, financials.  In a MAGA presidency, the old economy would triumph over the new.  Four years later, we can now see that nearly the opposite came true.  The only sector that outperformed the broad market was technology, a sector traditionally aligned with the Democrats.  The old economy MAGA sectors lagged the market, in some cases very badly.  None of this is to point fingers at David Kostin.  He is a very smart analyst.  My goal here is merely to point out how difficult it is to link political changes with investment outcomes.  Too many other factors swamp the idea that a particular occupant of the Oval Office will lead to a particular investment outcome.  In the case of the last four years, it is almost as though Trump won the White House but Hillary’s stocks won the market.

We don’t have an opinion as to what today’s election outcome will be.  We simply observe that the polls and the betting odds favor the Democrats.  That’s as far as we go in our political analysis.  For each stock in the portfolio, however, what matters far more than politics are the key features of companies we like: valuation, management skill, product positioning, and balance sheet strength.  Whoever occupies the White House on January 20th, those characteristics are the enduring drivers of value creation for shareholders.

Calling John Templeton - Thursday, November 05 2020

Legendary investor John Templeton once remarked that “bull markets are born in pessimism, grown in skepticism, mature in optimism, and die in euphoria.”  I like this quote because it captures well the sometimes paradoxical nature of markets.  Markets are nothing more than a collection of people agreeing to exchange securities at prices that reflect what they believe to be an accurate state of the world.  When things look bleak, most people sell under the assumption the future will remain bleak.  When things look great, people buy under the assumption that the future will remain great.  In reality, neither assumption is a good one.  Bleak periods often give way to better times just as great periods can sometimes give way to trouble.  In markets, however, this sort of  “thinking in a straight line” - that good times will last forever and bad times will never end - leads to stocks getting overpriced in good times and underpriced in bad times.  Templeton’s quote speaks to the fact that it is our own overreaction to the present that creates the very disconnect between price and value that drives good investment performance.  

On election day 2020, where do measures of investor sentiment stand?  Squarely in the pessimistic camp.  While there is no perfect measure of investor sentiment - they all have various flaws - the American Association of Individual Investors has published a bullish/bearish sentiment reading weekly for the last 35 years.  Despite its flaws, it is one of the oldest surveys around.  This past week marked something of a milestone for this survey.  Bearish sentiment exceeded bullish sentiment for 34 straight weeks - the longest on record by far.  How has the stock market performed after long streaks of bearish investor sentiment?  Very well.  In the prior six episodes when bearish sentiment exceeded bullish for ten weeks or more, the S&P 500 returned an average of 5.4% over the following 3 months compared to 2% for all other three-month periods.  While we don’t know what today’s election will bring, nor do we know the precise date when our lives will return to normal following the COVID pandemic, we do observe that investor sentiment is already prepared for a bad outcome.  If John Templeton were still with us today, I would imagine him to be leaning bullish.

Software Ate the World. Now What? - Monday, October 05 2020

Big picture: Marc Andreesen - software engineer, founder of Netscape in the late 1990s, and more recently the founder of Andreesen Horowitz, one of the most renowned VC firms in Silicon Valley - in 2011 penned a now famous essay:  “Why Software is Eating the World.”  Andreesen’s main point:  stop worrying about what you pay for an investment in a truly world-changing software or services company.  We are at the early stages of a long-term re-allocation of revenues and profits in the business world from hardware to software, from the tangible to the intangible.  Andreesen put it this way:

  • “But too much of the debate is still around financial valuation, as opposed to the underlying intrinsic value of the best of Silicon Valley’s new companies. My own theory is that we are in the middle of a dramatic and broad technological and economic shift in which software companies are poised to take over large swathes of the economy.”

Over the nearly 10 years since Andreesen’s essay was published, he has been proven more than right.  These innovative companies have created tremendous wealth for their founders, their VC investors, and eventually for their public shareholders.  They have upended traditional industries and have created entire new ones.  Remember, in 2011, “the cloud” was still something that produced rain, not a business model.  As a side note, Andreesen should have tipped his hat to the Wu-Tang Clan and titled his essay “S.R.E.A.M.”  - Software Rules Everything Around Me.  But that’s a topic for another day.

What's next: Ten years into software eating the world, it is time to consider what the next 10 years may hold.  Is there more of the world left for software to eat?  Will software companies just turn to eating each other?  Should we now question Andreesen’s fundamental premise - forget valuation, just buy innovation and potential growth any any price?  

To answer some of these questions is it worth remembering a few basic things. 

  • First, simply being in the software industry does not in some magical way repeal the microeconomic fundamentals of business in a competitive marketplace.  Product quality, market opportunity, competition, and management talent, all matter, just as they do in, say, the steel making industry.  In his essay, Andreesen touted video game maker Zynga as a disruptive game company delivering its products over the internet, especially to mobile phones.  Andreesen saw this as upending the traditional game makers like Electronic Arts (EA), which at the time was still delivering its console-based games on CDs.  Zynga, which was still private in 2011, grew revenues 100% over the prior year.  EAs’ revenues shrank 11% over the same time period.  This contrast seemed to prove Andreesen’s point.  But, over time, product quality and innovation still proved crucial to success, regardless of the distribution format.  Zynga turned out to be a one-hit wonder (FarmVille) while EA subsequently doubled down on high quality content and went on to great success.  Zynga went public in early 2012 at $12/share.  That year, the company generated $1.3 billion in revenue. Today it trades for $9/share and is expected to generate $2.2 billion in revenue.  EA on the other hand, generated $3.7 billion in revenue in 2012 and its stock traded as low as $11/share that year.  This year, EA is expected to generate $6 billion in revenue and its stock trades for $130/share.  Despite its buggy whip status in 2012, EA was clearly the superior investment.  Product quality and innovation still matter.
  • Second, the Zynga vs EA story points out another issue with Andreesen’s philosophy of growth at any price - it only works some of the time.  Growth at any price must come with truly world-beating business success in order to ensure investment success.  Not all companies, even ones in the software business, can achieve that.  Given reasonably similar business results, valuation still matters, at least over long periods of time.  Prior to its 2012 IPO, Zynga had grown its sales 10-fold in three years.  From their IPO to today, Zynga has grown its sales at a 6.5% compound rate, a material deceleration from its pre-IPO growth.  EA, over that same time period, also grew its sales at the same 6.5% rate.  Essentially, the two companies performed identically from 2012 onward.  But valuation was the crucial difference.  In 2012, EA stock was valued at 1x sales.  Zynga came public at 7x sales.  From that point until today, EA shareholders earned a 36% annualized return.  Zynga shareholders lost an annualized 3.5%.  Same business performance, vastly different stock market performance.  The reason?  Valuation.  

Yes, but: While the “Zynga vs EA” example above underscores that product quality, innovation, AND valuation still matter, one does have to step back and marvel at the overall success of the Andreesen’s “software eats the world” observation from 2011.  While he did get Zynga vs EA wrong, his general point still proved prescient.  The stock market has taken note.  Major stock market indices like the S&P 500 are now nearly as tech-heavy as they were at the peak of the tech bubble in 2000: 28% of the S&P 500 is now composed of technology stocks compared to 32% in 2000.  The long term average tech weight in the S&P 500 is 16%.  

The Biggest Loser:  This reallocation of market cap toward the tech sector had to come from somewhere.  The biggest donor was the financial sector, especially banks.  Today, financial stocks comprise just 10% of the S&P 500, well below their long term average weight of 15%. Just prior to the bursting of the housing/mortgage bubble in 2006, financials comprised 22% of the S&P 500.  For context, financial stocks today carry the same weight in the S&P 500 they held at the market’s low in March 2009 - a time when Citigroup and Bank of America both traded for under $5/share and their continued viability was questioned.  It is also worth noting that bank stocks in 2020 have underperformed the S&P 500 by the greatest amount since 1936.

How Much Should the Winners Win?  To be sure, this reallocation of market cap from financial to tech stocks is at least partially justified.  Many tech companies, especially some of the larger ones, produce massive amounts of free cash flow.  In fact, we own large positions in two of those - Apple and Facebook.  Financial companies, on the other hand, banks in particular, still labor under the long shadow of the financial crisis and suffer from shorter-term pandemic pain.  More specifically, tech companies in aggregate today trade at a 17 point P/E premium to financial companies, 7 points higher than the long-term average.  So in some larger sense, the stock market is forecasting a much better than average future for technology companies compared to financial companies.  The question is,  from here, does that still make sense? 

Does David Always Beat Goliath?  Unlike in the fable, in the real world of business, the plucky young upstart doesn’t always win.  That certainly was true in the case of Zynga vs EA.  In the financial vs tech debate, there is another David vs Goliath worth considering: Paypal vs Bank of America.  Some stats to consider:

  • Business Basics:Bank of America, as everyone knows, is a large global firm engaged in retail, commercial, and investment banking.  Last year, BAC generated $90 billion in net revenue, half from fees and half from net interest income.  Paypal is a payment services provider.  Most of its business comes from enabling merchants to accept payments - credit card, debit card, and money held within Paypal accounts - for their goods and services.  Paypal also offers a person-to person payment service: Venmo.  Finally, like a traditional bank, Paypal extends credit to small merchants and consumers.  Its loan portfolio currently totals $5 billion.  Last year, Paypal generated $19 billion in revenue, 90% from transaction related fees, 10% from net interest income.  At a very high level, the two companies bear some similarity.  Though the mix is very different, BAC does everything that Paypal does - plus a whole lot more.  Notably, looking only at the payments business, BAC and Paypal are both about the same size.
  • Valuation:Paypal is a member of the tech sector and trades at 44 times estimated earnings, a premium to the overall tech sector multiple of 32 times earnings.  The company carries a market cap of $214 billion.  Bank of America, a member of the financial sector, trades for a paltry 13 times earnings, roughly in line with the overall financial sector.  BAC carries a market cap of $202 billion.  Paypal, with 1/5th the revenues, is worth more in the stock market than Bank of America.  Another way to think about valuation is “pre-tax cash flow return on investment” - i.e. the amount of cash the business generates each year relative to the market value of the company.  Think of this measure as how much you are paying for the basic underlying economic engine of the company.  Last year, BAC generated pre-tax, pre-provision earnings of $35 billion.  Compared to its market cap, BAC generated a 17% pre-tax cash flow return on investment.  On that same basis, Paypal generated $4.6 billion in pre-tax, pre-provision earnings yielding a 2.2% pre-tax cash flow return on investment.  Purely on that basis, BAC looks like a bargain.
  • What is Growth Worth?  Of course, Paypal is growing leaps and bounds faster than Bank of America.  From that perspective, the rational investor should pay a higher multiple for Paypal’s current earnings. Paypal has grown, and is projected to continue to grow, 20% annually.  Bank of America has grown more slowly with pre-tax, pre-provision earnings growing only 6% annually over the last 5 years.  The question becomes, how much is faster growth worth?  And, how likely is that projected growth to materialize?  There are several ways to get at this.  One way is to ask, how long would it take to “earn back” the current market cap if recent trends stayed in place?  For BAC, if they continue to grow pre-tax, pre-provision profits at 6%, they would earn back their market cap in five years.  If Paypal continues to grow at 20%, they would earn back their market cap in 13 years.  So even assuming that Paypal’s current growth continues, BAC is a superior investment.
  • Can Rapid Growth Continue Forever?  If Paypal continued to grow 20% over the next 13 years, the company would have twice the combined pre-tax profits that Visa and Mastercard have today - both pre-eminent leaders in the payments space.  It seems likely that “the law of large numbers” would kick in for Paypal well before then.  It is also worth pointing out that Visa and Mastercard, while both great companies (we own Visa), have grown their pre-tax profits over the last five years between 9-10% per year, half the rate of Paypal.  Based on this, it seems very unlikely that Paypal could achieve 20% growth per year for the next 13 years.  For that to happen, major competitors in the payments space would simply have to “give up.”  In a well-funded and profitable industry, betting on the competition folding seems foolish.  Paypal spent $2.1 billion last year on “technology and development” with an eye toward continued innovation.  The competitors are not standing still. Bank of America spent nearly $11 billion in technology and development (though not all earmarked for the payments area).  The competitive results show.  In the P2P payment space, Paypal’s Venmo unit processed $37B in payments in the most recent quarter.  Bank of America’s P2P offering, Zelle, processed $32 billion in payments.  It is unlikely that the payments industry will become a winner take all industry.  The competition will not roll over very easily.

As we have written in the recent past, we like to find disconnects between the stock market price of a business and the value of the actual business itself.  We have nothing against Paypal.  It is a fine and generally well-run company.  However, the disconnect is that expectations for BAC are overly dire and that those for Paypal are overly rosy. 

Housing IS the Business Cycle - Saturday, September 05 2020

Big picture:In 2007, UCLA economist Ed Leamer penned a now famous paper “Housing IS the Business Cycle.”  Just as the great housing bust/financial crisis was getting underway, many observers and analysts dismissed the idea that an over-leveraged housing sector could cause a major economic downturn.  Housing - or “residential fixed investment” as it is called in the GDP accounts - accounts for only 4% of economic activity.  How could such a small fraction of the economy lead to a major economic downturn and subsequent global financial crisis?  Leamer’s key insight was that housing, although a small part of the economy over the course of an entire economic cycle, at turning points in the economy, housing punches well above its weight.  In fact, Leamer’s analysis showed that since WWII, in the year prior to a turn in the economy, housing contributed an average of 25% of the change in economic growth - the largest single contributor.  So, we would be well advised to pay close attention to what housing is telling us at key points in the business cycle.

Current Housing Stats:  What is the current state of play in the housing market?  The stats below tell the tale.

  • Housing Starts:In July, the industry started construction on 1.5 million new single family homes.  Excluding January 2020, this was the fastest rate of new home construction since 2007.  It is worth noting that this level of new home construction is not an unsustainable bubble.  It sits right on the average level of monthly new home construction seen since 1960.  This suggests more upside to come.
  • Housing Affordability:  The National Association of Realtors each month publishes a housing affordability index.  This index tracks the affordability of the median priced home for the median income buyer given currently available mortgage rates and terms.  An index level of 100 means that the median income buyer would just squeak by in being able to afford the median priced home.  In mid 2006, at the height of the housing bubble, the index touched 100.  Today, the index sits at nearly 170, well above its long term average (since 1986) of 140 - another indicator suggesting housing is in a good position to continue its upswing.
  • Home Prices:  The memory of the housing bubble and bust casts a long shadow.  Rising house prices naturally stokes skepticism that it’s all about to come crashing down as it did in 2007.  But there is a “normal” level of house price appreciation that is sustainable.  Since 1988, the average annual rate of house price appreciation has been about 4% nationwide - as measured by the Case-Shiller index.  Notably, in 2005,  at the peak of the housing bubble, house price appreciation reached 15%, clearly an unsustainable level.  Today, the Case Shiller index of house price appreciation sits right on its long-term average - 4%.  Another word for average is “sustainable.”
  • Housing Related Businesses: In addition to the direct economic effect of housing construction, we also should look to see how housing-related businesses are faring.  Home Depot and Lowes are two good examples.  In the most recent quarter, both companies reported amazingly strong same store sales growth - up 25% for Home Depot and 35% for Lowes.  While clearly these are unsustainable rates of growth, they do indicate a solid base for continued growth in the housing market.
  • Broader context:While the indicators above paint a robust picture for the housing market, it is worth noting that housing is not alone in showing robust signs of future growth.  The auto industry often follows the same dynamics that the housing market follows.   One leading indicator of the health of the auto industry is the level of used car prices.  If there is healthy demand for used cars, there is usually healthy demand for new cars as well.  Manheim Auto Auctions is a nationwide clearinghouse for used cars.  They publish a monthly index of used car prices.  This month, the Manheim index hit an all time high.  Like housing, the auto industry, which came to a complete stop at the height of the pandemic in March and April, is now growing strongly. 

The Bottom Line:  At the risk of understatement, 2020 has been an unusual year - one that has caused some investors to run for the hills.  A pandemic, civil unrest, and contentious presidential election have all yielded headlines that makes investing in stocks feel excessively risky.  However, if we ignore the headlines and follow the data closely, especially the housing data, we are led to a different conclusion - that the economy is on a surprisingly firm footing and is likely to continue growing.  As we have written in recent months, that observation has led us to tilt the portfolio toward recovery and away from the “pandemic winners”.  While that tilt has yet to fully pay off, our confidence in it remains high. 

The Paradox of Safety - Wednesday, August 05 2020

Big picture: In the investment business, generally speaking, safety is good.  No one intentionally sets out to lose money.  Intelligent investors always need to be mindful of the downside.  But can the quest for investment safety reach such a fever pitch that the high price of safety renders it risky?   This month, the evidence says the answer is yes.

Measurement Questions:  Valuing stocks - from a purely mechanical perspective - is easy.  Getting it right, however, is much harder.  Among other things, selecting the right valuation paradigm is difficult and fraught with the potential for cherry picking an answer that suits one’s pre-existing opinion.  Should we compare price/earnings ratios?  Discount future cash flows?  What about using multiples of book value? Should we compare a stock’s valuation to the overall market of all stocks or to the company’s own history?  All of these questions can lead to different perspectives on whether a stock seems expensive or cheap. 

One major source of potential error can come from a simple extrapolation of the recent past.  Companies’ earnings never grow in a straight line.  They go through cycles of expansion and contraction.  Assuming recent strong earnings to be permanent, for example, can lead to an overly rosy estimate of what a stock is worth, and vice versa.  One way to deal with this problem of “recency bias” is to compare a stock’s price to the average of its earnings over some longer period of time.  Economist Robert Shiller popularized this view with what has come to be known as the CAPE (Cyclically Adjusted P/E) ratio: the ratio of a stock’s price to the average of its earnings over the prior 10 years.  Ten years, Shiller believes, is a sufficiently long period of time to smooth out the inevitable ups and downs of a company’s lifecycle. 

When is Price too High?  To be sure, the CAPE ratio is not a uniquely accurate measure of value.  It is just one of many tools that can provide a useful view of what a stock is worth.  But it can be of particular use when recent earnings are subject to large swings - as is currently the case.  If we assume that the current pandemic is not permanent (a good assumption in our opinion) then viewing current stock prices against the backdrop of the average of the last 10 years’ earnings can provide a more useful guide to a “normal” valuation than can measuring against “pandemic driven” earnings.

Clearly, the current pandemic has benefitted some companies and sectors while at the same time hurting others.  More generally, the earnings and share prices of economically-sensitive cyclical companies have suffered while the opposite is true for perceived safe-havens and “pandemic beneficiaries.”  But how do those two groups - the pandemic losers and the pandemic winners  - look when measured against by their CAPE ratio?  To answer that question, let’s first divide the sectors of the S&P 500 into two groups: the perceived-to-be economically stable and safe sectors - healthcare, telecom, technology, utilities, and consumer staples and the perceived-to-be-economically sensitive sectors - financials, consumer discretionary, energy, and industrials.  The safe and stable stocks are currently trading at a 150% CAPE-ratio premium to the economically sensitive sectors - a level matched only at the height of the tech bubble in June 2000.  The current “safety premium” even exceeds that seen in March 2009 at the height of the financial crisis when it measured 137%.

What Happens Next:  In prior periods, when the “price of safety” reached these rarefied levels, what happened to subsequent returns?  In the five years following the safety bubble in June of 2000, economically sensitive sectors (as we defined them above) outperformed the economically safe and stable sectors by a cumulative 47%.  In the five years following the safety bubble in March 2009, cyclical stocks outperformed safety by a cumulative 77%.  Clearly, these are just two data points, but they do fit with investor behavior more generally.  At the depths of bad times, investors are fearful and want out of anything perceived to be risky, no matter the price.  Out of this fear is born the opportunity to earn superior returns after the crisis has passed.

As we mentioned several months ago, we don’t know precisely what the future holds.  The current pandemic presents the world with a unique set of challenges.  But, it is worth recognizing that each “safety bubble” also had its own unique set of challenges as well.  Recall that in early 2009 it seemed that the entire banking system might cease to function.  Is that more worrying, or less worrying than a global pandemic?  Impossible to say, but each crisis sows the seeds of its own resolution.  In the global financial crisis it was aggressive central bank actions and bank recapitalizations that helped turn things around.  In the current case, central banks, government stimulus, and above all, scientific progress likely will turn the tide.  Whatever the facts of the particular case, the CAPE ratio, and the high price of safety is leading us to tilt the portfolio in favor of recovery and away from safety.  In our view, the high price of safety has paradoxically rendered it too risky.

Strange Times: Real Yields - Wednesday, August 05 2020

Call us old fashioned:  To us, there is something truly strange about bonds that carry negative yields.  Today, a bit more than $15 trillion in bonds trade at prices that result in a negative yield to maturity.  No investor should want to lose money.  Yet, in light of the huge quantity of debt that carries negative yields, there evidently must be large pools of capital that willingly sign up to guarantee a small loss.  Weird. 

In the weeds: Of course, there are technical reasons why some investors may be OK with negative yields.  For example, they may be making an implicit bet that we are entering a period of deflation so that in real terms, negative nominal yields become positive real yields.   And it is of course true that any investor’s ultimate long-term goal is to make money in real terms after accounting for the effects of inflation.  Also, there may be non-domestic investors who, though the magic of currency swaps and forwards, can transform a negative yield in Euros, for example, into a positive yield in Yen.  But it would seem unlikely that these kinds of “technical investors” can, in aggregate, be the cause for over $15 trillion in bonds to trade with negative yields.  There must be people with actual, non-technical money that consider this a good idea.  Put us in the “we don’t get it” category.

Yes, but: So far, the US has escaped the grip of negative nominal bond yields.  However, since the beginning of the pandemic, yields on inflation protected US Treasuries (TIPS) have fallen below zero - meaning investors are locking in a loss in real terms over time.  For the first time in history, 30-year TIPS carry negative yields.  As the month ended, ten year TIPS carried a 1% negative yield, the lowest on record.  This is truly The Twilight Zone in the capital markets.  It is worth noting the last time 10-year TIPS traded close to these levels was in 2012 during the Euro Debt Crisis/US  government shutdown.  In the following year, the S&P 500 returned 32%.  We are not claiming that lightning will strike twice and 2021 will turn in record stock market returns.  Instead, to us, perceived to be risky securities - like stocks, where you at least stand a chance to make money over the longer term, seem safer than supposedly safe securities that guarantee a loss.  But then again, maybe we’re just old fashioned.

Election Tradeoff: Uncertainty vs Taxes - Sunday, July 05 2020

We are four months away from the upcoming presidential election.  Presidential elections in normal times are cause for market worries.  Given recent events, and the nature of this particular election, investor worries have reached a fever pitch, no matter what side of the debate you are on.  From the perspective of the stock market, the simple, knee-jerk analysis is this:  Biden means higher taxes and regulation.  That’s bad for markets.  Trump means status quo.  That’s good for markets.  Can it really be just that simple?  Unlikely.  Markets are “complex adaptive systems” - meaning that many variables impact the outcome, and the variables themselves interact with each other often in unpredictable ways, thereby rendering the outcome difficult to distill into a simple equation.  If markets really were that simple, wouldn’t there be thousands of Warren Buffets instead of just one?

Disclaimer:  Do not take any of what follows as an endorsement of any particular candidate. The stock market doesn’t care in the slightest what our political views are, nor should you.  Instead, this is an attempt at understanding how the stock market might respond to what happens in the political realm and to do so with as much objectivity as we can muster.

Side Note: What is Uncertainty?  Before we go further, it is worth defining what we mean by “uncertainty.”  Uncertainty is best understood as being distinct from risk.  Risk is where we know the probabilities of the various outcomes flowing from choices we make.  Think of risk like playing blackjack.  We know the number of cards, we know our hand, thus we can calculate the probability of winning or losing associated with taking another card.  Uncertainty is different.  Uncertainty means we truly don’t know the probabilities of the various outcomes that flow from the choices we make.  We are truly operating in the dark making wild-guesses.

Why it matters: The economy as a whole - businesses and consumers - is built around making risk-based decisions.  Investors in a new business judge the probability of success based on what they believe to be a well-defined probability distribution.  Consumers buy a new car based in part on the probability of that car functioning reliably.  On the other hand, there is a rich body of economic research related to how uncertainty depresses economic activity.  When a business or a consumer has no idea of the probability of success, they have a strong tendency to do nothing.  That depresses economic activity.  A recent study led by Nicholas Bloom at Stanford estimated that “uncertainty shocks” can lead to as much as a 2.5% decline in GDP.  If economic actors don’t know the game, they don’t play.  More specifically, economists at the Fed recently looked at the impact of China trade policy uncertainty on investment and capital spending.  They concluded that business investment was depressed by 1.8% as a result of the 18-month long drama-by-tweet that finally concluded with the Phase 1 trade deal with China.  Not knowing the odds, businesses sat on their hands.  What CEO would want to make a long-term investment when the chance of success might change with every new tweet?

Measuring Uncertainty:  Helpfully, economists at Northwestern, Stanford, and the University of Chicago (Baker, Bloom, and Davis) have constructed an index that measures the degree of economic uncertainty in the U.S. going back to 1985.  Under Trump, economic uncertainty was 25% higher than average, the highest of any administration since the inception of the index.  The lowest was seen during Bill Clinton’s administration when economic policy uncertainty was 21% below the long term average.  Other presidents rank somewhere between those two poles with George W. Bush ranking below average in uncertainty and Obama ranking above average in uncertainty.  Fittingly, the economic uncertainty associated with George H.W. Bush’s administration sits right on the average.

Uncertainty or Taxes: Pick Your Poison: As we see it, through the lens of the stock market, the upcoming election is not a simple Biden=higher taxes=bad equation.  Instead, the choice is between high levels of uncertainty in a second Trump administration and higher taxes in a Biden administration.  Put differently, Biden is likely to be negative for earnings (higher taxes) but good for multiples (less uncertainty) but Trump is likely to be good for earnings (lower taxes) but bad for multiples (more uncertainty).  On net, the stock market, beyond whatever initial knee-jerk reaction it might have the day after the election, might look at these two negatives as roughly offsetting each other.  From the stock market’s point of view, the biggest surprise in this upcoming election might be how little surprise we end up experiencing.

Signposts on the Road to Recovery - Sunday, July 05 2020

We have little history to draw on when it comes to understanding the economic impact - and the probable outcome - of the current pandemic.  Worse still, most of the traditional economic data at our disposal is reported with a lag measured in months and sometimes quarters.  With the rapidly changing situation we are facing, we need to throw out the old playbook and look at non-traditional near-real-time indicators of economic health.  What follows is a run-down of what we see today:

Used Car Prices:  Historically used car prices are a good leading indicator of the health of the automotive industry with rising prices a strong indicator of health.  Manheim Auto Auctions acts as a clearinghouse for most of the used cars in the country - think of them as the NYSE for used cars.  Last week, Manheim’s index of used car prices hit an all-time high, rising 4% from a year ago and up 16% from the lows seen in March.

Rail Car Volumes:  Railroads carry an enormous amount of the country’s freight. The Association of American Railroads releases data weekly on the volume of freight shipped.  Freight volume, as you might expect, is a good leading indicator of economic health.  Intermodal freight - the stuff carried in standardized steel shipping containers is most relevant to goods used by end consumers.  In the most recent week of data, intermodal carloads were up 5% from a year ago and up nearly 57% from the lows seen in early April.

Shipping Rates:  Ships carry a large proportion of global trade and, naturally, shipping rates are a gauge of global economic health.  The Baltic Dry Index is a daily measure of global shipping rates.  This index is up 46% from a year ago and up nearly 350% from the lows seen in early May.  Clearly, this is a volatile index, but it’s current direction is clear - up.

Copper Prices:  Copper is an incredibly widely used industrial metal.  Housing, electronics, automotive, and commercial construction are among the many heavy users of copper.  Some refer to the metal as “Dr. Copper” given its track record of rising and falling almost in lock step with the economy.  Copper prices are flat year over year and up 27% from the lows seen in late March.

Apple Mobility Index:  Apple publishes an index of mobility of people with iPhones.  This is a new and unique dataset reaching back only to mid-January of this year.  The idea being that the more people are moving around, the greater the level of economic activity.  Since we don’t have a long enough data set to make year over year comparisons, suffice it to say that the index is up sharply from levels seen in January of this year and up even more strongly from the lows seen in late March and early April.

Credit Card Spending:  J.P. Morgan releases a weekly index of spending seen through their network of credit and debit cards.  That index currently is down 10% from a year ago but up 30% from the lows seen in late March.  Almost all of the decline seen in the year-over-year number is driven by airlines, hotels, restaurants and related categories.  Outside of those categories directly impacted by the virus, spending seems surprisingly strong in light of the current situation.

Conclusion:  As best we can tell, these unconventional data sources are consistent with the optimistic scenario for the recovery we painted last month.  Could it change?  Of course.  We are definitely not in the clear yet.  As we pointed out last month: “What could go wrong this time that would derail a V shaped recovery?  Plenty.  The viral outbreak could re-accelerate requiring renewed economic shutdowns.  The rapid progress being made on drug therapies and vaccines could come up short.  The trade tension with China could take a turn for the worse, especially given that we are in an election year.  Finally, as this letter goes to press, the George Floyd-triggered unrest could restrain consumer spending and cause another viral outbreak.”  All of these concerns remain true and we continue to look at the data as dispassionately as we can.  For now, optimism remains our interpretation of the data we see.  For the portfolio, this means we have retained the “pro-recovery” tilt we introduced in March with a bit more cash than we had a month ago.  More on this below.

To V or Not to V: That is the Question - Friday, June 05 2020

As the stock market has rebounded in April and May, much ink has been spilled by economists and strategists pontificating on the shape of the post-COVID economic recovery.  Optimists have claimed it will be shaped like a “V,” with a sharp rise matching the sharp decline.  Self-proclaimed realists have said that a V is impossible for certain reasons (the reasons vary depending on the person doing the forecasting) and that the recovery must be a shaped like a “U” or “NIke Swoosh” with an elongated period of bumping along the bottom followed by a gradual and sub-par recovery.  Pessimists have even claimed there will be no recovery, and we are in for a sort of medieval-style “L” shaped experience.  All decline, no recovery.  Where is the broad mass of opinion on this topic?  My guess is that it lies in the “U” or “Nike Swoosh” camp with a few pessimists looking for a return of the Middle Ages.  There are almost no optimists looking for a V shaped recovery.  In a recent survey of 31 professional economists, only one saw a V shaped rebound.  The title of an economic research note from J.P. Morgan summed it up best: “V is for Very Unlikely.”  

All of this has led to a deep sense of unease and disorientation among investors.  The stock market has (almost) traced out a V shape while the professional economic forecasting community has nearly ruled out the possibility of the economy doing the same.  Market pundits then resort to one of several tired, old explanations, especially this one: “the Fed is manipulating the market and it’s all a house of cards waiting to collapse.”

Our thought bubble:  We find most of this debate, especially in the way it is captured in soundbites in the media, to be super unhelpful.  There are several very important things missing in the midst of all this hand-waving.

  • Which Econ Stat Are We Talking About?  You can measure an economic recovery in many ways - GDP, employment, corporate profits, etc.  While all are related, they can move at different rates, at different times, for different reasons, and with different investment implications.  We should be clear about which stat we are measuring and why.
  • Are We Talking Levels or Growth Rates?  This is an important distinction.  If, for example, GDP declines by 40% in the 2nd quarter and then rises by 40% in the 3rd quarter, then someone who cares only about growth rates will say we have just had a V shaped recovery.  Someone who cares about levels, on the other had will disagree.  A 40% decline followed by a 40% rise doesn’t get you back to the same level.  
  • What Does History Tell Us? Most pundits use a single reference point - the recovery from the 2008/09 Financial Crisis.  In some ways, the 2008 experience was historically unique.  What does a longer look at the historical record tell us?  As a related issue, few pundits discuss the differences between a “normal” recession versus a “pandemic” recession.  Or, as econ geeks would have it - the difference between endogenous and exogenous economic shocks.

Given all of this confusion and lack of specifics, we thought it would make sense to cut through the noise.  Here is our attempt to bring clarity out of confusion.  A few assumptions first:

  • Corporate Profits Matter Most:  We invest primarily in the stock market.  Over the long term, stock prices are propelled mainly by corporate profits.  Other things matter too - interest rates and regulation, for example - but less so and in more indirect ways.  So we should measure the shape of an economic cycle principally by the shape of corporate profits.  Aggregate GDP is worth keeping an eye on but it can often be too broad a measure to be highly useful for investment purposes.
  • Employee Compensation also Matters, but for Different Reasons:  Consumer spending represents 70% of GDP.  The main driver of consumer spending is consumer incomes earned through employment.  Over the very long term, profits and compensation move in the same direction.  No company can prosper without sharing at least some prosperity with its employees.  But in the short term, especially at turning points in the economy, they can move in opposite directions.  Examining this occasional disconnect can help us understand why the stock market can sometimes rally even when the average consumer feels awful.
  • Levels Matter More than Growth Rates:For aggregate economic statistics, this should be somewhat obvious.  When the economy hasn’t reclaimed it’s pre-recession level of, say, corporate profits, we shouldn’t declare victory because it grew at a high rate from a low level.  In aggregate, profit dollars, rather than growth rates, matter most for the overall level of the stock market.
  • What is a “V” Shape Anyhow?  Given our assumptions above, this is our main definition of a V shaped economic recovery:  The number of quarters of decline in the level of aggregate corporate profits versus the number of quarters it takes for the level of aggregate corporate profits to reclaim the prior high.  So, a V shaped cycle would be one where profits decline for 4 quarters and rise to their prior level in 4 quarters or fewer.
  • Final Note for Numbers Nerds: Since we are looking at the overall economic picture and we want to focus primarily on corporate profits, we are faced with a choice of what data set we should rely on.  For our purposes, the after-tax profits data reported in the GDP accounts provides the best read on things.  They are free of accounting gimmicks and cover all incorporated businesses whether publicly traded or not.  To complete the picture, we should do our analysis in real terms, adjusting out the effects of inflation.

With all of that out of the way, let’s take a look at what history tells us.  The chart below looks at the 5 recessions since 1970 and measures the magnitude and time from peak to trough for both real after-tax corporate profits and for real employee compensation.

Magnitude and Time to Trough and Recovery


Real After-Tax Corporate Profits

Real Employee Compensation



Peak to Trough

Magnitude of Decline

Trough to

New High

Peak to



of Decline

Trough to

New High


7 qtrs


5 qtrs

5 qtrs


3 qtrs


7 qtrs


5 qtrs

5 qtrs


2 qtrs


7 qtrs


2 qtrs

2 qtrs


3 qtrs


13 qtrs


6 qtrs

3 qtrs


6 qtrs


9 qtrs


4 qtrs

8 qtrs


12 qtrs

  • Observation #1:  Corporate profits ALWAYS have a V-shaped decline and recovery.  They recover their old level in a shorter time than they declined.  This may be a surprising conclusion, but those are the numbers.  If you think about it for a moment, however, this should be an intuitive result.  Companies always cut costs in a downturn.  When the upturn arrives, a modest rise in revenues can result in a surprising uplift to profits.
  • Observation #2:The time it takes for employee compensation to recover after a recession has been getting longer.  In the 1970’s, employee compensation used to undergo a V-shaped rebound.  No longer.  In the most recent recession, employee compensation took 12 quarters to recover - the longest on record.  By itself, this is an interesting observation that could drive a separate and involved discussion that would touch on politics, technology/automation, inequality, and trade.  But for your sake, and for ours, we will not try to touch that third rail in this letter.
  • Observation #3:  The increasing disconnect between corporate profits, which always seem to recover in a V-shape, and the recovery path of employee compensation, which seems to be elongating, is, in my view, the main reason why stock market recoveries feel so “weird” to most people.  Their employment and compensation feels tenuous and at risk while stocks grind higher.  In reality, it’s not “Fed manipulation,” or any other conspiracy theory.  It’s simply that profits bounce back faster than employment.

Is the Past a Good Model for a Pandemic?  All of the prior recessions in the table above are, in some sense, “normal recessions” driven by excesses - excess housing investment, excess tech investment, excess inflation.  In a way, that is good news this time around.  Because there was no economic excess going into this downturn, there is no “dead weight” restraining the recovery.  On the other hand, none of prior recessions feature an exogenous shock similar to a natural disaster.  That said, we do have some limited models of how local and regional economies recover following a natural disaster.  The New York Fed recently published a study looking a the economy in Louisiana following Hurricane Katrina.  While it’s difficult, if not impossible to measure accurately “corporate profits in Louisiana” or “GDP in Louisiana,” you can easily and accurately measure employment.  The study states that in Louisiana, “the unemployment rate surged from 5.4 percent in August to 11.3 percent in September, and stayed above 11 percent for three months before retreating to a new low of 4.9 percent by January.”  That record doesn’t exactly meet the strict definition of a V shaped recovery, but it is a fairly quick bounce back.

After cutting through the noise, the hand waving and the pontificating, it’s time for some conclusions drawn from the actual data.

  • Corporate profits have a long track record of V-shaped recoveries.  For investors, that’s really what counts.  Based on that, the odds favor one here.
  • Employment and compensation may take longer to recover.  So, most people will feel glum even while stocks rally.  This isn’t Fed manipulation or speculation, it’s just math+history.
  • Regional economies tend to bounce back quickly after natural disasters. While we don’t have a super robust data set, the data we do have suggests that things bounce back quickly once the disaster passes.  The post-Katrina experience in Louisiana is a good example.

What could go wrong this time that would derail a V shaped recovery?  Plenty.  The viral outbreak could re-accelerate requiring renewed economic shutdowns.  The rapid progress being made on drug therapies and vaccines could come up short.  The trade tension with China could take a turn for the worse, especially given that we are in an election year.

With all due respect to the risks, and we worry about all of them, history and logic would point toward a V-shaped recovery in corporate profits which should underpin a V shaped rebund in markets.  As a final note, here is a comment from the Dallas Fed’s end of May survey of business conditions in Texas: “Again, it is very difficult to complete this survey due to so many unknowns, which also make it difficult to plan everything from inventory levels to staffing to capacity. Looking at only the past two weeks, incoming orders are unexpectedly strong.”  

The Economy ≠ The Stock Market - Tuesday, May 05 2020

Big picture:The big rebound in the stock market in April, coupled with the historically bad economic and employment statistics, have induced a sense of disorientation in most investors.  We take as almost an unquestioned assumption that the performance of the stock market is a sort of mirror that directly reflects the performance of the economy.  In other words, “economy good” = “stock market good” and vice versa.  To echo Professor Kingsfield in the film “The Paper Chase” - “Let me assure you that is a total delusion on your part.”  Two examples prove the point.

Global Financial Crisis:  The stock market bottomed on March 9, 2009.  On that date, unemployment stood at 8.3%.  Unemployment kept rising until it peaked at the end of October 2009 at 10% - a bleak period in our economic history.  Interestingly, from March 9 to the end of October 2009, the S&P 500 rose 55%, even as millions were losing their jobs.  If you waited until the coast was clear and unemployment declined back to 8.3% - where it stood when the market bottomed in March 2009 - you would have had to wait until January 2012 and would have missed another 32% increase in the S&P 500.  Here’s the point:  markets anticipate the future.  At turning points, it often pays to “buy bad news” in advance of better news to come.  Waiting until the coast is clear can be quite costly to long term portfolio performance.

Shanghai vs New York:  China’s entry into the WTO in 2000 helped ignite a decades-long period of rapid economic growth for that country.  Over the past 20 years, Chinese GDP (measured in nominal dollars) rose 12-fold.  Leaving aside the recent controversy as to whether that “should” have happened, it remains a truly impressive achievement.  On the other hand, U.S. GDP (again measured in nominal dollars) over that same time period a bit more than doubled - respectable, but nowhere near the 12-fold increase seen in China.  If markets were merely a mirror of economic performance, one would expect that stocks in Shanghai would have beaten the pants off those traded in New York over the past 20 years.  Instead, over this long period of time, in two countries with radically different rates of economic growth, the Shanghai Composite index and the S&P 500 had almost identical rates of return.  The lesson:  even over long periods of time, economic growth, while helpful, is only one of many inputs into long term stock returns.  The competitive landscape, technological change, returns on capital, to name a few, often can be far more important.  

The bottom line:The massive job losses seen in recent weeks and notable economists calling for -40% GDP growth in the 2nd quarter seem completely out of step with a sharp rise in markets in April.  I get it.  But remember, markets and the economy each march to their own drummer.  In this case, the market’s drummer is the length of time it takes for the world to return to something resembling normal.  And what the market is saying is that normal may be closer than most expect.  Given recent advances in drug and vaccine therapies, that would seem a non-outlandish assumption to make.

Fighting the Last War, Stimulus Edition - Tuesday, May 05 2020

Big picture:  Fighting the last war is an enduring feature of human society.  When an unexpected disaster comes along, our natural reaction is “I’ll never let THAT happen again.”  History is chock full of examples.  After the bloody trench warfare of World War I, the French built the Maginot Line - an impenetrable line of fixed fortifications that would have rendered suicidal a WWI-style “over the top” frontal assault.  After 9/11, air travel security and surveillance increased meaningfully making a 9/11-style hijacking very unlikely.  This is a logical response.  We prepare for the disaster we know - and what we know most clearly is the disaster we just experienced.  But the problem is this:  Disasters are disasters precisely because we aren’t prepared for events we don’t expect and can’t imagine.  So, when we fight the last war, the disaster of the last war isn’t what we should worry about - we’re already prepared for it.  Instead, our real worry should be the unexpected thing we’re NOT prepared for.  The French, after building the fixed Maginot line, could never imagine a highly mobile Blitzkrieg that simply routed around the problem.

The Global Financial Crisis, our most recent last war:  As I see it, there were two main lessons learned in the GFC.  First, strengthen the banking and financial system so that they can dampen, rather than amplify, an economic downturn.  Second, when it comes to fiscal and monetary stimulus, go big and go early.  Much economic research post-2008 has shown that the slow, grudging recovery was due in part to the slow, and undersized, nature of the stimulus packages applied at the time.  Why does “big and early” matter?  As Treasury Secretary Hank Paulson quipped in 2008, “If you’ve got a bazooka in your pocket, and people know you’ve got it, you probably won’t have to use it.”  As the “corona crisis” has unfolded, both lessons from the last war seem to be well-learned.  Banks, rather than pulling back, have aggressively leaned into the provision of credit to the economy.  Congress and the Federal Reserve have done far more in the first weeks of the current crisis, than they did in the first 9 months of the GFC.    A few of the more notable ones that caught my eye:

  • Unemployment benefits have been topped up through July where the average income of those laid off thus far has been replaced essentially 100% (even more in some states). 
  • Banks have offered generous forbearance policies for mortgage and credit card payments.
  • The Paycheck Protection Program has offered forgivable loans to small businesses to keep workers on the payroll.
  • The Fed has gone “all in” providing essentially unlimited liquidity across almost all elements of the capital markets in a host of programs too numerous to detail here.

Will it be enough?  Hard to answer that question with precision and much depends on the course of the pandemic.  For now, the early signs are encouraging.  The best real time read on the economy comes from Visa, which, in my view, functions as the economy’s central nervous system for spending and payments.  According to the company, spending hit bottom at the end of March, declining 28% from last year.  In April, things have gotten “less worse” with spending declining 19% from last year - not good by any means but pointed in the right direction.

What's next:  The main concern in 2008 that led the stimulus programs enacted then to be “small and late” was policymakers’ fears of inflation.  Concerns over monetary debasement sparking inflation were everywhere.  In today’s “big and early” world, concerns over inflation are nowhere to be found.  While for now, I think any near-term worry over inflation is misplaced, over the next several years it is not inconceivable that inflation could rise from current low levels.  Why?  Through either luck or ingenuity, the pandemic could pass more quickly than many expect, making the simulus bigger than the problem it is intended to solve.  More money chasing the same goods.  Also, in the name of “health” and “nationalism,” trade and travel barriers could become more of a problem.  This shift would make the global wage rate arbitrage that helped kill the inflation of the 1970s a thing of the past.  Are we betting on this outcome?  Not exactly.  But we are keeping a watchful eye out for it, and, more likely than not, would be be an unexpected tailwind to our portfolio as currently constructed.

Forecasting, “Retrocasting”, and Pattern Matching - Sunday, April 05 2020

When an investor says “this is my forecast of the future,” they are not really being honest with themselves.  Instead, what’s really happening is a form of pattern matching from their historical experience.  Current events are similar to some historical event, so future events  therefore should play out roughly as they did last time around.  A better word might be “retrocasting.”

Why it matters:  Most of the time, retrocasting is a very good mental model for how to deal with the uncertainties of the future.  As Mark Train reportedly quipped - “History doesn’t repeat, but it often rhymes.” 

An example:  In 2008, our belief was that modern governments don’t let the failure of major financial institutions impose losses on creditors and depositors.  The banking failure in the 1930’s, and the subsequent losses imposed on depositors and creditors, was a major contributor to the depth and length of the Great Depression. Banks are so deeply interconnected, both to each other and to the real economy, that the failure of one can lead to a major economy-wide credit crunch.  History as seen from 2008 was replete with examples of government intervention to save creditors and depositors.  Continental Illinois in 1984 and the S&L crisis/RTC in the late 1980’s and early 1990s provide two examples of government intervention to save creditors and depositors.  (Shareholders, rightly, were wiped out in both cases.)  That pattern was reinforced in early 2008 when the Fed intervened to aid the merger of Bear Stearns with J.P. Morgan; and again in the late summer when the Treasury forced mortgage giants Fannie Mae and Freddie Mac into conservatorship in order to save the creditors of both firms.

Yes, but:  On rare occasions, events blow your “retrocast” out of the water.  The “Lehman Moment” was one of those.  All historical experience led us to believe that Lehman would be dealt with as other firms had been - and would be again after Lehman.  But at that moment our assumption ended up being dead wrong.  And our portfolio at the time was not positioned for that unexpected outcome.  So, while 2008 was our worst year on record, we were determined to stay focused on the future.  Doing so helped 2009 become our best year on record with portfolio we managed at the time rising 43%.  Our combined results for the two years were good, exceeding the S&P 500 by 9%, though with much more volatility than we anticipated.  Like a good golfer who always stays focused on his next shot after putting his ball into the water, our key lesson from that time was:  despair and second guessing in the middle of an economic and market crisis are toxic to good returns.  Staying firmly focused on the future is a far more productive strategy.

The bottom line: Our view (i.e. our retrocast) going into this current pandemic and global economic sudden stop was that this would be another version of the SARS, MERS and the H1N1 viral outbreaks.  In other words, the current coronavirus outbreak would follow the pattern from prior viral outbreaks.  Thus, our initial belief was the economic impact would be isolated to Asian supply chains and would prove relatively short-lived.  What we did not anticipate was the need for the major economies to go into a quarantine-induced deep freeze.  And our portfolio was not positioned for that outcome.

Listening > Speaking - Sunday, April 05 2020

Another lesson we learned in 2008: in the middle of an economic and market crisis, listening is more powerful than speaking.  

Big picture:  Once you are in the middle of a highly volatile and uncertain investment environment, making precise forecasts about the future is a fool’s errand.  That is what I would call “speaking.”  On the other hand, prices in securities markets contain information about what investors collectively think about the future.  Paying close attention to the implied forecast imbedded in stock prices is what I would call “listening.”  And in 2008, listening attentively to what stock prices were telling us about the future made all the difference in allowing us to position for a strong rebound in 2009.  We are employing that same mental model now.

The Future Ain’t What it Used to Be:  Valuing companies is part science, part art. So, if investing is about the future, you can run a typical discounted cash flow calculation backwards to glean a market implied estimate of a company’s future growth prospects.   In other words, what is the stock market’s belief about what the future is worth?  In late 2008, according to our simple calculation, the stock market was implying that the future growth of many well-known and financially sound companies was deeply negative.  Not only was the current situation bleak, but the market was pricing an even worse future.  A quick example:  United Health Group was the nation’s largest health insurer.  At the market’s bottom in March 2009, the stock market was implying that the value of the company’s future growth was a NEGATIVE 24% of the then current share price.  The implication was that health insurance, as then currently practiced, would shrink in perpetuity.  That seemed absurd to us then as it seems to us now.  Another example:  Bank of America’s share price, according to this calculation in March 2009, implied that the value of its future growth was a NEGATIVE 55% of its then current share price.  Again, the implication being that the bank would shrink dramatically in perpetuity.  Listening to the absurdity of these calculations led us to push our portfolio in that direction.  Over the 12 months from the market’s bottom in March 2009 both United Health and Bank of America meaningfully outperformed the market rising 86% and 349% respectively.

The bottom line:  Today, in the middle of the current global pandemic, when the future seems so uncertain, the stock market is again implying a dire forecast about the future growth of many great companies to a degree that seems to us absurd.  Take the case of Goldman Sachs.  The stock market is implying that the company’s future growth is worth a NEGATIVE 46% of the current share price.  Is the company really going to shrink that much in perpetuity?  We doubt it.  We don’t know the future path of this global pandemic.  We aren’t trying to “speak” our forecast of how this plays out..  We are, however, confident that the pandemic will end, likely soon.  In the meantime, we are “listening” very closely to what the market is saying.  In our view, the share price of many companies imbeds an overly dire forecast of the future.  We think that’s an opportunity, even if it seems risky in the short-term.  We are acting on what we hear.

Gravity and Value Investing - Thursday, March 05 2020

Some things in our lives are so pervasive we never question their existence.  No one wakes up and wonders whether or not gravity will still “work” today.  Gravity is one of those things that is more basic than a mere assumption.  It is more like the unquestioned bedrock upon which the assumptions of our daily lives are built.  We never wonder if something we drop will “fall up” because the existence of gravity is built into the very fabric of how we perceive the world.

In the investing world, Isaac Newton’s laws of gravity have an analogous force – that over long periods of time, cheap stocks outperform the rest.  The so-called “value stock premium” was first rigorously documented by Eugene Fama and Kenneth French in their 1992 paper “The Cross-Section of Expected Stock Returns”.  This paper is one of the most frequently cited papers in all of economics and finance and helped pave the way for Fama to win the Nobel Prize in Economics in 2013.  Fama and French calculated that in the nearly 30-year period from 1963 to 1991 cheap stocks earned a return premium of 42 basis points per month on average.  That may not sound like much but that compounds to a greater than 5% annual return premium – a massive advantage.   As a result, most of the professional investment management business has for decades been oriented around the idea that “cheap stocks outperform.”

Fama and French also made a related, and less well understood, finding.  The value premium did not come in a steady stream of 42 basis points per month, each and every month.  Over the period of their study, while the average value premium was 42 basis points per month, it was quite volatile.  For statistics geeks, the standard deviation of the monthly value premium was 236 basis points – meaning on any given month the extra return one could earn from owning cheap stocks could swing from strongly positive to strongly negative.  So, to successfully exploit Fama and French’s observation, investors had to focus on the long term.  One could earn the 42-basis point monthly value premium only on average over long periods of time.  Ever wonder why so many fund managers historically have referred to themselves as “patient value investors?”  Though they may not recognize it explicitly, Fama and French are the reason.

But the reality of patience isn’t just that the fund manager has to have it - the fund manager’s clients do too.  Any stats geek will immediately grasp that a strategy with an average monthly premium of 42 basis points and a 236-basis point standard deviation will have long periods of underperformance on the way to ultimate success.  That’s just the math of it.  The late 1990’s tech stock bubble was a good case in point.  In the three years leading up to January 2000, value stocks underperformed growth stocks by a cumulative 74%.  The good news: over the subsequent seven years ending in December 2006, value stocks outperformed growth by a cumulative 99%.  Over the entire 10-year period ending December 2006, Fama and French’s value premium paid off in spades.  A million dollars invested in the main growth stock benchmark at the end of 1996 would have turned into about $1.7 million by 2006.  On the other hand, a million dollars invested in the main value benchmark over that same time period would have turned into nearly $2.9 million.  That’s a great result but it came at the cost of looking like an idiot for the first three years.  Another way to think about “patient value investing” both for manager and client is “being OK with occasional public embarrassment, as long as it pays off in the end.”

Over the last few years, value stocks have again badly lagged their growth counterparts.  In the three-year period ending this January, value stocks have underperformed growth stocks by a cumulative 50%.  That’s a painful level of underperformance nearly equal to that seen in the late 1990s.  It is also worth pointing out that over these past three years, as value stocks have embarrassed their owners, their earnings have done just fine.  Despite the huge difference in performance, aggregate earnings for the main benchmark of value stocks rose 44% over the past three years, the same rate of earnings growth seen by their growth counterparts.  This yawning disconnect between price performance and earnings performance has prompted some soul searching in the academic and investment communities.  Fama and French themselves conducted a new study released last month following up on their original one from 1992.  In it, the pair concludes that the value premium they discovered in 1992 has indeed eroded somewhat, but not by enough to say it no longer exists, or, that the erosion is anything other than temporary.  In short, they don’t have any idea why cheap stocks are underperforming.  They just are, as the statistics indicate they sometimes will do.  Others have suggested that accounting is to blame and we are mis-identifying the “real” cheap stocks.  In a recent paper, noted accounting professor Baruch Lev argues that because companies now account for intangible investments like R&D differently than how they account for tangible investments like a new factory, a company’s accounting book value is a now (at best) a weak indicator of a company’s actual value in a way that was not true in the past.  This is key: a company’s accounting book value was the main variable that Fama and French used to sort stocks into value and growth cohorts.  So, if book value is mis-specified, the Fama and French analysis falls apart.  That said, when Lev re-runs the numbers using book values adjusted for intangibles, the “value premium” does reappear in the recent data but only to a small degree.  So “accounting changes” are part of the answer, but only a small part.

What conclusion can we draw from this most recent period of value stock underperformance?  Fama and French themselves don’t have a ready answer.  Baruch Lev points to accounting changes but that explains only a small part.  Fundamental earnings performance is not the answer either.  The only reasonable conclusion one can draw is this:  that’s just the math behind an investment strategy with a 42 basis point average monthly premium with a 236 basis point standard deviation.  It’s just going to happen from time to time in a way that’s hard to predict.  Even well-founded investment strategies can undergo painful periods that make their practitioners look silly.  For value managers, even very talented ones, this is just one of those trying times.  

Our take on all of this has always been to tip our hat in the direction of Fama and French while maintaining a healthy respect for the shortcomings of their approach.  At its heart, the Fama and French’s value premium is basically driven by a single variable that defines cheapness – the ratio of the market value of a stock to its accounting-derived book value – the so-called price-to-book ratio.  While cheap is indeed good, our strategy is much broader than a book value, accounting-driven process.  We look for major disconnects between a company’s current market price and our estimate of the company’s intrinsic value – what it would be worth to a smart buyer of the whole company.  And in our view, the long-term intrinsic value of a company is driven by many factors, book value being just one.  Many items of significant value are never going to be captured by the strict rules of GAAP accounting.  Business processes, management skill, network effects, brand equity are but a few of the things that can be of great value to a company that will forever escape being captured by the rigors of GAAP accounting.  As a result, we are completely unconcerned about the label (value, growth, etc) that anyone would attach to a potential investment.  Cheap is good in our view, but cheap can be defined in more ways than just price to book.  Over most of the history of our firm and fund, our returns have had a very low degree of correlation to either the main value benchmark or to the main growth benchmark.  That is exactly the result we want – great companies trading at a discount to intrinsic value irrespective of “style category.”

But despite our overall history and preference for not making explicit “style bets” in our portfolio, over the past year, as the level of value stock underperformance deepened further, our attitude has begun to change.  Cliff Asness, founder of quantitative investment manager AQR, wrote a research paper in November of last year titled “It’s Time for a Venial Value Timing Sin.”  In it, Asness argues even though “style timing” is a difficult game to play, sometimes the relative valuation disparity between growth and value stocks can get so out of whack, that it makes sense to do it anyhow.  Asness slices the data several different ways, but on each measure, value stocks have been cheaper only 5% of the time since 1964.  Our own work backs this up.  Using the last 10 years of post-financial crisis data, value stocks have been cheaper only 2% of the time.  As a result, we have nudged our portfolio in the direction of becoming more value sensitive.  In the short run this has, and may continue to, be a drag on returns.  Assess himself followed up on his November work in late February with an update titled “Never has a Venial Sin Been Punished This Quickly and Violently.”  Asness points out that the first 6 weeks of 2020 witnessed the worst period for value underperforming growth since the end of the financial crisis and a 3rd percentile event since 1991.   But despite all of this, given the longer-term opportunity that value stocks now represent, deviating from our “style-free” history makes good sense.  As February ended and we put our cash to work, we did so mostly in our more value-oriented holdings.

Your Own Less Private Idaho - Wednesday, February 05 2020

Because I live in Illinois and work in Chicago, state and local taxes are a frequent topic of discussion.  It seems only natural to do so when “bankruptcy,” “Illinois,” and “Chicago” are often mentioned in the same sentence.  But the real question underlying every one of these discussions is a simple one – should we vote with our feet and move to a more tax-friendly state?  Are other people doing the same thing?  Helpfully, United Van Lines, the country’s largest moving company, has some answers.  Each year for the past 43 years, the company has released a report summarizing the data from the hundreds of thousands of household moves they conduct each year.  In particular, their annual report looks at which states are receiving the most net inbound and outbound moves.  In 2019, Idaho took the prize as the number one state for the greatest proportion of inbound moves.  Is it just a sudden love of Idaho potatoes driving this?  Unlikely.  A much more likely explanation of inter-state moves is tax differences between states.  The non-partisan Tax Foundation ranks states across several tax metrics – individual income, corporate, property, sales, and provides a blended average.  Of the 10 states with the best overall tax picture, seven of them experienced positive net inbound migration (Wyoming, South Dakota, Florida, New Hampshire, Nevada, Oregon, and Delaware). Note: they are not all sunny and warm states, as anyone who has experienced a New Hampshire winter can attest.  On the other side of the coin, of the ten states with the worst overall tax environment, only two showed positive inbound migration – Arkansas and Vermont.  The remaining eight on the list – New Jersey, New York, California, Connecticut, Minnesota, Maryland, Iowa, and Louisiana all saw net outbound migration.  Of course, this does not prove that taxes are the only cause of people moving to a different state.  It does, though, suggest a strong correlation.  In case you’re curious, Idaho ranked 21st on the Tax Foundation’s list - better than average.  But where Idaho really stood out was in the categories of sales and property taxes – two items that are very visible to the average taxpayer.  I hope the State of Illinois and the City of Chicago are paying attention.  The citizens of Illinois certainly are – Illinois just missed making the top 10 list for the worst state tax environment and trailed only New Jersey in the proportion of people moving out of the state.

A Parting Thought for 2019 - Sunday, January 05 2020

Any reader of these letters will know we are a proponent of long-term thinking.  The stock market in the short run is propelled by more by noise than by the longer-term drivers of what a business is worth - customers, competition, pricing power, market size, capital allocation, management quality.  We choose to focus our attention on the latter.  With that in mind, let’s take a “generational” point of view – 20 years – and ask where we stand today.  Despite this year’s strong performance, the annualized performance of the S&P 500 over the last 20 years was 6%.  The 20-year period ending last December 31 was slightly worse at 5.6%.  These two most recent 20-year periods are the worst since those that ended in 1947, ’48, and ‘49 – years that included the Great Depression and World War II.  The average 20-year performance of the S&P 500 since 1927 was 11%.  The best returns were the two 20-year periods ending in 1961 and 1997.  In both of those periods, the S&P 500 had annualized returns of 17.5%.  Most investors active today take as their “mental default” that the last 20 years of stock market returns is “normal.”  A longer look shows that it is anything but – the tech bust, 9/11, and the financial crisis saw to that.  This is not a prediction about what might happen next year or the next 20 years.  Instead, this is a reminder that the last 20 years have been unusually bad ones.  As fraught with concern as the headlines would have us become, the market’s returns over the last 20 years, in some sense, already “know” this.  We all should keep that firmly in mind as we think about the next 20 years. 

The Gambler’s Fallacy and How Not to Think About 2020 - Sunday, January 05 2020

The Gambler’s Fallacy is the mistaken belief that if something happened more frequently than normal in the past, it should happen less frequently in the future.  Things have to “even out,” right?  If I toss a coin and get five heads in a row, we have this instinct that the next toss really ought to be tails. In markets, we often have a similar instinct – a great year like 2019 really ought to be followed by a bad year in 2020.  But as we know, each coin toss is independent from all the others that came before and from the ones that follow.  While annual stock market returns are not truly random events like coin tosses, the pattern of market returns does share something with coin tosses – the stock market has no memory of what it did last year and has no “manifest destiny” pushing it toward what it will do next.  Here are some statistics to consider.  Since 1927, the US stock market (as measured by the S&P 500) has had positive returns in 73% of all years and negative returns in 27% of all years.  Over that time period, is a negative year more likely to follow a positive year?  Or, a positive year more likely to follow a negative one?  Not at all.  Following a positive year, the stock market had positive returns the same 73% of the time it does on average.  What about a very good year like 2019? Surely, that must mean that 2020 is more likely to be negative.  Not really.  If the market rose greater than 10% (approximately the market’s long- term average annual return) in any year (which occurred in 58% of all years), the next year was positive 70% of the time – basically in line with the overall average.  The market has no memory and no “plan” for where it might go next.  It responds to business conditions, interest rates, and the aggregate cash flow generation of companies.  Right now, those fundamental drivers remain in good shape and, as we enter 2020, our portfolio is positioned accordingly.

Follow The Money - Thursday, December 05 2019

Given the state of politics in Washington, it was only fitting that I re-watched the great 1976 movie All the President’s Men on a recent rainy weekend.  The movie starred Robert Redford and Dustin Hoffman who played Bob Woodward and Carl Bernstein, the Washington Post reporters who, through persistence and a bit of luck, broke open the story of the Watergate scandal and its ties to The White House.  It’s a truly great movie, though in hindsight, some of its visual elements now seem like artifacts from an ancient time.  Remember wide lapels, weird ties, and bad haircuts?  How about people using phone booths and taking Yellow Cabs instead of Uber?  Oh, and everyone smoked back then, too.

The movie’s dialog, on the other hand, seems as though it was drawn straight from today’s headlines.  One of the movie’s most gripping scenes occurs when Redford/Woodward contacts “Deep Throat” – his informant from inside the FBI.  (It was revealed 40 years later, just before his death, that Deep Throat was FBI Associate Director Mark Felt).  They meet in a dark, deserted parking garage somewhere in Washington.  Woodward complains that he and Bernstein can’t find the link between all the seemingly unrelated threads of evidence they were beginning to uncover.  Deep Throat replies: “Forget the myths the media has created about the White House. The truth is, these are not very bright guys, and things got out of hand.”  A line that seems as relevant today as it did then. 

Woodward then asks Deep Throat where to look for the next leads in the story.  Deep Throat only offers this: “Follow the money – Just follow the money.”  That was the critical clue that led Woodward and Bernstein to crack open the connection to the Oval Office of a second-rate, botched burglary at the Watergate office building.  It is also very good advice when considering what to do with markets at all time highs.  Should we dial back risk?  Stay the course?  Head for the hills?  The stock market, unlike people, has no memory of where it’s been and no knowledge of where it’s going.  In the final analysis, we all should “follow the money” when charting our course through the markets. 

The most common shorthand way of thinking about valuation is the “price-to-something” method.  Price to earnings, price to sales, price to book.  Each method has its strengths and weaknesses, but the basic idea is: what price am I paying compared to some fundamental characteristic of a company or of the market as a whole.  But if we take Deep Throat’s “follow the money” advice, we should be looking at price to cash returned to shareholders – meaning how does the price I am paying compare to how much, in aggregate, a company is giving back to me in cash in the form of dividends and share repurchases.  Zooming out to the S&P 500 as a whole, here are some numbers to consider.  Currently, the S&P 500 is trading for about 20x the cash amount returned to shareholders over the last 12 months.  On average, since 1991, the S&P 500 has traded for about 35x the cash returned to shareholders.  For further context, today’s level of 20x is close to the lowest level seen since 1991.  The absolute low was last December’s market correction.  Then, the S&P 500 traded for 19x the cash returned to shareholders.  Today’s cash return multiple of 20x also compares very favorably to corporate bonds.   Longer term corporate bonds today yield about 3.9%.  If we flip that yield over (1/.039), corporate bonds trade for 26x their annual cash return.  So why would I want to lend money to US corporations at 26x when I can OWN a collection of US companies for 20x?  Shouldn’t I be willing to pay a HIGHER multiple of cash return for the long-term upside of ownership?  It seems to me, at least in theory, you should.  So despite the market’s gain this year, and in spite of all the political chaos, our indicator tells us to stay the course.  None of this means the market can’t decline in the short run – and as we enter December it looks like it might do just that.  As mentioned in prior months, we retain a larger than normal cash position in the Fund to enable us to take advantage of short-term volatility.  That said, our Follow the Money indicator does imply that the odds of success over the long term are tilted in our favor.

Beneath the market’s surface, our cash return indicator is pointing toward a portfolio tilted toward cyclicals and away from safety.  Energy stands out as representing a particularly good value while Utilities and Consumer Staples stand out as being especially overpriced.  While energy is not a large part of our portfolio, we do think our high-quality holdings (EOG and Schlumberger) make sense while we find little of interest in the Utility and Consumer Staple sectors.

Employment Milestone - Wednesday, November 06 2019

October’s employment report contained an important milestone.  The proportion of people in their “prime working age” (25-54 years old), that were employed hit 80.3% - a level matching the peak for the prior economic cycle in January 2007.  What’s more, October’s level was exceeded in only 7% of all months since 1950.  As Jay Powell said in his last press conference, “the economy is in a good place.”

The New Vampire Squid - Wednesday, November 06 2019

In the immediate aftermath of the financial crisis in 2009, reporter Matt Taibbi penned an article in Rolling Stone magazine that labeled Goldman Sachs “a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.”  The article made the case that rapacious Wall Street greed was entirely responsible for the financial crisis that then resulted in massive job losses, foreclosures and the shattered lives of ordinary hard-working people.  Leaving aside for the moment whether Taibbi’s argument is reflects reality (for one thing, it leaves out the government’s crucial role in encouraging subprime lending for decades), it did spur years of sustained bad press for the Goldman.  In addition, it bolstered the case for passing the Dodd Frank Act in 2010 which placed substantial new regulations on many activities in the financial services industry.  So, what happened to Goldman’s financial performance in the 10 years since Taibbi’s article?  Since 2009, the per share book value of Goldman Sachs rose 94% and the annual dividend paid to shareholders rose 254%.  An impressive performance.  In the face of terrible press and onerous regulation, how did they manage this feat?  By ignoring the headlines and focusing their energies on what they could control – their clients, their service offerings, and their cost structure.

Today, Facebook is in the same “vampire squid” position that Goldman Sachs was in after the financial crisis.  The company is vilified by many in the press and at risk of unknown and potentially onerous new regulation.  To be sure, Facebook, like Goldman Sachs during the financial crisis, has made some missteps, some quite serious.  But like Goldman in the decade following the financial crisis, Facebook is focusing intently on what they can control – connecting people around the world while minimizing harmful side effects.  This approach resonates with users.  In the company’s most recent quarter reported last week, Facebook’s base of 1.6 billion daily active users grew nearly 9% over the past year.  This approach also resonates with advertisers with revenues growing nearly 30% off an already large base.  Better still, free cash flow looks set to accelerate throughout 2020.  The shares are a bargain, trading for a slight P/E premium to the market (20x vs 17x) for much faster than market earnings growth (20% vs 6%).  That’s a very attractive vampire squid.

Don't Mess With Texas - Wednesday, November 06 2019

Last month’s letter discussed the current economic and political landscape and the extreme degree of perceived uncertainty associated with it.  A trade war, domestic political turmoil, Brexit, and a highly consequential presidential election have all conspired to make forecasting seem closer to guesswork.  I labeled it a “BTW IDK” environment – By The Way, I Don’t Know.  But in the midst of uncertainty, it is a good idea to get out of the filter bubble of one’s own pre-conceived notions and talk to the people on the front lines – the foot soldiers in the battle for economic growth.  Helpfully, the Dallas Fed does this for us in their monthly economic report.  October’s report includes useful comments from business owners and managers.  A sampling below:

  • “There is a lot of uncertainty that is causing us to delay capital expenditures. Raw materials costs are uncertain due to unknown duties impacts. Planning is difficult and getting more uncertain.”
  • “Tariffs remain a concern, but things seem to have stabilized.”
  • “The continued shortage of semi-skilled and skilled labor is a major problem impacting growth.”

My summary: jobs are plentiful and so consumer confidence is likely to remain high.  Business owners and managers, on the other hand, are cautious about capital spending as a result of trade tensions.  This sort of cautious optimism, in my experience, is the fuel for extending economic and market expansions. 

Finally, my favorite comment from the Dallas Fed survey: “Give me a level playing field and a free market and we can beat even low–labor-cost suppliers. I don’t want a subsidy but I can’t beat a tariff.”   Proof we should take seriously the state’s tag line: “Don’t Mess With Texas.”

BTW.....IDK - Tuesday, October 08 2019

Since we all now communicate with tweets and texts, and the world around us seems so uncertain, it seems appropriate to title this section BTW…IDK – By The Way, I Don’t Know.  Fund managers, especially the ones that appear frequently on TV, often are called on to prognosticate on world events - “What’s Going to Happen Next.”  Will the Fed cut rates?  Will we reach a trade truce? Will the president be impeached?  Will Elizabeth Warren be the next president?  How will all of that impact my investments?  Fund managers obligingly answer these questions with definitive and reasoned answers.  For the most part, they sound smart and their answers often make for great TV.  The reality, however, is this: they don’t know.  So let me admit the truth – BTW IDK.  Events have put us in uncharted territory, and I think we would all benefit from admitting BTW IDK to ourselves and to others. 

But this is no cause for despair.  Our inability to foresee with certainty the outcomes of these unprecedented events, does not imply we should stuff our money under the mattress.  If we pay close attention, we do know a few important things – and this makes all the difference. 

We know that stocks are historically cheap versus bonds.  In data going back to 1954, the S&P 500 is priced in the 95th percentile (cheap) as compared to corporate bonds.  This does not guarantee the stock market can’t decline, but it does mean the odds of success are strongly in favor of those of us deciding to be a shareholders instead of a bondholders.  We manage a flexible fund that could, if we chose, own bonds over stocks.  We own no bonds.

We know that value stocks are historically cheap versus the broader market.  The median P/E of the cheapest quintile of the S&P 500 is trading at a 7x discount to the entire index – in line with the most extreme reading ever recorded.  The flip side of this is that low volatility stocks – stocks that are perceived as “safe” – are extremely expensive.  The uncertainty in the current environment is the main reason for this.  A quick example:  Bank of America sells for 9 x earnings and is buying back stock at a furious rate.  Its share count shrank 7% last year.  BAC is an economically sensitive value stock.  Procter and Gamble is perceived as less volatile than BAC and sells for 26 x earnings.  They, too, are buying back stock yet the share count shrank less than 1%.  We own BAC as part of a portfolio that skews value and away from over-priced low volatility stocks.  P&G is a good company, but its shares don’t make sense at the current price. 

We know that the companies in our portfolio produce high levels of free cash flow.  This means our companies are self-financing and not dependent on the markets to fund their operations.  In the midst of all this uncertainty, our companies have the wherewithal to grow even in an unexpected downturn.

We know that the aggregate statistics of our portfolio look quite favorable compared to the market.  In aggregate, our portfolio trades for 16x earnings.  The S&P 500 trades at 17x.  Currently, the consensus forecast for the long-term rate of earning growth for the companies in our portfolio is 11%.  For the S&P 500, the comparable figure is 7%.    Our portfolio carries an aggregate dividend yield of 1.8%, exactly in line with the S&P 500. In aggregate, we like our portfolio much more than the market – cheaper, faster growth, same dividend yield.  In our view, that’s a winning combination over the long haul.

We know that sharp economic downturns – the kind we want to avoid – are built out of economic excess.  Too much investment, too much borrowing, excess speculation.  It’s hard to find excess investment or speculation in the aggregate economic statistics either with businesses or with individuals.  In fact, the personal savings rate this year has exceeded 8% - a 20 year high.  As a result, if the economy were to head south, it is likely to be a mild downturn.  No excess means no need for retrenchment.

Finally, we know we have a higher than normal level of cash in the portfolio.  This gives us the freedom to add new positions, or add to existing ones, if the market presents us with the opportunity.  Because “BTW IDK,” we know that cash, intelligently deployed during periods of unexpected volatility, can become the seeds of future strong returns. 

To summarize, we really don’t know the outcome of the extraordinary headlines we see each day.  To repeat – “BTW….IDK.”  We suspect that history will show we are living through an unusual period.  We do know this: the market has already priced in much of this uncertainty and our portfolio is positioned favorably compared to the overall market.  And that, in the midst of this uncertainty, gives us comfort, whatever the outcome.

Checkbook USA - Wednesday, September 04 2019

This month, the investing world developed a bad case of “news headline whiplash.”  Each day brought a new tweet, a new headline that signaled either trade war disaster or the beginning of trade peace.  Markets responded to each one, gyrating wildly from one day to the next.  While we think it is a fool’s errand to forecast precisely how this trade debate ends, we would offer two observations.  First, it is very difficult to argue with the idea that free trade helps propel economic growth.  Seventy years of post-war global economic growth has been underpinned by declining tariffs and exponential growth in trade.  While global trade can create both winners and losers within a country, it is also clear that countries on the whole win far more than they lose.  Countries that are better off, have a strong tendency to keep in political office those currently in office.  While we can never rule out mistakes, blunders and miscalculations -especially now - the forces of electoral politics would argue for a peaceful conclusion to the current trade war.  No politician wants to go down with the ship.

The second observation we would make relates to conditions on the ground in the US.  At heart, economic contractions (recessions) are born out of prior economic and financial market excess.  The 2008 financial crisis is the most recent case in point: too much investment in residential real estate funded by financial market speculation.  Excess inevitably leads to retrenchment.  Now, the question to ask is – is there economic excess today?  One way to measure this is the “private sector financial balance.”  Think of this as the country’s collective checkbook - how much money are we saving (net domestic savings) minus how much money we are investing (net domestic investment).  Most of the time, the checkbook balance is positive.  Prior to turning points in the economy, however, the checkbook balance almost always turns negative.  We collectively, and unsustainably, do more than we can afford to do.  When this happens, the only question is not whether a retrenchment will happen, but when.  Looking back over the last few economic cycles, the private sector financial balance – the county’s checkbook – was in the red for several years before the economy and the markets ran off the cliff.  Today, the private sector financial balance is healthy and positive – about 4% of GDP – toward the higher end of its range over the last five years.  This fact by itself does not rule out a recession.  A blunder on the trade front could set in motion a business-led economic contraction.  However, were that to happen, the flush position of Checkbook USA will likely serve to cushion, rather than intensify, any downturn in the economy.  As a result, we are looking for intelligent places to add exposure to our portfolio rather than run with the crowd to safety.

Low Calorie Investing - Wednesday, September 04 2019

I have always been confused by foods that purport to be something they are not, especially regarding calories.  A calorie is just a measure of how much energy is stored in the food we eat.  We need energy to, well, not die.  So, at some level, going to great lengths to take out of our food the very property that keeps us alive seems somewhat absurd.

In some ways, investing in public markets has taken on a low cal dimension.  Just as we consume food to gain the energy necessary for life, we invest to earn a return over time.  It’s the basic point of both exercises.  Yet increasingly the investment world is driven by forces other than the need to earn a return.  This seems especially true when it comes to explaining part of the recent plunge in global interest rates.  Let me explain.  Publicly traded securities bring with them a host of statistical properties that have little to do with the intrinsic value of the security.  Because the price wiggles from day to day, we can measure volatility.  We also can measure the relationship of the price wiggles among a whole group of securities by calculating their covariance.  In the bond world we can measure a security’s convexity.  Convexity is the second derivative of the relationship between price and yield, a property particularly useful in understanding mortgage-backed securities.  The common feature all these measurements share (and there are many others) is that they are derived from the price movement of the security, not a calculation of what it is worth.  Yet the underlying premise of active management is that talented managers can exploit those instances when price deviates from value.  And if value is the fundamental driver of returns over the long term, then shouldn’t we question how useful these price-based statistics really are?  Yet they remain the foundation of almost all modern portfolio construction and asset allocation.  Intrinsic valuation often takes a distant backseat.  In a way, that is one advantage that private equity retains over investing in public equities.  All that a private equity manager cares about is how much money an investment can make over the time he owns it.  The statistical properties of its short-term price movements are irrelevant.  It’s not that the private investment is less risky than the public one.  In most cases, because the private equity investment is leveraged, it’s likely carries more risk.  But because the fund manager can’t measure the statistics surrounding its trading price, he is free to get on with the main business of selecting investments that he can purchase at a substantial discount to what they are worth – i.e. generating a superior return.

Before we start a bonfire with a pile of finance and investment textbooks, how does this relate to the downdraft in interest rates that has given the world this huge pile of bonds with negative yields?  Recent research from J.P. Morgan estimates that somewhere between 1/3 and ½ of the recent bond buying frenzy comes from investors who need to buy MORE bonds as their yields decline simply because of their statistical properties: Investors needing more duration because of the negative convexity of their mortgage backed securities portfolio; “liability-driven” investors who buy more bonds because the discount rate for their pension liabilities has declined.  The list could go on but the general point here is this: much of the fuel for this decline in rates has almost nothing to do with people making an informed judgement about what a bond is worth.  Its statistical properties carry all the weight and value carries almost none.  In other words,  this class of investors is upside down.  The more a bond’s price rises (and its yield declines) the more they want to buy, the exact opposite of what logic would dictate. 

Given all of this, we have a good degree of skepticism around reading the recent bout of bond market noise as a meaningful signal for the equity markets.  Are negative interest rates really presaging a re-do of 2008-style economic disaster?  Or are they just an artifact of too many “statistical” investors who are unconcerned with value?  Our (small) bet is on the latter.

Even Crazier Eddie - Monday, August 05 2019

In our May investor letter, we wrote about the strange disconnect between certain parts of the financial markets and the real economy.  The financial markets, especially government bond markets around the world, seem to be forecasting doom.  On the other hand, the real economy here in the US seems to be, for the most part, doing just fine.  A few examples from May are worth revisiting.  The global aggregate amount of negative yielding debt back in May was $11.5 trillion.  At the end of July, it stood at $14 trillion.  One example deserves attention.  On July 10, the German government sold €4 billion of 10-year bonds.  The bonds paid no coupon and were sold at 102.64.  For those not conversant in bond-speak, this means investors gave Germany €102.64 in return for which they will receive no interim payment of any kind and after 10 years Germany will return to them €100.00.  In most places, this is referred to as “slow theft.”  But in negative yielding bond-land, it’s all entirely legal!  Investors must believe that Armageddon is around the corner to consider this an intelligent investment.  After all, the main German stock market index (DAX) sports a current dividend yield of 3.2%. 

In the US, investors also are expressing a sense of doom and gloom.  In mid-July, weekly outflows from equity mutual funds ranked among the highest on record.  Weekly flows into bond funds were in the top 10% of all periods in history.  A measure of hedge fund net equity market exposure ranked in the bottom third of its 10-year range.  Finally, the valuation spread between a basket of low volatility stable stocks and traditional value oriented cyclical stocks stands at its widest ever.  In broad terms, investors seem to be running for the hills. 

Consumers, on the other hand, feel relatively upbeat.  Employment and wages continue to grow.  The University of Michigan Consumer Sentiment index is hovering near an all-time high.  The broadest measure of unemployment – the U-6 rate which includes the true unemployed plus those “marginally attached to the labor force” recently reached 7.2% - a low level last seen in 2001.

Which way will things break?  Will the pessimism in global government bond markets prove prescient?  Or do consumers really have it right?  We can’t claim to be better forecasters than most.  We do claim to be good students of valuing companies – and many now are cheap, especially relative to bonds.  And we also can claim to be keen observers of investor sentiment – which is currently bleak.  These two facts leave us looking for an occasion to put our cash to work.  The main risks to the economic expansion and to equity markets remain the ones we might inflict on ourselves - in particular, a drastic increase in trade tensions.  And on that score, the impending 2020 presidential election, and the obvious desire to “keep the good times rolling,” means that fiery trade rhetoric may prove worse than reality.  So, we can best summarize our portfolio strategy by borrowing from Howard Marks - “move forward, but with caution.”

"What do we have on the spacecraft that's good?" - Saturday, July 06 2019

Investing, especially in the current environment, is an exercise in what economists call “decision making under uncertainty.”  So much seems subject to radical change depending on the next tweet from the President.  Success in this environment (or at least sanity) depends on paying close attention to the relevant the data and asking the right questions.  This year marks the 50th anniversary of the first Apollo moon landing.  Especially when things didn’t go according to plan, the Apollo program was a master class in how to make decisions.  The movie Apollo 13, which chronicled the “successful failure” of that mission, had a great scene which illustrates the point.  After the explosion on the spacecraft, the Apollo flight controllers on the ground struggled to make sense of what was going on.  The spacecraft was tumbling end over end and various gauges and readouts were going haywire.  Nothing made sense.  Controllers were calling out all the things going wrong and all the systems that were failing.  To break through the confusion, legendary flight director Gene Krantz turned the question around.  Asking what was wrong was easy – he had a room full of engineers telling him that.   Krantz instead asks the question the other way around – what’s still good?  Krantz asks one of the controllers “Sy, let’s look at this thing from the standpoint of status - what do we have on the spacecraft that’s good.”  That question focused everyone in the room on the right question; what systems still work and how can we get use what works to get the astronauts home – which they did with great skill.

Through this lens, the current economic and political backdrop pushes most investors into the role of the Apollo 13 engineers and flight controllers.  The readings on our gauges and dials look strange and there is a palpable feeling of risk in our investment mission.  However, it is often useful to take on the role of Gene Krantz and ask, what’s still good?  In the investment business, corporate profits, the raw material of good investment returns, are still very much in the good category.  By this, I don’t mean the short-term quarter to quarter fluctuations that the financial press obsesses about.  For the most part, that is still good, though not as good as last year in the aftermath of the Trump tax cuts.  Instead, the underlying strength in corporate profits comes from the long-term fundamental drivers behind them, especially the amount of actual cash that companies produce.  The information source that helps cut through the noise is the corporate profit data in the GDP accounts.  One piece of data stands out over time – aggregate corporate cash flow.  If the US were one big company, think of this number as that company’s free cash flow.  And when measured against GDP, this number is equivalent to the “free cash flow margin” of the US.  In the 1950 and 60s, the height of the post-war economic boom, the free cash flow margin of the US was about 10% of GDP.  In the most recent decade, that number has averaged around 14%.  Basically, US companies are much more profitable than they have been in the past.  Why?  The GDP accounts also point to an answer: In a word, software.  Going back to the economic boom of the 1950s and 60s, 95% of corporate capital investment went to hard assets – equipment and structures.  Today, 2/3 of corporate investment goes to a category labeled “intangibles and intellectual property,” the bulk of which is software and R&D.  And as a show of how important this category is to companies, in 2008 and 2009 at the height of the financial crisis, corporate investment in equipment and structures went to zero.  On the other hand, even when the economy was flat on its back, corporate investment in software and R&D continued to grow.  At its heart, software allows companies to do more with less – and that is the raw material of increasing profitability.  And so the answer to the question “what do we have on the spacecraft that’s good” is best answered with the reply “stronger corporate profits.”  That is a good cause for long term optimism in the midst of the current confusing environment.

Crazy Eddie - Tuesday, June 04 2019

Anyone who came of age in in the BA Era (“Before Amazon”) remembers the New York-based retailer of consumer electronics – Crazy Eddie.  Crazy Eddie was known mostly for its oddball, low-budget TV ads where the pitch man ends by saying “Crazy Eddie, his prices are insaaane.”  While the ads did the trick because everyone knew the “it’s insaaane” tagline, they were also quite ironic.  It turned out that founder Eddie Antar – the Eddie behind Crazy Eddie – directed a decade long fraud aimed at inflating the company’s financial results.  The contrast between the company’s outward appearance of health and the company’s appalling, but hidden, financial condition could not have been more stark.  The company declared bankruptcy in 1989 and Antar went to prison for 8 years.

That same sort of stark contrast between outward health and inward troubles is now being expressed throughout the economy and markets.  Outwardly, the current environment is robust.  Unemployment is at a 50-year low.  Wages are growing again.  Productivity, after a long slump, is rising.  Consumer sentiment, as measured by the University of Michigan consumer sentiment survey is hovering near a post financial crisis high.  Comments in the Dallas Fed’s manufacturing survey released at the end of May sum up the current situation well: “While there is significant uncertainty and trade talks with China could have a longer-term impact, growth is currently robust and would be even stronger without current supply chain and labor constraints.”

On the other hand, financial markets are supposed to discount the future – and the future that financial markets are currently forecasting is a troubling one.  The demand for the safety of government bonds has skyrocketed around the world.  10-year government bonds in Germany, Switzerland, The Netherlands, and Japan now carry negative yields.  Even certain highly rated corporate bonds now sport a negative yield.  “Negative Yield” is perhaps too bland a term for what this really signifies.  It means that investors are so fearful that they would willingly hand over their money to someone for 10 years and guarantee a small loss rather than “take the risk” of some alternative investment.  Helpfully, Bloomberg keeps a running total of the total value of all negative yielding debt around the world.  At the end of May, that figure stood at $11.5 trillion, approaching the all-time high level of $12 trillion last seen in the immediate aftermath of the Brexit vote in mid-2016.  Crazy Eddie would say “these negative yields are insaaaane.”

The US stock market also shows strong signs of risk aversion.  Electric utility stocks, a traditional safe haven, now trade at a higher P/E ratio than does the market as a whole – an extremely rare occurrence.  Many highly rated and stable companies have dividend yields that far exceed the yields on their own corporate bonds.  One case in point:  Wells Fargo’s stock currently carries a dividend yield of 4%.  The bank’s 10-year bonds trade at a 3% yield.  Doesn’t it seem far better to be a part owner of Wells Fargo over the next 10 years than merely to lend it money?  Apparently, the extra 1% per year of current income (tax advantaged, I might add) and the long-term upside of owning a good banking franchise is too good for investors to bear.  Wells is not alone in this.  At the end of May, almost half the stocks in the S&P 500 had dividend yields that exceeded the yield on the 10 year Treasury bond – a rare occurrence.  Finally, it is worth noting that the weekly survey of investor sentiment produced by the American Association of individual Investors has turned quite gloomy.  The survey last week recorded that only 25% on investors were bullish while 40% listed themselves as bearish.

Economist Paul Samuelson once quipped that the stock market has successfully predicted nine out of the last five recessions.  So the question on the table is this:  is the message coming from the markets “signal” or “noise?”  Clearly, a trade war, especially one fought on two fronts, is an unambiguous negative to global economic growth.  However, many economists estimate the trade war’s “first order” direct impact at less than ½% of GDP in the worst case.  However, the more important question is the “second order” effect.  Can uncertainty coupled with stock market jitters cause companies and consumers to take precautionary steps to avoid a recession, and in so doing, cause one?  While that is always a possibility, it seems an unlikely one at this stage.  In our experience, for market jitters to cause a meaningful economic downturn requires the presence of some underlying instability – too much debt, over investment in capital equipment, too many employees.  None of that seems evident in the data.  So if there is no dry tinder on the forest floor, a forest fire in unlikely to ignite.  Our base case at this point is that we will experience a mild economic slowdown, such as that seen in late 2015/early 2016 and the trade wars will come to a less onerous resolution - because it is overwhelmingly in all parties’ interest to do so.  Finally, it is worth noting that the markets are already “pre-positioned” for a downturn as we have outlined above.  This perspective leaves us looking for spots to become more bullish not less.  As May ended, we found one of those spots.

The Taxman: That's One for You, Nineteen for Me - Saturday, May 04 2019

It’s April, so a few words about taxes are in order.

In 1966, The Beatles released their seventh studio album - Revolver.  The opening track on that album was “Taxman.”  The song begins with the line “Let me tell you how it will be, there’s one for you nineteen for me, ‘cause I’m the taxman.”  At this point in their careers, the Beatles fame had begun to translate into serious fortune.  However, it began to dawn on the group that UK tax policy under Harold Wilson’s Labour government made it nearly impossible for their musical efforts to translate into after-tax earnings in their pockets.  The Wilson government was caught between expensive Labour Party social programs and the straitjacket of the Party’s promises not to devalue the pound.  Recall then that most major currencies had exchange rates fixed either to the dollar or to gold.  The only way to bridge that gap – or so it was thought at the time – was to raise revenue, principally by taxing the rich.  The top marginal rate was 95% and hit earned incomes over £20,000 (around £200,000 today).  On top of that, Wilson’s government imposed a surtax on unearned income, making the effective rate on interest and dividends nearly 98%.  Basically, returns on capital above a certain threshold were confiscated by the government.  So, it’s no wonder that The Beatles chose “Taxman” as the lead track on Revolver.

UK tax policy in the pre-Thatcher era led many British musicians to take unusual steps to avoid the tax man.  The Beatles set up their own record company – Apple Records – in part to lower their tax bill.  The Rolling Stones left for the south of France in 1971 becoming UK tax exiles.  While there, they recorded their hit album Exile on Main Street in 1972.  David Bowie left for Switzerland.  Rod Stewart left for California.  The point here is that the Labour Party’s tax policy in the 1960’s and 70’s, however well-intended, led to a brain drain of high-income UK citizens whose work could be conducted anywhere.  And those citizens could, and did, seek out more favorable tax treatment in other countries. 

Today, with a large and growing share of the global economy dedicated to “intellectual property” or “intangible goods and services” untethered to a factory floor, this issue of incomes moving to locations with more favorable tax treatment has become only more acute.  The US provides a good laboratory to study this issue.  Each state (and city) conducts its own policy with regard to taxing incomes, retail sales and property.  The non-partisan Tax Foundation publishes a combined “total state tax burden” calculation for each state allowing for easy comparison across 50 highly disparate tax policies.  This burden ranges from a low combined total of 6.5% in Alaska to a high of 12.7% in New York (note: this is an average tax rate across income tiers, not a top marginal rate).  We also have data from the largest moving company in the US – United Van Lines.  Each year, United releases data on the number of moves they conduct to and from each state.  In 2018, United moved a bit more than 200,000 people to a new state.  Combining these two data sources – tax burdens and the number of people moving across state lines - will allow us to see if people are moving for tax reasons – at least in part.  In 2018, six states accounted for 75% of all the net loss of population in the United Van Lines data – Illinois, California, New York, New Jersey, Ohio, and Massachusetts.  Five of these six states have tax burdens that average 1.5% above the national average of approximately 10%.  Ohio sits at the national average.  On the other side of the ledger, eight states accounted for 75% of the net gain of population – Colorado, Virginia, Arizona, North Carolina, Texas, Oregon, South Carolina, and Tennessee.  Seven of these eight states have tax burdens that average 1.5% below the national average with only Oregon imposing a tax burden slightly above the national average.

Does any of this “prove” that state tax policy is the sole cause of population movement within the US?  No.  Correlation should never be confused with causation.  However, it is worth pointing out that most research on the topic does highlight that tax policy is increasingly driving the movement of people and their incomes.  A recent study by Princeton economist Henrik Kleven (Taxation and Migration: Evidence and Policy Implications) points out that “certain segments of the labor market, especially high-income workers with little location-specific human capital, may be quite responsive to taxes in their location decisions.”  But Kleven also acknowledges an important offsetting factor – the perception that high taxes could, under certain circumstances, be seen as a “fair deal.”  This could “include local or national amenities, agglomeration effects, and the provision of public goods and services.  Rather than compromising redistribution, or restraining free mobility in an inefficient way, these can, in a productive way, be fostered to make the country or state attractive to people.”  To translate from Kleven’s econ-speak, if you are going to sock people with a high tax bill, you had better provide, among other things, good roads and good schools.  Otherwise, they are headed to Colorado.  Hopefully, the politicians in Illinois, California, New York, New Jersey, Ohio and Massachusetts are paying attention.

Is It Over - Friday, April 05 2019

As March drew to a close, the U.S. stock market took on an “end of cycle” character.  Safe haven stocks performed well while economically sensitive stocks performed poorly.  The main question in the press was – “after 10 years of economic growth, are we about to enter a recession?”  The proximate cause of these fears was the slight inversion of the Treasury yield curve – the difference between long term rates (usually 10 years) and short-term rates (usually 3-12 months).  Most of the time, long-term rates are higher than short-term rates.  On rare occasions, when short-term rates are higher than long-term rates, a recession has nearly always followed in the next 12-24 months.  So, the existence of an inverted yield curve is something well worth paying attention to.  As we have written in various monthly letters over the past few years, the slope of the yield curve is an important element on our recession checklist – and recessions are things we very much want to avoid.

It is worth noting that our recession checklist has more elements than just that slope of the yield curve.  In general, we pay attention to data from the financial markets (yield curve, credit spreads) and from the real economy (housing, employment).  In theory, any one of these indicators could yield a “false positive” recession reading.  That’s why we look for several of these indicators to show the same thing before taking action.  As of now, none of our other recession indicators confirm what the yield curve seems to be saying.  In addition, there is a good explanation for the unusual behavior of the yield curve – the negative term premium.  Without getting into the complexities, in the bond market, the term premium is the extra compensation demanded to own longer-term bonds over the implied path of short-term rates in the future.  As of now, the term premium is deeply negative – the most negative on record.  What does this mean?  Economists from the Richmond Fed pointed out in a recent paper (Have Yield Curve Inversions Become More Likely, December 2018) yield curve inversions are now much more likely than in the past.  According to their simulations, this extremely negative term premium means, all else being equal, that the yield curve could in theory be inverted 46% of the time.  In practical terms, this means that the yield curve, while still useful as a recession indicator, is less bulletproof than it was in the past.

In addition to the various financial market and real economy recession indicators we track, it is worth stepping back and thinking through the underlying microeconomic process that drives recessions.  The indicators we track are just that – indicators of deeper economic forces at work.  In general, recessions are built out of excess and over optimism.  Households and firms – the private sector - buy too much, invest too much, hire too many people and then need to retrench.  How can we measure this idea of excess?  One good way to do it is to look at the aggregate income and spending of all households and firms – the private sector financial balance.  If household and firms are spending more than they are taking in, they are likely to retrench in the near future.  This imbalance gives rise to an economic contraction.  If the opposite is true, and households and firms are spending less than they are taking in, then continued economic expansion is likely.  For example, the private sector financial balance turned decidedly negative two years before both the housing market bust that led to the financial crisis and the tech bust in 2000.  Today, the private sector financial balance is a positive 3.5% of GDP, in line with the average seen over the last five years.  This is hardly a sign that the economy is overextended and due for a retrenchment.  So, while the first sign of a yield curve inversion gets our attention, the broader view – at least for now - says the current economic expansion has some ways to run.

The Baroque Period of Index Investing - Tuesday, March 05 2019

Baroque architecture flourished in Europe in the 1600s.  With its highly ornate and often extravagant design elements, this style found its clearest expression in the façade and piazza of St Peter’s in Rome.  While to our eyes today, St Peter’s is an impressive place to visit, for a 17th century churchgoer, it must have been a truly awe-inspiring experience that bonded one forever to the Catholic Church.  And that was precisely the point.  The Baroque period followed the Protestant Reformation.  The centrality of the Catholic Church was under threat.  In some sense, Rome was competing with Protestant theology for ecclesiastical market share.  What better way to do that than with a really impressive, expensive, and extravagant church?

In some sense, the business of passive and index investing, in its search for new customers, is entering its Baroque period of extravagance and excess.  Even though I am an active manager, I have no general quarrel with passive investing.  In its basic form, it is an entirely sensible way for investors to gain exposure to an asset class in a simple and inexpensive fashion.  We even offer some of these services to our clients who request it.  But taken to an extreme, some examples (discussed below) of index and passive investing are little more than “high fee active management in drag” with a bit of a regulatory dodge to boot.  Let me explain.  (Note:  in the discussion below, I will use the terms “passive” and “index fund” and “ETF” interchangeably.)

First, it is worth pointing out that in the US, passive investing is now an enormous business.  Some have estimated (BIS, 2018) that 43% of US equity fund assets are managed passively.  Vanguard, founded by index investing pioneer Jack Bogle, now manages $5 trillion.  That’s huge growth for a fund management style that didn’t exist prior to the 1970s.  Clearly, there was a problem left unsolved by the asset management industry (fees, performance, simplicity) that Vanguard and others have addressed very well.

Second, we should recognize passive management isn’t truly passive in the sense that when you buy a passive portfolio it remains forever static.  Indices change: companies get taken over, spin offs happen, IPOs occur, some companies go bankrupt and, market caps change.  Some analysts estimate that after 10 years, only 60% of an index portfolio remains in its original form.  So, a better way to think of passive investing is to consider it to be “mechanically active.”  The passive portfolio can, and does, change over time – but it changes according to a set of mechanical and non-discretionary rules known and disclosed well in advance.  The classic example is the S&P 500 index fund.  S&P publishes a set of rules on how they assemble a market cap weighted index composed of the 500 largest US companies.  Various fund managers pay S&P a license fee for the data and then manage and distribute a mutual fund or ETF according to S&P’s rules.  And each year, on average, S&P changes about 7.5% of the index.  So, as you can see, “mechanically active” is a better description of what actually happens in an index fund.  “Passive” implies a “set it and forget it” portfolio, which isn’t the case.  The good news for investors in this equation is that it is very cheap to implement and thus management fees are very low.  So far, so good.

It is worth keeping in mind the nature of the portfolio management function carried out by an index fund.  The fund manager, and the fund’s board of directors, are, in effect, outsourcing the portfolio management and stock selection function to the provider/publisher of the index.  In theory, there is nothing wrong with this, provided the investors in the fund really understand how the index is constructed and how it changes over time.  The S&P 500, and the large number of funds that track it, are good examples.  The index rules are well known by almost everyone and the index changes in ways that make sense.

Problems start to crop up when, in the search for new customers and higher management fees, “mechanically active” management, inexpensively executed, according to a well-known set of simple rules morphs into a complex, opaque and confusing form executed at fees comparable to what active managers charge – yet marketed under the friendly guise of being a low-cost, passive vehicle.

One sign of a simple business becoming needlessly complex is the explosion in the number of indices and index funds.  A recent study (Robertson, 2018) found 912 index funds in the US.  Those index funds tracked 557 different indices.  To be sure, most of the AUM is contained within a small fraction of those funds that track a handful of well-known and easy to understand indices.  But are there really 557 (and growing) different ways to track all, or part of, the US stock market?  Well, here are a few of the more interesting examples.  S&P publishes the “Catholic Values Index” which alters the makeup of the S&P 500 according to rules laid down by the US Conference of Catholic Bishops as interpreted by S&P.  How do the Bishops and S&P do that?  It’s not clear.  This index is tracked by an ETF (ticker CATH) distributed by Global X Management in New York.  State Street publishes the “Gender Diversity Index” which measures the proportion of women either employed at, or on the board of, the 1000 largest US companies.  Companies with proportionally more women are included in the index.  But under what rules?  The prospectus isn’t clear on that.  That index is tracked by an ETF (ticker SHE) distributed by State Street.  These may be noble goals, but it is worth noting that the management fees on these two ETFs are about three times that of an S&P 500 ETF.  All of these fees go directly to the fund sponsor, not to the causes at hand.  One is left with the nagging thought whether more social good could come from investing in the S&P 500 and then donating the “avoided excess fees” directly to the Catholic Church or to a charity benefiting women.

Some index funds also have begun to look nearly identical to actively managed funds.  There is an index in the mix, but how the index is constructed is completely up to human judgement.  The best example is the Van Eck Vectors Morningstar Wide Moat ETF (ticker MOAT).  Morningstar constructs an index of companies that they “determine to have substantial competitive advantages based on proprietary methodology that considers both quantitative and qualitative factors.”  Meaning (I think), the index is whatever Morningstar says it is.  Van Eck then licenses that index to use for the ETF.  But it gets better.  The ETF need only invest 80% of its assets in stocks in the index.  The rest can be whatever Van Eck wants it to be.  So, if this a “passive” fund, or an “active” one?”  In general, this sounds a lot like Shorepath’s portfolio.  We use a mix of qualitative and quantitative factors to uncover discounted “franchise value” – our word for “moat”.  However, we make no representation that we are anything other than what we are – a concentrated, active fund managed by one portfolio manager.  In the case of MOAT, who is really making decisions – Morningstar?  Van Eck?  How does an investor make an intelligent decision as to whether or not to buy or sell the fund if you have no idea who is doing the managing and how they are doing it?  Needless to say, this fund charges active-level management fees even though it is marketed with the soft, friendly glow of being a passive fund.

Finally, we should take note of the regulatory regime.  For the most part, the fund management business is governed by the Investment Company Act of 1940.  The ’40 Act places on fund managers a wide range of requirements relating to disclosure and conflicts of interest.  Index providers, however, operate under a “publishers’ exemption” from the ’40 Act.  They bear none of the burdens faced by active managers relating to disclosure and conflict-avoidance.  I can accept this exemption for simple indices like the S&P 500.  But for opaque indices like CATH and MOAT, this publishers’ exemption from the ’40 Act makes little sense.  These sorts of funds are, in fact, “publishing” their opinion on matters relating to Catholic values and “corporate moats” in the same way that an active manager expresses his fundamental opinion in his portfolio.  But perhaps the worst example of this is the Gender Diversity Index fund mentioned above.  State Street is the fund manager AND the index provider/publisher.  In effect, State Street is outsourcing “opinion based” portfolio management to itself.  Isn’t that exactly what active managers do?  Yet SHE operates in this regulatory gray area when its activities are anything but.  I don’t know the regulatory history that has allowed these developments to occur but clearly the spirit of the ’40 Act has been forgotten in favor of an increasingly tortured reading of it.

What’s the point of this examination of the Baroque Period of index funds?  The last few years have seen lots of triumphant headlines about the superiority of passively managed funds.  This meaningfully overstates a complex story.  Simple and easy to understand index funds are indeed a useful tool and they have helped investors lower costs.  But they can’t do everything.  And, they shouldn’t be marketed as something they are not.  And, they should operate under the same regulatory regime that active managers do.  This is an old story in the investment business.  A good idea pushed too far in search of fees, ends up becoming a bad idea.  RIP Jack Bogle.

Bad News is Good News - Tuesday, February 05 2019

Indulge a bit of obviousness for a moment - in financial markets, over the long term, risk and return are related.  All things being equal, we should expect riskier investments to deliver superior returns.  Leaving aside the deep and complex question of how you ought to measure risk, so far, so obvious.  However, the challenge for most investors is remembering that the risk of owning a particular stock over the long haul is only very loosely related to the macroeconomic and geopolitical headlines that dominate the daily news.  Far more important are the things that make for less exciting stories on page 10 of the newspaper: product innovation, competition, pricing power, cost structure, management skill, and capital allocation to name but a few.

For the entire stock market, investors getting lost in the day’s bad headlines often means a sea of red on your Bloomberg terminal.  December was a case in point.  For academics, on the other hand, it’s an ideal time to revisit the linkage between risk and return – the equity risk premium (ERP) – the excess expected return on stocks above that on risk free government bonds.  Estimating this relationship takes some skill and care.  One of the best at it is Aswath Damodaran.  Damodaran, who writes a very worthwhile blog on the topic of corporate finance and valuation, teaches at NYU’s Stern School of Business.  Damodaran also publishes a widely used dataset with his estimate of the ERP going back to 1960.

On average, over the last 60 years, according to Damodaran’s data, the ERP has averaged about 4%.  Meaning that stock market investors should expect to earn an extra 4% per year over the returns earned by investors in treasury bonds.  The variation around that average, though, is large, and that’s where things start to get interesting from today’s perspective.  Let’s divide this data into periods where the ERP is greater than 5% (+1 standard deviation) and less than 3% (-1 standard deviation) and then measure the average 5 year forward returns on the S&P 500 index.  In other words, how did stock market investors do following periods when they were either being paid handsomely for taking on the risk of owning stocks or being paid a pittance?  Not surprisingly, in periods when the ERP exceeded 5%, average 5 year forward returns were 112% - slightly better than double your money.  The worst gain in this subset was 94%.  On the other hand, when the ERP was 3% or below, forward 5 year returns averaged a mere 4% and you stood a 50-50 shot of actually losing money over 5 years.  That’s hard to do.

At the beginning of this year, the ERP stood at 5.96%, towards the very high end of history.  Looking back, periods when the ERP is very high coincided with terrible headlines.  Bad news causes investors to become very fearful; stocks become cheap; and therefore you get well paid to take risk.  One year stands out as a case in point – 1974.  President Nixon had just resigned following the Watergate scandal.  Inflation stood at 12%.  GDP fell 2% that year.  That’s a boatload of bad news that makes today’s headlines seem tame in comparison.  Yet from that point forward, the S&P 500 rose 98% over the following 5 years.  The opposite also holds.  The late 1990’s were an amazing time - roaring economic growth, the end of the cold war, the creation of the Euro, the US government ran a budget surplus.  Democratic capitalism won.  The news could hardly have been better.  In 1999, the ERP fell to its lowest on record - 2%.  Over the next 5 years, the S&P 500 fell 11%.  In the midst of the current headlines – political turmoil, market volatility, trade tensions – it is very useful to keep all of this in mind.  The day’s headlines matter far less to wealth creation over the long term than does the compensation the stock market offers to take on the risk of investing in it.  Right now, that compensation is rich indeed.  After a rough 2018, we like the opportunities ahead of us.

Ich Bin Ein Atlantic City - Monday, December 03 2018

From the end of World War II to 1989, West Berlin stood as a lone outpost of democratic ideals located deep inside Soviet controlled East Germany.  From the Berlin Airlift in 1948/49 to the dealing with the East’s construction of the Berlin Wall in 1961, the city often served as the focal point for US and NATO led efforts to overcome Soviet aggression.  In the summer of 1963, at the height of the Cold War and less than a year after the Cuban Missile Crisis, JFK traveled to West Berlin and declared his citizenship: “All free men, wherever they may live, are citizens of Berlin, and therefore, as a free man, I take pride in the words "Ich bin ein Berliner!”  Thus, West Berlin became a symbol of thoughtful, collective, coordinated, and sustained action in the face of a threat.  26 years later, that sustained collective action resulted in the fall of the Berlin Wall and the dissolution of the former Soviet Union.  It took a while, but the good guys won.

Today, our global trade regime faces the opposite situation.  Like democratic capitalism, free trade is, and always will be, a driving force for global prosperity.  However, the leaders of the former champions of free trade – the US and the UK – seem consumed with an incoherent and antiquated vision of retreating behind tariffs and exiting trade agreements.  Being a “globalist” is now seen by some as being the equivalent to “axe murderer.”  Clearly, there are real trade issues to be overcome – non-tariff barriers, intellectual property theft, forced technology transfer to name a few.  But rather than a compelling – and fact based – vision for the future prosperity of the globe led by actual free and fair trade, a vision that would rally our allies to our side, the leaders of the US and the UK seem driven by an incoherent and faded view of the past, animated by local, cynical, partisan politics.  Atlantic City stands as a proper metaphor for this situation - a fake Taj Mahal casino playing to the base instincts of the locals and ending in bankruptcy.  Surely JFK would roll over in his grave to know today’s global trade version of his famous speech would be “Ich Bin Ein Atlantic City.”

Know Thyself - Monday, November 05 2018

In ancient Greece, the Oracle of Delphi was believed to provide wise counsel and occasionally prophetic predictions about the future.  Much of the wisdom given by the Oracle was captured in 147 Delphic Maxims.  Most of them remain great advice today – “Pursue Honor”, “Praise the Good”, and “Long for Wisdom”.  A few, though, have not aged well and would cause me particular trouble today, especially “Rule your Wife.”  That said, the most notable of these maxims was inscribed into the Oracle’s residence, Temple of Apollo at Dephi.  That maxim said simply “Know Thyself.”  As an investor, knowing oneself and one’s biases, at least in part, can be enormously helpful in managing through the passions found in turbulent markets. 

A recent paper published by the National Bureau of Economic Research explored how good people are at actually knowing themselves.  In particular, the paper surveyed over 2,000 people for the purpose of understanding their preferences for certain types of bets.  For example, would you rather have bet A – a 33% chance of winning $12 and a 67% chance of winning $3 or bet B – a 33% chance of winning $18 or a 67% chance of winning $0.  Both A and B have the same expected value payoff ($6).  However, in asking many questions like these, the researchers determined that people systematically prefer bets like B – the one with the larger, but less likely, payoff.  Or, conversely, people tend to systematically “over-avoid” large but unlikely losses.  In other words, most people have subjective probability preferences that deviate from what abstract statistical theory would dictate.  This research is consistent with the idea the most people believe that unlikely events are more probable than they actually are.  And, that things in the middle of the probability distribution – the boring stuff – are less likely than they actually are.  Our culture screams out that this flawed view is the way the world actually works.  The daily headlines shout extreme riches or terrible tragedies.  No headline, other than one found in The Onion, ever reads “Area Man Has Normal Day at the Office.”  For the stock market, though, the boring middle – the part that people generally underestimate - is where all the money is made over time.  Nothing notable happens, other than your money steadily compounding its way forward while invested in a great franchise purchased at a reasonable price.  For those math nerds out there, few things are as powerful in creating wealth as e^rt.

The Report of My Death Was an Exaggeration - Thursday, October 04 2018

In 1897, Mark Twain wrote the sentence above to The New York Journal in response to rumors that he had died. In classic Twain fashion, it says a lot in a few words and does so with great humor. Recently, journalists following the investment business have been circulating rumors of the death of value-based investment strategies. The Wall Street Journal recently led with an article titled “Value Investors Face Existential Crisis After Long Market Rally.” The article notes that a widely-followed index tracking value stocks (the Russell 1000 Value Index) is trailing the performance of its growth counterpart again in 2018 – the fifth consecutive year and the 10th out of the last 11 years where this has occurred. After a losing streak of that magnitude it seems right to ask - is value investing really dead? Or, if Twain wrote for The Journal, are reports of its death an exaggeration? This is an important question to answer. One of the most well-studied market inefficiencies is that cheap stocks, on average, beat the market. If that anomaly is truly dead, decades of academic research would be completely upended.
At a practical level, whether value investing succeeds or fails shouldn’t really matter all that much. The job of a fund manager, in my opinion, should be to achieve long term returns for clients that exceed those broadly found in the stock market. And managers should have a free hand to pursue this result without regard to style (value vs growth), capitalization, or other externally imposed artificial constraints. To me, those constraints are to a fund manager like a football coach who calls only one play. It might work for a while, but markets are like the opposing team in football. They have an uncanny way of adjusting to, and defeating, a narrow, “one play only” strategy. Flexibility, therefore, is one of the keys to success.
At a deeper level though, “value” does matter, and matters a lot. The price one pays for an investment is perhaps the single most important determinant of investment success. However, figuring out what is true bargain versus something that merely appears cheap is a challenge. A stock with a low multiple relative to some indicator of intrinsic value – earnings, book value, free cash flow – may be cheap in reality, but not always. Often in my career I have seen low multiple stocks continue to get even cheaper as the company’s fundamentals deteriorate. In our work, we tend to look beyond this simplistic approach to low multiples and ask a basic question - “Why is it cheap?” Low multiples, in our view, are an indicator of something more important - investor fear and controversy about a company’s prospects. We try to acknowledge that markets are generally efficient most of the time. Therefore, investor fear and controversy often are entirely justified. Our job is to use research and our experience to determine those cases where that controversy is NOT warranted, or, is meaningfully overstated. In other words, our work centers on the controversy, not on the multiple. It is only after we feel that the controversy surrounding a company is meaningfully overstated do we then feel confident that a stock is truly a bargain.
Let’s put this view of “investing in controversy” into the more familiar language of value versus growth investing. Value investing, as traditionally practiced, looks for cheap multiples of current earnings, cash flow, or book value. In other words, value investors look for controversy about the present. Growth investors, on the other hand, tend to pay less attention to current multiples and more to a company’s earnings potential several years hence – controversy, in other words, about the future. Controversy successfully resolved becomes the fuel for a stock’s outperformance as the broader investor community comes to accept your view. Viewed through this lens, reports of the death of value investing is another way of saying that in recent years, there hasn’t been much investment controversy about the present. Interest rates remained low, the economy had plenty of slack capacity following the financial crisis and most companies seemed set to churn out decent earnings for some time to come. However, from the standpoint of 5 to 7 years ago, there was enormous controversy about the future – the cloud, social media, and electric vehicles, for example, all seemed like pie-in-the-sky. It turned out, though, that most of the controversy about these future-oriented technologies got resolved favorably. As a result, growth stocks performed well and value stocks lagged. In other words, value investing didn’t die, its just that the real controversy was about the future, not the present.
Today, the situation is reversing. Many things controversial five years ago – the cloud, or video over the internet, for example – are now uncontroversially assumed to represent permanent and unending growth. Instead, the real controversy is more likely to be found in the present – the current impact of Netflix on Comcast, for example. Or, whether the rebound in activity in the energy industry is a blip or something more lasting. Our strong desire not to be pigeonholed into a certain style of investing – value or growth – is driven by our belief that successful investing is all about using research to untangle controversies wherever, or whenever, they crop up. Five years ago, our portfolio looked more “growthy” because the future looked more controversial. Today, it has more of a value bent because we find more investor confusion over the present. In the short run, this shift has cost us some potential performance. In the long run, it is the right move.
One final thing to keep in mind. The stock market functions as a discounting mechanism for a company’s future cash flows. When interest rates are very low, as they have been for the past decade, the cash flows of the future are worth more, relatively speaking. When interest rates are high, the cash flows of the present are worth relatively more. Now that interest rates are rising after a long period of near zero rates, we have a factor that will raise the importance or current cash flows relative to those far out in the future. This will likely provide a tailwind to value investing at the moment when the press is questioning its demise. So, like Twain, reports of its death are indeed an exaggeration.

Do Stocks Outperform Treasury Bills? - Monday, August 06 2018

Part of my job is to keep abreast of current academic research in finance and economics – and it is a part that I very much enjoy.  Perhaps in some other life I would have been a finance professor.  In this life, though, my goal in keeping abreast of this sort of research is to inform and sharpen my investment practice.  Often, the research that captures my imagination is focused on some sort of anomaly that proves unexpected and surprising.  I came across just that sort of thing in a soon-to-be-published paper (Journal of Financial Economics) with the provocative title “Do Stocks Outperform Treasury Bills?”  Since everyone knows the answer to that question is “yes,” the author must have something interesting up his sleeve.

The paper revolves around a very interesting analysis of the CRSP database.  CRSP is the Center for Research in Security Prices and provides the definitive dataset covering prices for ALL publicly traded securities over the last century.  A few statistics from the paper:  Since 1926, there have been 25,967 publicly traded stocks in the US.  Those stocks collectively generated $35 trillion in aggregate wealth over that time period – a staggering sum.  That alone makes a very good case for owning stocks.  However, here is the interesting part: just 5 firms (Exxon, Apple, Microsoft, GE and IBM) accounted for 10% of the $35 trillion in aggregate wealth created.  Only 1,092 firms (out of a total of 25,967) accounted for ALL of the wealth created in the stock market.  On the other side of the ledger, the majority of stocks (57%) did worse than Treasury bills over their lifetime.  Finally, the author points out research highlighting that 60% of this aggregate wealth creation occurred on only 13% of all trading days. 

There are several conclusions to draw from this.  First, over long periods of time stocks exhibit highly skewed, almost venture capital like returns.  A small number of companies drive the results for the whole.  The majority of stocks generate mediocre results.  Second, returns are lumpy.  The lion’s share of returns come on a small number of days.  For investors, there are only a few logical responses to this highly skewed and lumpy pattern of returns.  Either one should “own them all” – the quite reasonable premise behind passive investing.  Or, one should invest like a private market investor – own a highly concentrated portfolio focusing on top notch franchises purchased at reasonable prices and held for a long period of time to take advantage of the power of compounding – exactly the strategy we employ at Shorepath.  We will leave the indexing to Vanguard.  The long term statistics imply that the “middle ground” - overly diversified actively managed funds – the way the much of the industry conducts its business – is not likely to succeed.

How Much Does The Economy Weigh? - Tuesday, June 05 2018

At first glance, the question posed above seems like one only Yogi Berra would ask – humorous nonsense.  In fact, it was a real question posed by Alan Greenspan in a speech given back in 1999.  His speech was about the effect of technology on the global economy.  His framing of “how much does the economy weigh” was meant to capture the notion that global economic growth is increasingly based on the power of ideas – which weigh nothing.  Greenspan is nothing if not a data junkie.  He knew the Commerce Department captured both the value and the weight of U.S. imports and exports - form FT 920 in case anyone needs a data fix.  Per FT-920, in 2004, one thousand dollars of global trade with the U.S. weighed 960 pounds.  In 2017, that same one thousand dollars of global trade (adjusted for inflation) weighed 780 pounds, a nearly 20% reduction in weight.  In other words, each dollar of economic activity has 20% more intangible ideas in it, or looked at the opposite way, 20% less “physical stuff.”

What difference does this make to us as investors?  It makes a big difference in several ways.  First, interpreting a company’s financial statements is an important component of intelligent stock analysis.  Our current accounting standards are generally well equipped to capture the value of physical and financial assets.  However, financial statements are poorly equipped to account for the value of ideas.  This means that balance sheets, the place in the financial statements where we record the value of something physical, in some sense have become increasingly disregarded by investors.  If physical things matter less and less in generating economic growth, then all we should care about is cash flow regardless of whether there are any physical assets required to generate that cash flow.  While this cash flow focus is not an entirely bad idea - after all,  a company’s cash flow generation is one of the keys to its value.  That said, taken to an extreme, ignoring the value of physical assets is a mistake.  Both the physical and the intangible are important in determining the right price to pay for any investment.

In the old days (i.e. back when I started doing this) you would hear the words “book value” quite a bit.  The fairness of a company’s stock price was assessed by looking at how much you were paying relative to the accounting value of its net assets – its price to book ratio.  This was very much a balance sheet driven, physical asset view of the world.  Today, those words are seldom heard.  In my view, investors ignoring physical assets has resulted in a fairly large anomaly – the extreme underperformance of so-called value stocks over the last decade.  Let me explain.  In general, investment consulting firms sort stocks into growth and value categories on the basis of well-defined measures.  Value stocks are those that are cheapest as measured by book value – a physical asset view of the world.  Growth stocks are those that are growing their earnings the fastest, a view more compatible with the intangible assets/ideas view of the world.  While in general, I believe paying attention to the external labels applied to stocks is a waste of time – if you care about intrinsic value, what difference does it make what label someone else puts on it? - at extremes, it makes sense to take notice.  We may be close to one of those extremes now.  Over the last 10 years, and intensifying in the last two, value stocks have underperformed growth stocks by cumulative 83%.  This is on par with the level of value stock underperformance last seen in the run up to the tech bubble bursting in 2000.  This is the sort of large scale anomaly worth paying attention to. 

Let me be clear: I am not about to claim there is a tech bubble that is about to burst.  The are several growthy/techy stocks in our portfolio, and we think they are reasonably priced and have good prospects.  I also am not claiming that the trend that Greenspan identified – the power of ideas to spur growth - won’t continue.  Ideas will indeed continue to grow in importance in their contribution to the economy.  However, I am making the observation that markets can over-extrapolate a trend.  A couple of statistics to make note of.  Growth stocks are defined by earnings.  The P/E ratio of growth stocks compared to the broader market is in the highest 3% found over the last 10 years.  By contrast, value stocks are defined by their book value.  The price to book ratio of value stocks compared to the broader market is in the lowest 3% found over the past 10 years.  The point here is this:  measured the way growth stocks are defined – by earnings – growth stocks are very expensive relative to their 10-year history.  Measured the way value stocks are defined – by book value – value stocks are very cheap relative to their 10-year history.  While nothing guarantees this can’t continue for some time, it does, at the margin, inform which way we have been leaning in the portfolio.  Compared to a year ago, the portfolio today has a somewhat greater weighting in banks and energy stocks – both big components of the value index – and less technology, a big component of the growth benchmark.  Over the last six months, this has hurt performance somewhat.  Over the longer term – the investment horizon with the greatest opportunity – we like the odds before us.

The Italian Job - Tuesday, June 05 2018

As May drew to a close, worries over Italy, the European Union, and the stability of the Euro swept through markets.  While I claim no special knowledge about Italian politics, I do know that, on their face, the issues in Italy are indeed serious ones.  Italy is one of the more indebted countries in the developed world.  Government debt stands at 130 % of GDP.  Also, the sheer amount of Italian government debt is very large – nearly $2.5 trillion.  Against that, the country just elected a government that has pledged to ramp up government spending on social programs.  This raises prospects of a collision between politicians’ promises to the Italian people and adherence to the financial rules and commitments to the broader European Union and its single currency.  It is worth keeping in mind that the Euro is a strange beast.  In many ways it shouldn’t exist: one single central bank setting monetary policy but 19 separate countries that determine fiscal policy, all bundled into a single currency.  All that said, the prospects for Italy wrecking the entire European Union project are remote.  First, despite Italy’s indebted status, most of it is owed to Italians – nearly 70% of their government debt is owed to their fellow citizens.  So the threat that the populist parties that now rule Italy will work toward a Euro exit and a return of the Lira is mostly an empty one.  Most of the costs of a debt redenomination would be borne by Italian savers – a very good way for these populist parties to get voted out of office – quickly.  Second, we should not forget the famous “bumblebee speech” given by Mario Draghi in 2012 at the height of the last Euro crisis.  Draghi begins the speech by comparing the Euro to the aerodynamics of the bumblebee – it shouldn’t fly, yet it does.  Why?  Draghi, states, “the point I want to make is in a sense more political.  When people talk about the fragility of the Euro…non-euro member states or leaders underestimate the amount of political capital that is being invested in the Euro.  And so we think the Euro is irreversible.  And that is not an empty word because I have told you exactly what actions have been made to make it irreversible.  But there is another message I want to tell you.  Within our mandate, the ECB is ready to do whatever it takes to preserve the Euro.  And believe me, it will be enough.”       And so my view is, despite periodic Italian brinksmanship, which may from time to time send markets into a tailspin, the incentives and the broader will of European policy makers are well-aligned with Italy remaining firmly within the single currency.  Volatility, with an ultimately successful ending, is the most likely narrative for this version of The Italian Job.

Fire Drill - Monday, March 05 2018

About twice a year in our office building, the building manager and the fire department conduct a fire drill.  An ear-piercing siren goes off and we all have to troop down the stairs (never the elevator) to the floor below to hear a brief lecture from the fire chief on high-rise office building fire safety.  It’s a minor inconvenience made slightly less so by the fire chief’s usual mordant humor – apparently he has ample opportunity to hone his routine.  In any case, it works, everyone is good-natured about it, and after five minutes we are all back at work. 

Our office fire drills are a good illustration of how to deal with an unexpected emergency: plan, prepare, practice.  If our building were to befall some calamity, I can’t say for sure that I would come through unscathed, but I do feel my odds are improved knowing what to do in case it happens.  In managing a portfolio of stocks, the same principle applies.  The unexpected can happen, the investment climate can change for the worse, and thinking clearly about the actions to take in various adverse circumstances can improve the odds of success. 

Though we are never directly asked “what is the fire drill plan for your portfolio?,” we are often asked a related variant in the form of a simple, but important, question.  How much stock market exposure do you take in the portfolio?  Answering that simple question in a way that makes sense opens the door to a host of related questions.  A few examples:  Is the degree of market exposure you take a constant over time, or does it vary?  What is the right level of exposure today?  Since February witnessed the first 10% market correction in over two years, this letter is a good place to outline, in as clear a fashion as possible, our fire drill plans. 

First, as we have written before, we choose to ignore externally imposed notions of what exposure we “should” have in order to neatly fit into an investment category.  Being permanently “long-only” makes as little sense to us as being forever “market-neutral.”  Data, careful study, common sense, and experience will lead us to different conclusions at different points in time.  Keep in mind we are big investors in our fund.  We don’t want our own money managed in an unchanging fashion merely to satisfy an external gatekeeper.  Neither should you.  Instead, our goal is simple - strong after-tax returns over time. 

Some may claim that our first point makes us “market timers” who try to guess the next move in the market as a way to make money.  Nothing could be further from the truth.  We have no skill in that department.  We do believe, however, that we possess some skill in making judgements about economic growth, the trajectory of corporate earnings, interest rates, and the valuation of companies.  And that distinction makes all the difference.  This leads to our second point – market corrections come in two versions.   We try to take advantage of one type and try to avoid the other type like the plague.  Some numbers help to illustrate this distinction.  Over the last 65 years (since 1954), there have been 33 instances where the S&P 500 has declined 10% or more.  Of those 33, nine have been associated with recessions.  These nine recession-related declines are big.  On average, stocks lose about a third of their value.  Moreover, the real economy hits the skids.  People lose their jobs.  The real value of businesses decline and some go bankrupt.  These turns in the real economy, if you are paying attention, can be seen in advance.  They are largely built out of economic excess and tightening financial conditions.  We closely monitor a set of economic and financial market indicators that have proven to be reliable recession indicators over decades.  The LEI, NIPA corporate profits, the level of real estate investment, home prices, the shape of the yield curve, stock market valuation, and investor sentiment are a few of the data points to which we pay close attention.   When these indicators begin to roll over – and they do in advance of every recession - we plan to have a very modest level of market exposure in the portfolio.  In contrast, the other 24 market declines greater than 10% since 1954 have quite a different character.  First, they are smaller in size; on average, stocks decline about 15% during these “non-recession corrections.”  More importantly, they are largely “endogenous” events.  The stock market declines for reasons unrelated to the economy or real changes in the value of businesses.  The market declines and the real economy yawns.  The best example is the stock market crash in October 1987.  A one-day decline of over 20% and the real economy barely noticed.  These declines, because they are not fundamentally driven, are generally not observable in advance and we claim no special skill in divining their arrival. However, they are generally excellent opportunities to add more market exposure to the portfolio.  Rather than fearing these declines, we should embrace them.  Stocks are “on sale” (who doesn’t like a sale?) and the value of the underlying businesses has not changed.

February’s market decline gave us a good opportunity to test out our fire drill training.  Our first question was – how likely are we to be on the doorstep of a recession?  Every economic indicator we track indicated that a recession was an extremely unlikely outcome.  Readings for industrial production, employment, corporate profits, the housing market all remain robust.  Financial conditions, despite interest rates increases, remain accommodative.  The data led us to conclude this was one of the market’s “endogenous” declines rather than one that presaged an imminent recession.  The second question was, how should we take advantage of this decline?  As detailed in prior letters, we had been carrying higher than normal levels of cash in the portfolio, so we were fortunate to have “dry powder” to put to work.  Experience has shown us that the most prudent way to deploy our dry powder during a downturn is via a combination of adding to our highest conviction holdings and new holdings that present an unexpected price opportunity.  In February, as detailed below, we followed exactly that playbook.  In addition, we kept an extra bit of dry powder available in the event the decline lasted longer or became more severe than anticipated.

What Now? - Thursday, February 08 2018

January started out with a bang.  So what now?  Does January’s outstanding market performance presage a blockbuster 2018?  Or did we have 12 months of returns in the first few weeks of the year?  In last month’s letter, we discussed our outlook and positioning for 2018.  We noted that the business climate and the outlook for corporate earnings is likely to be very good.  Strong employment, rising wages, robust overseas economies coupled with corporate tax reform will all work to produce very strong corporate earnings.   On the other hand, we noted the prospects for rising interest rates, especially long-term interest rates.  This, we wrote, will have the effect of constraining the multiple that investors are willing to place on those robust earnings.  Two steps forward (earnings), one step back (rates/multiples).  Events so far this year seem to support this line of thinking.  Earnings reports have been outstanding, as have the economic data, but interest rates have been rising.  If January was the two steps forward, as we begin February, we may be taking one step back as rates begin to break out to levels not seen in several years.  Over the course of the entire year we still believe this results in a positive market environment – just not as positive as the business environment and the economy might suggest.  

2018: Outlook and Positioning - Monday, January 08 2018

The economic and business backdrop in 2018 is likely to be quite good. We now have a synchronized acceleration in global GDP growth, a tailwind coming from a more business friendly US regulatory environment, and a one-time boost from lower corporate tax rates. In that environment, S&P 500 earnings are likely to rise at a mid-teens rate. That is a very good outcome. Also, I believe the items that are dominating the current news headlines – Trump administration dysfunction and North Korean saber rattling – are unlikely to erupt into full blown crises, at least during the coming year. Given that, you might guess that the Fund’s positioning would be “max bullish.” We are not. Valuation matters. While we would not call the overall stock market “overvalued,” it is becoming harder to find bargains we are truly excited about. We started 2017 generally fully invested with 23 stocks in the portfolio. We begin 2018 with 19 stocks in the portfolio having sold 5 positions during 2017 and adding only one new one. As a result, our cash levels are higher than normal. In addition, as 2018 progresses, interest rates may start to become a slight headwind for stock prices. As we have written in the past, the comparison between yields on corporate bonds (low) and the earnings yield on stocks (high) is currently quite favorable for stocks. That is one reason for our optimism over the past five years. However, if interest rates continue to rise, then we may end 2018 with this earnings yield/bond yield comparison much closer to its post WWII average rather than 1 standard deviation cheap where it stands today. All of this leads us to think that the S&P 500 return in 2018 is likely to lag behind corporate earnings growth. In other words, 2018 may see earnings multiples compress somewhat. Thus, if earnings rise at a mid-teens rate, then stocks may rise at a mid to high single digit rate as the headwind from rising rates begin to bite. Against that backdrop, look for us to continue to harvest winners and to deploy capital only into true bargains or into meaningful market declines. This is not the time to stretch the boundaries of our valuation discipline.

The Future Ain't What it Used to Be - Wednesday, December 06 2017

There is a perfect Yogi Berra quote for almost every circumstance. What makes Yogi-isms so memorable is that they capture life’s contradictions in an unintended and humorous way. The future not being what it used to be speaks to the contradiction that things often appear better in advance than they end up being after the fact. Investment geeks might say that evaluating an investment opportunity ex ante is very different than evaluating it ex post – or, forecast returns are often very different than realized returns.
This disconnect between investors’ view of the past and their view of the future seems particularly notable when it comes to investments in corporate equities. At the highest level, investors can become equity owners in one of two ways. They can buy shares of publicly traded companies via the stock market or
invest in the shares of private firms either directly or through a private equity fund. Both represent ownership in some sort of business enterprise. Since the end of the financial crisis, investors, broadly speaking, have strongly preferred the private form of ownership. Since the end of the financial crisis, nearly $1 trillion has been committed to private equity funds in the US (prior to fund distributions). By contrast, mutual funds have seen a cumulative $500 billion in redemptions. Another way to measure the same ownership shift: the Wilshire 5000 index, the broadest stock market index in the US, has only 3,500 companies in it. There aren’t 5,000 public companies to include in it. The last time the Wilshire 5000 had 5,000 stocks in it was 2005. More companies are electing to stay private because, as Willie Sutton said about the reason he robbed banks, that’s where the money is.
Has this shift in corporate ownership resulted in a better experience for investors? Since the end of the financial crisis, the evidence points in the other direction. The largest institutional investors in the US are state and local pension plans. Six of the very largest are the plans from California, New York, Florida, and Texas – CALPERS, CALSTRS, NY State Common, NY Teachers, Florida State Board of Administration, and Texas Teachers. Collectively, these six plans oversee assets of a bit more than $1 trillion, of which between 10 to 15% is dedicated to private equity. Given their size, it is reasonable to assume that these plans would be able to select only the best and brightest private equity managers. Here are the results. From 2009 to 2016, the private equity portfolios of these six enormous pension plans returned an average of 13.8% per year. Not bad. However, over that same time period, the S&P 500 returned an average of 14.9% per year. Are these pension plans especially bad at selecting private equity mangers? No. Cambridge Associates tracks the returns of almost every U.S. private equity fund. Over this same time period these pension plans matched, almost exactly, the returns of the entire private equity market as tracked by Cambridge. Based on the data I see, it is hard to claim these plans had no idea what they were doing in private equity.
My aim here is not to throw private equity under the bus as an asset class. There are private equity managers that are extremely talented and consistently produce very good returns. The problem is investors’ perception that because some private equity managers produce truly extraordinary returns, that the whole asset class is somehow “better” than the stock market. This “fallacy of composition” rests upon the fact that the spread between a top quartile private equity manager and a bottom quartile one is gigantic. Top quartile PE funds launched in 2009 returned an average of 20% per year net to LPs. That’s fantastic. Bottom quartile funds, on the other hand, returned 7% per year. In other words, manager return dispersion was 13% per year. That’s huge. In the public markets, large cap manager return dispersion is about 2% per year over a comparable time period. The lesson here is that the massive shift of investor capital from public to private equity is not entirely justified by the overall portfolio effect experienced by the largest, most highly capable investors. If they aren’t successful in repeatedly identifying the top quartile PE managers in advance, and steering clear of the bottom quartile ones in advance, how can anyone be? Manager return dispersion winds up making the returns of their entire PE portfolio, which consists of many different funds, rather mediocre compared to broad equity market returns since the financial crisis. In advance, many PE funds have great pitches delivered by skilled professionals. Reality often winds up differently. The future, in PE investing, often ain’t what it used to be.

Sherlock Holmes and Productivity - Monday, November 06 2017

There are Sherlock Holmesian aspects to the job of managing money.  No, we don’t walk around on dark, foggy moors wearing deerstalker caps brandishing a magnifying glass muttering “it’s elementary, dear Watson.”  Instead, Holmes’ job was to make sense of odd bits of disparate evidence that often add up to surprising conclusions.  Our job is a lot like that.  Holmes summed it up in The Sign of The Four: – “when you have eliminated the impossible, whatever remains, however improbable, must be the truth.” 

If Sherlock Holmes were an economist, he would try to crack the one big, economic mystery – why is productivity growth so low?  And why would he focus on that one question?  Simple – it’s the single statistic that is the key to an economy’s long term economic health.  While productivity can be measured in several different ways, the basic idea is “can we do more with less?”  And if we can do more with less, companies are more profitable, shareholders make more money, workers’ wages rise, and the economy can grow faster without generating inflation.  These are all very good things, especially from an investor’s point of view.  Since the financial crisis, however, labor productivity (output per hour worked) has run well below historical trend.  In the last 10 years, US productivity growth has averaged about 1% per year.  In the 20 years prior to the financial crisis, labor productivity growth averaged about twice that – about 2% per year.  While these differences may seem small in any one year, over course of a generation, those small differences can result in meaningfully higher GDP and living standards for millions of people.  

Holmes sometimes found that the key to solving a mystery was the “missing clue” – the dog that didn’t bark.  Today’s dog that doesn’t bark is technology.  We are surrounded by technology and communications advances that would seem almost unimaginable a generation ago.  Surely, all of these advances didn’t depress productivity.  Are we all just ignoring our jobs and Snapchatting each other?  I spent a career at two very large banking and investment firms, J.P. Morgan and Alliance Bernstein, and for the last five years have been running a small investment operation.  The cloud based investment tools now at my disposal are meaningfully better, cheaper, and faster than the ones I had previously that likely cost millions.  Isn’t that the definition of productivity growth?  Also worth noting: corporate profit margins are historically high and rising.  Wouldn’t strong productivity growth be an important contributor to that?  Clearly, something is missing in our measurement of productivity.  The dog that ought to be barking, isn’t.

A recent paper from the Fed’s research department points toward an answer.  Maybe we have measured technology and its cost incorrectly.  And if we have done that incorrectly, then we may have overstated inflation and therefore understated real economic growth.  And if we have done that, then perhaps productivity isn’t depressingly low after all.  Maybe we really are doing more with less.  The paper identifies two issues.  First, the inflation statistics are generally good at measuring the price changes of physical goods.  They are less good at measuring the price changes of services.  Services, and the price of services,  are generally non-standard, intangible, and therefore hard to measure.  Second, much of what we call technology is now delivered as a service rather than as a product.  Nearly all of the technology Shorepath consumes in its operations is a service.  Aside from a few end user devices (PCs, tablets, cell phones), we own zero physical technology infrastructure.  And here is the thing – the price of technology services has been declining at an astounding rate.  The Fed’s paper estimates that the official price statistics for technology understate actual price declines by as much as 6% per year.  And as a result of technology “actually” being cheaper than we currently measure, they estimate that productivity is likely higher than measured.  Tech itself could be boosting productivity by up to 1.4% per year.  That’s huge.  What does this all mean?  It means that the “secular stagnation” theme espoused by many is wrong.  The secular stagnation theory views the corporate profits and stock market gains since the end of the financial crisis as nothing but a mirage formed by overly stimulative central banks.  This research points toward the idea that these gains are well founded on strong productivity flowing from a dynamic technology sector.  And, absent a fiscal or monetary policy mistake – the thing we worry about most -  it is likely to be sustained for some time.  At its heart, this is the long-term basis of our continued positive stance on the economy and markets.

Been Down So Long, It Seems Like Up to Me - Tuesday, October 03 2017

The music buffs among you will recognize “Been Down So Long” as the title to a song by The Doors.  If you haven’t heard the song, think of a traditional blues track filtered through a dense haze of psychotropic drugs.  The music historians among you will speculate that The Doors probably got that title from somewhere, maybe from an old, obscure blues track.  They would be right.  “Been Down So Long, It Seems Like Up To Me” is a line from an old Mississippi bluesman’s (Furry Lewis) song “I Will Turn Your Money Green.”

“Been down so long, it seems like up to me” and “turning your money green” is an excellent backdrop for the end of quantitative easing and the question of whether interest rates may finally rise from historic lows.  First, let’s state the obvious: most people find the idea of QE to be confusing and are uncertain of its effects.  How does creating new excess reserves in the banking system in order to purchase government bonds make the economy grow faster than it otherwise would have?  Even Ben Bernanke, in one of his last speeches as Fed Chairman in 2014, half-jokingly quipped, “We have shown that QE works in practice but we are not quite sure it works in theory.”

Leaving aside the academic case for QE, as a practitioner in the markets, I think its main effect has been on the supply and demand of government bonds.  Simply put, the supply of bonds available to the public to buy has been reduced because central banks have “removed” trillions of dollars of potential supply from the market.  And, the demand for government bonds has increased due to regulatory changes to liquidity requirements.  Banks and money market funds now must hold a much greater proportion of government bonds than before.  It doesn’t take an econ PhD to see that lower supply and higher demand leads to higher prices and therefore lower yields for government bonds.  Put another way, the level of interest rates is lower with QE, all other things being equal.  And lower interest rates are a clear boost to the economy.  So far, this is simple and obvious.

What might be less obvious is QE’s effect on the term premium in the bond market.  What is the term premium?  Basically, it is the extra bit of yield the market requires to buy a longer maturity bond.  As a technical note, the term premium is more than just the “shape of the yield curve” – the yield difference between, for example, the 10-year treasury and the 2-year treasury.  Instead, imagine that you could disaggregate the 10-year treasury into a series of ten 1-year treasures stretched out ten years in the future.  If you do that, you can ask an interesting question – how much extra yield is there for a 1-year treasury, 5 years from now versus a 1-year treasury, 4 years from now.  That extra bit of yield is the term premium.  It can’t be observed directly and must be estimated by some fairly sophisticated math.  Fed economists have estimated that QE has depressed the term premium by about 75-100 basis points.  So irrespective of the level of rates, the term premium one normally would gain by owning a longer maturity bond is currently 100 basis points lower than it otherwise would be.  But unlike the level of interest rates, where lower is good for economic growth, it is not clear that a lower term premium is good for economic growth.  In fact, there is a strong case to be made that an unnaturally low term premium is bad for at least one part of the economy – the banking business.   In the abstract, banks are “maturity transformation machines.”  They take in short term deposits and make longer term loans.  In other words, collecting “term premium” is one of their main lines of business – a line of business that QE has “taxed.”  And less profitable banks have a lower propensity to lend.  That is a clear drag on economic growth.

The reason for this long discussion is that we are likely nearing an inflection point.  The Fed recently announced it will begin allowing its holding of government bonds to shrink.  The ECB has hinted it will follow suit next year.  The result is that the aggregate net supply of government bonds available to the public in the “big three” markets – the US, Japan and Germany - will be positive next year for the first time in 5 years.  It is difficult to foresee how thelevel of interest rates will change given positive net supply of government bonds next year because central banks still control the level of short term interest rates.  However, it seems more clear to me that the end of QE and a return to positive net supply of government bonds will lessen the dead weight that central banks have placed on the term premium.  As you may remember from reading these letters, the portfolio has healthy weighting in financial stocks that will benefit greatly from the term premium returning to its natural – and higher - state.  These stocks have mostly marked time this year.  Given this likely change in the term premium environment, we feel optimistic that banks may yet turn our money green.

Walter Mitty and Air Canada 759 - Thursday, September 07 2017

Let me go out on a limb and make a bold statement – almost every one of us harbors a secret, Walter Mitty-style fantasy of being the completely ordinary person who does extraordinary things.  For me, it is the idea of being a pilot.  I still have this sense of amazement that a heavy hunk of aluminum and titanium can fly through the air at hundreds, or even thousands, of miles per hour.  How cool would it be to be in the driver’s seat of that?

As a result of my inner Walter Mitty, I have always paid very close attention to aviation-related news.  So it was with some interest that I read about a near-disaster a few months back (July 7).  An Air Canada flight attempting to land at SFO at night, and in clear weather, nearly landed on a taxiway full of packed airliners instead of landing on the runway it was assigned.  Had that happened, the loss of life could have been catastrophic.  So how could a highly trained pilot, with over 20,000 flight hours, operating in clear weather, come 50 feet away from what could have been one of the worst aviation disasters in history?  Simple, he thought “looking out the window” to land the plane was better than using the highly precise navigational instruments in the cockpit.  My point here is not to blame the pilot, or anyone else for that matter, for this near miss but to illustrate a larger point about “decision making under uncertainty.”  Sometimes even a highly trained professional, performing what should have been a routine task (landing in clear weather) can be at risk of making a major mistake.  Why?  Our eyes, our senses, and more generally our perception of the world around us can be deceiving.  That’s why airliners have instruments and why portfolio managers like me pay close attention to the data instead of just falling back on our “gut.”  As Groucho Marx put it – “Who are you going to believe, me, or your lying eyes?” 

It is tempting, especially today as I write this, to steer the portfolio based on the latest headlines -  to “look out the window” for guidance.  What you see is political and social dysfunction, natural disasters, and nuclear brinksmanship by North Korea – storm clouds everywhere.  However, our navigational instruments, the data, tell a different story – growing corporate earnings, stronger global economic growth, modest inflation, low commodity prices, low unemployment, and strengthening wage growth.  In another era, I believe this would have been described as “Goldilocks.”  To be sure, enough scary news headlines can steer people into precautionary actions that can cause the real economy to contract.  But we are not at that point yet.  For now, we continue with a portfolio constructed to do well based on what we see with our instruments (the positives) rather than what we see by looking out the window (the negatives).  Howard Marks, a very savvy investor and founder of Oaktree Capital (the “other” Marx brother), recently summed it up best – “move forward, but with caution.”

How to Succeed in Business Without Really Trying - Friday, July 07 2017

Though I wasn’t around to see it first hand, the late ’50 and early 60’s carry an image in my mind as the high point of a particular mood in American business.  Classic American companies like General Electric, Ford, and IBM stood atop the business world and were run by conformist armies of Organization Men all wearing Grey Flannel Suits.  Broadway, as it so often does, took this as an excellent opportunity for satire.  How to Succeed in Business Without Really Trying opened in 1961, won 7 Tony Awards and ran for nearly 1500 performances.  If you haven’t seen it (there is a movie version), think Mad Men meets The Office.

The play revolves around J. Pierrepont Finch, a lowly window washer working at the Manhattan skyscraper headquarters of the World Wide Wicket Company.  As Finch washes windows, he longs to be on the other side of the glass - a grey flannel suited executive of World Wide Wickets.  Finch stumbles upon a cheap how-to book – How to Succeed in Business Without Really Trying.  He comes to believe the book’s simple advice (believe in yourself) can catapult him from window washer to the executive suite.  Without rehashing the plot’s twists and turns, Finch’s dreams come true and as the curtain falls, he is made Chairman of World Wide Wickets. 

For those tasked with the job of managing money for a living and hoping to outperform the market, we are all, to a great extent, just like J. Pierrepont Finch.   We labor away at a tough task and hope to make it to the other side of the glass and into the executive suite of long term outperformance.  And, like Finch, we are vulnerable to thinking our dreams can come true if we just follow the directions in a simple book, to believing in “the one new thing” that will set us on the path to success.  But unlike Finch on Broadway, where the easy way always works, markets have a unique way of defeating get-rich-quick schemes.   Simple sounding, market beating schemes have come and gone over the years - The Nifty Fifty in the 70’s, Portfolio Insurance in the 80’s, the Dot Com era of the 90’s, BRIC country investing in the 00’s.   All of these simple investment themes, at the beginning, had a kernel of truth to them.  But a good idea chased to extremes by waves of investor money and enthusiasm becomes self-defeating.

The current “easy money” scheme attracting buzz is quantitative investing – or “quant.”  There have been countless news articles discussing how some well-known fund manager is adding a quant team, or is re-vamping his investment process to harness the power of quantitative investment techniques.  In fact, The Wall Street Journal’s lead article on May 21st of this year was “The Quants Run Wall Street Now.”  To be clear, there is nothing inherently wrong with quantitative investment techniques -  I use some simple quant techniques in what I do.  But let’s keep in mind what quant is and how it works.  At a high level, quantitative investment techniques allow a manager to analyze more data, to analyze it faster, and to analyze it systematically and without bias.  These are good things.  But there are two points to keep in mind.  First, the data itself is a publicly available commodity.  It can be different data than financial analysts are used to – like the publicly available data from social networks – but it is not in any way “secret” or “proprietary.”  Also, the cost of computing power required to analyze these big data sets has fallen rapidly.  Anyone with the know-how and a modest amount of money can avail themselves of the latest quantitative investing techniques.   So the question is, where’s the investment edge in exploiting a publicly available commodity?  Second, and perhaps more importantly, the data the computer is analyzing stems from events that happened in the past.  Successful investing is founded upon making good judgements about the future.  So inherent in using quantitative investment techniques is the assumption that the future investment landscape will look like the past.  Much of the time that is true.  However, in my experience, the potential for major gains and avoiding major losses comes at turning points in the market – in correctly anticipating that the historical data that you have is about to be a poor guide to the future.  I know of no quant technique able to render that sort of judgement.  The point is this: don’t get caught up in the hype around quant – it’s a tool, nothing more.  And, to be used successfully, it must be applied by skilled humans making wise choices.  Quant used by less than expert hands is unlikely to result in superior returns.   Skill, and intelligent risk taking, will never go out of fashion.

The Checklist Manifesto (Stock Market Style) - Friday, April 07 2017

I have always been interested in human behavior – why do we do the things that we do?  What motivates us?   The main reason why I find our behavior so interesting is that we are this curious mixture of rationality and emotion.  On top of that, we aren’t very adept at knowing whether or not we are using, or should be using, our logical selves or our emotional/instinctual selves.  In other words, “thinking about thinking” is a rich and fascinating field.  See Daniel Kahneman’s “Thinking Fast and Slow” for a full and fascinating look at the topic.

Investing, especially in the public markets, is a daily case study in the intersection of these two sides of human behavior.  Academics have debated for decades the proposition of whether markets are efficient – whether or not market prices accurately discount all that is known about a company.  As a long time practitioner, I can state with great confidence that while markets may be efficient as a whole and over the very long term, they are quite often, in a local and temporary sense, highly inefficient.  Look no further than Robert Shiller’s 1987 observation that stock prices are over 10 times more volatile than the underlying drivers of their value (earnings and dividends).  That observation only makes sense if we assume that market prices are a combination of rational efficiency and emotional inefficiency at the same time. 

Shorepath’s goal, as we state in our marketing material, is to outperform the market in good times, while being nimble enough to protect our investors’ capital during times of major market downturns.  To many, this statement would smack of trying to “time the market” – something that might get me burned at the stake in the polite company of professional investment consultants.  But that would be a misreading of what we are trying to do.  We have no skill in foreseeing every garden variety wiggle in the market.  As Shiller observed, markets wiggle far more often than the change in the underlying value of companies.  Most of those wiggles, in my opinion, are opportunities to put MORE capital to work, not less.  Instead, we are trying to foresee the MAJOR downturns associated with economic recessions.  In other words, our job in managing the Fund’s market exposure is to accurately distinguish between two states – “endogenous” market moves that are unrelated to any change in the value of our holdings and fundamentally driven moves where the value of our holdings might be seriously impaired.  Each of these states requires two opposite actions, in the first, we should be looking to invest more capital at better prices.  In the second, caution and high levels of cash in the portfolio are the correct recipe.  If you want to call this “market timing,” go ahead, but I think a better label is “investing.”  Recessions and their accompanying major declines in the stock market are always preceded by excesses – overbuilt housing markets, excessive capital spending, too much inventory.  Bull markets, so goes the old saying, die of excess – and these sorts of excesses are things we can observe in advance.

However, making the observation about excesses, and acting on it in the portfolio are two different things, especially in the context of fast moving global markets.  Making money in a bull market is fun and “letting the good times roll’ are siren songs that make it very easy for a portfolio manager to ignore signs of growing excess.  In 2007, author and surgeon Atul Gawande wrote one of the most interesting articles (in my opinion) ever to appear in The New Yorker – “The Checklist,” which grew into a book two years later – “The Checklist Manifesto: How to Get Things Right.”  Gawande observed that even highly trained specialists – think doctors in intensive care units or test pilots – can make simple and sometimes fatal mistakes during times of stress.  The wrong data is considered, steps get skipped, the seemingly unimportant can turn out to be quite important.  In an era of increasing speed and complexity in almost everything, markets especially, the way forward, Garwande argues, is the checklist.  The checklist reminds you of all the things you should be doing in busy, stressful situations so that you don’t fall back on easy, and sometimes wrong, rules of thumb.

So what is on our recession/bear market checklist and how does it look today?  The checklist has five elements:

1)      Overall Economic Activity – as measured by the Conference Board’s Leading Economic Index.

2)      Housing – as measured by residential investment as a percent of GDP.

3)      Financial Conditions – as measured by the shape of the U.S. Treasury yield curve (the yield difference between the 10 year Treasury Note and short term bills).

4)      Corporate Profits – non-financial corporate profits as measured in the GDP accounts.

5)      Valuation – as measured by the difference between the earnings yield on the S&P 500 and corporate bond yields.

Prior to every major downturn you will find the following features: a declining LEI (the broad economy getting weaker), housing investment above its long term average (overbuilt housing markets), a flat or inverted yield curve (tight financial conditions), falling corporate profits (companies making less money) and a stock market valued above its long run average.  When those conditions are met, we will meaningfully trim the sails of our portfolio and turn our attention toward protecting your capital.  Currently, we are relatively far from meeting these conditions.  The LEI is rising and is only fractionally above its prior peak.  Housing investment as a percent of GDP is still far below its long run average.  The yield curve is positively sloped, implying easy financial conditions.  Corporate profits are rising.  Overall market valuation (as compared to corporate bonds) is below average.  In summary, of the five things on our checklist, zero of them are signaling a cause for concern.  Note this does not mean we are forecasting “no market decline.”  As stated above, we have no skill in forecasting every market wiggle.  What it does mean, though, is that an economic downturn and a major, long lasting, and painful market decline is unlikely in the near term. 

The Marshmallow Test - Tuesday, March 07 2017

In the late 1960’s Stanford professor Walter Mischel conducted what would go on to become one of the most famous human psychology experiments in history – The Marshmallow Test.  The test, conducted on a collection of kindergarteners, examined their ability to exercise self-control and delay gratification.  Each child sat at a table in an otherwise empty room and were asked if they would like to have the single marshmallow in front of them now or whether they would like to wait 15 minutes and get two marshmallows.  Over 600 kids ultimately took part in the test.  About 1/3 ate the marshmallow immediately.  Another 1/3 tried to wait the 15 minutes it took to get the second marshmallow, but gave up early and ate the single marshmallow anyhow.  The final 1/3 managed to wait the entire 15 minutes and get the ultimate two marshmallow reward.  Over the next 30 years, Mischel discovered that the group who successfully delayed gratification to get two marshmallows were generally more successful.  They had on average higher SAT scores and generally greater educational attainment.  What are the personality traits of these “delayed gratifiers?”  Mischel found that they are generally 1) persistent and do not give up easily, 2) use and respond to reason, 3) are attentive and able to concentrate, 4) plan and tend to think ahead.  In short, they followed their mother’s advice: good things come to those who wait.

Success in the investment business also depends, in part, on following your mother’s advice to be patient.  Much has been written, both in the academic literature and in the popular press, about the characteristics of funds that consistently beat the market.  One characteristic, first analyzed by Petajisto (NYU) and Cremers (Notre Dame), looked at a measure they called “active share.”  This measure, which has now become standard in portfolio manager evaluations, calculates the degree of difference between a manager’s portfolio and the index he is trying to beat.  The conclusion (obvious now in hindsight): to beat the index, your portfolio needs to look different than the index.  And the greater the difference, the more likely the portfolio is to outperform the index.  The second characteristic of outperforming portfolios is patience – the financial market equivalent of successfully waiting to get the two marshmallows.  In a recent paper (“Patient Capital Outperformance: The Investment Skill of High Active Share Managers Who Trade Infrequently”) Cremers examined a refinement to his earlier work on active share.  He discovered that not all high active share managers outperform.  Instead, it was a subset that really stood out – those managers who make long term investment decisions as measured by the length of time they hold their individual positions.  On average, high active share portfolios with holding periods over two years tended to outperform by about 2% per year.  In other words, they had the courage to look different than the index and the patience to see their ideas through to fruition.  How do we look on these measures?  Our active share is about 90% (max is 100%) and about half of the current portfolio weight is in stocks first purchased at Fund’s inception over four years ago.  We are definitely comfortable waiting for that second marshmallow.

Cremers goes on to ask a very interesting question.  What is it about these patient portfolio managers?  Are they smarter?  Better looking?  Do they employ more or better staff?  Do they have “special” information? Nicer offices?  None of those things seems to be the case – as I can attest.  Instead, Cremers chalks it up to the limited amount of capital available to pursue a patient strategy “it requires that [clients] are fairly patient in giving the manager time to stick with his strategy, rather than evaluate the performance after relatively brief periods of time…..trading on long-term mispricing is more expensive and difficult, especially if the fund manager risks being fired in the short-term before successful long-term bets pay off.”  Thus if relatively few people are able to pursue a patient strategy, the rewards to actually pursuing it ought to be that much greater – and more persistent.  Yet much of the so-called innovation in investment products runs in the opposite direction – toward encouraging increasingly shortsighted investor behavior.  Standard mutual funds, offer daily liquidity and ETFs offer instantaneous liquidity.  All of this encourages investors to “panic sell” during times of stress and “panic buy” during times of euphoria, exactly the opposite of what they should be doing.   In other words, the market for financial products is trending toward ever more creative ways to encourage people to eat their single marshmallow immediately rather than waiting for the second one.  To a certain extent, that short term activity just makes the second marshmallow we are looking for bigger and sweeter.

We Have Met the Enemy and He is Us - Friday, February 17 2017

Commodore Perry, in the War of 1812, defeated the British in the Battle of Lake Erie and sent his famous message proclaiming victory -  “We have met the enemy and they are ours.”  On the first Earth Day in 1970, noted newspaper cartoonist Walt Kelly had a wry take on Perry’s victory announcement.  Kelly published a cartoon about the environment with the caption “We have met the enemy and he is us.”  This also applies very well to the investment business.  Successful investing requires victory over a very stout foe – yourself.  Many investors, even highly trained professional investors, can panic.  Rather than buying low and selling high, many end up doing the opposite – and that can be quite costly.  This leads to the second misleading rule of thumb – that the return on the investment is the return you will actually realize.  Often, investment returns are hindered by the investor’s own actions.

You can observe this “shoot yourself in the foot” effect almost everywhere, even in passive, index-tracking investments.  In theory, passive investments are the ideal long-term, buy-and-hold strategy where all investors earn the index return, no more, no less.  Well, that’s not exactly how things have worked out for the average investor, especially in ETFs.  Much of the new money that has flooded into passive investments in recent years has done so in the form of ETFs.  But because ETFs have become so instantaneously liquid, they have turned what should be a sound, long-term strategy into a loaded weapon aimed at your foot.  ETF liquidity has enabled people to chase past success and punish recent failure, when they should be doing the opposite, or perhaps doing nothing.  As an experiment, I took data for the largest ETF – the one tracking the S&P 500 (SPY) – and tracked fund flows into and out of it over the last 5 years.  I then created a “follow the crowd” trading strategy that purchased SPY when investor money was flowing in, and sold when investor money was flowing out.  I also created a “contrarian” trading strategy that did the opposite.  Finally, I created a “buy and do nothing” strategy.  Here are the results over the past 5 years.  “Buy and do nothing” was clearly superior with an annualized return of 14.65% - exactly equal, as you would expect, to the annualized return of the index.  “Follow the crowd” was clearly the worst with an annualized return of 14.06% and the “contrarian” strategy saw an annualized return of 14.50%.  Here’s the lesson: liquidity is a double edged sword.  It’s great in theory.  The problem is it can become like having liquor store on every corner – it allows people easy access to their bad habits.  My best advice:  invest for the long haul and resist the temptation to over-trade.  If you feel compelled to trade, generally try to do the opposite of what the crowd is doing.  If you are a Dr. Seuss fan, you will know what to call the day you trade against the crowd – Diffendoofer Day.

We hold these Truths to be Self Evident - Tuesday, February 07 2017

To borrow a bit from The Declaration of Independence, most investors believe the following to be self evident – that all investment returns are created equal.  The meaning here is simple; all one needs to do is pick those investments delivering the highest return “number” in order to secure one’s Life, Liberty and pursuit of Happiness.  Unlike men, however, all investment returns are NOT created equal.  A quick example is in order.  Imagine you and a friend each have $100 and you both are asked to choose between investing in Shorepath and investing in a private equity fund.  Let’s assume you both know for certain that Shorepath with deliver a net return of 12% per year over the next 10 years and that the private equity fund will deliver an annual net return of 13% over the same period.  Clearly, you both would prefer the private equity fund, right? Well, maybe not.  As always, it pays to look at the details.  Let’s assume that you, just on a hunch, decide to pick the “inferior” 12% Shorepath investment (perhaps the manager talked you into it).  After ten years, you will have $310.58  – a tidy profit.  Your friend, being more urbane, and possibly better looking than you, chooses the “obviously superior” 13% private equity investment.  In your friend’s private equity case, we need to make a few industry-standard assumptions.  First, that his $100 commitment is drawn in three equal installments over the first three years of the 10 year period and second that his investment profits are harvested in three equal installments in years 8, 9 and 10.  This is a fairly typical pattern in a private equity fund investment.  Your money is drawn as needed, and returned to you as the fund’s investments are sold.  If this fund delivers the anticipated 13% return over 10 years, using these assumptions, your turn three capital calls of $33.33 into three distributions of $88.52 for a total of $265.56 at the end of 10 years.  So how can your better looking friend’s “obviously superior” 13% return result in significantly less money ($256.56 vs $310.58) after 10 years than your rather homely 12% return?  Easy, because the return numbers aren’t comparable – they are apples and oranges.  Private equity investments (and venture capital investments for that matter), are almost always calculated as an internal rate of return (IRR).  An IRR is a “money weighted” return.  It takes into account the fact that you don’t invest all your money up front and that you get some of it back before the 10 years is over.  The hypothetical 12% return from Shorepath is a “time weighted” return which assumes you invest all the money on day one and leave it, undisturbed and quietly compounding away.  Essentially what’s happening here is that the entire Shorepath investment stays invested for the entire 10 years, at an apparently “inferior” return, while the “obviously superior” 13% return from the private equity fund results from having your money invested later and harvested earlier than the total 10-year life of the investment.  The point here is simple.  What matters in investing is the amount of money you have at the end and a simple comparison of returns often can lead you astray.  If none of this makes any sense, just remember this:  never compare returns from a manager of public securities to a private equity or venture capital fund.  They are almost always prepared on a different basis – one that tends to flatter the perceived long term wealth generating potential of the private investments.  None of this is meant to bash private equity or venture capital – they can be great parts of an investment portfolio.  What they are not, in my view, is a portfolio panacea that guarantees wealth generation superior to the stock market.  

Baby You Can Drive My Car - Tuesday, January 17 2017

People of a certain age will immediately recognize the words from the 1965 Beatles song “Drive My Car.”  That silent stereo in your brain should now be playing that famous Paul McCartney riff “baby you can drive my car, yes I’m gonna be a star.”  To me, McCartney invokes an image of the intoxicating mix of fame, fortune, and the desire to display it all to the world through a flashy car.  This is a deeply felt human desire: to seek, and gain, the approval of society and to show off the trappings of that approval for the world to see.  Surprisingly, this theme is at work in the investment business, too.  I recently came across an academic paper titled “Sensation Seeking, Sports Cars, and Hedge Funds”.  The opening lines of the paper’s Abstract speak for themselves – “We find that hedge fund managers who own powerful sports cars take on more investment risk.  Conversely, managers who own practical but unexciting cars take on less investment risk.  The incremental risk taking by performance car buyers does not translate to higher returns.”  The authors propose that this is due to “sensation seeking” on the part of the performance car owner – that extra bit of emotion one gets from driving a cool car over and above the mere utility of getting from point A to point B.  In the stock market, that extra bit of sensation seeking is often manifested in owning “popular stocks” or in using too much leverage in a portfolio.  The problem is that markets are set up to frustrate the desire of the sensation seekers.  Popular stocks are often overpriced and therefore generate poor future returns and leverage can wipe out the imprudent when the unexpected happens (as it always does).  In my view, the best strategy is to leave the sensation seeking aside and treat both cars and stocks as the “vehicles” that they truly are – one is a tool to get you to your destination and the other should compound your money with an acceptable level of risk.  This means you need to comfortable with sometimes driving the frumpy car and buying the unpopular stock.  As for me, much to my wife’s dismay, I still drive my 8-year old clunker to the office (at least when I am not riding my bike).

Watch This Space - Sunday, January 15 2017

Last year at this time, I noted that banks and energy companies were trading at some of their cheapest valuations on record.  I also mentioned that I was adding to both in the portfolio.  That turned out to be a spectacularly bad idea for the first 6 weeks of 2016 – and a VERY good idea for the remaining 46 weeks of the year.  Who is on the naughty list this year?  Health Care, especially pharmaceutical and biotech stocks.  In aggregate, this sector is trading 1.5 standard deviations below its average valuation relative to the market – at levels last seen at the height of the Clinton-era health care reform and at the beginning of Obamacare.  For those who need a reminder of the power of cheap valuation, from both starting points – Hillary-care and Obamacare, healthcare stocks went on to outperform the S&P 500 by a factor of 2 over the following 4 years.  We truly don’t know the direction our health care system will take under a Trump administration.  No one knew what Hillary-care and Obamacare would look like either.  But as is so often the case, cheap wins.  We are sharpening our pencils as we speak.

How High is Up? - Saturday, January 07 2017

Though I have always had an appetite for pranks and silly humor, as a kid I was never a fan of the Three Stooges.  Even for me they crossed the line from humor into simple stupidity.  They did, however, release a short film in 1940 called “How High is Up?”  where the trio masqueraded as iron workers on the 97th floor of an under-construction skyscraper.  You can guess the rest of the plot.  However, “How High is Up” does serve as a useful framing device for thinking about corporate earnings over the next year or two.  As I have said many times (and will continue to say) – stock prices follow earnings.  So, in thinking about how to steer the portfolio over the next year or two, knowing “how high is up” is quite important.  Let’s start with the pre-election baseline.  S&P 500 earnings for 2017 are projected to be close to $130.  On that basis, the S&P 500 is trading at a bit more than 17x next year’s earnings.  That’s probably a slightly optimistic starting point, but let’s start there and see where the argument leads. 

First, let’s consider corporate tax reform.  Most estimates of the effects of the likely Trump/Ryan plan for corporate tax reform look for a $10 to $15 boost to S&P 500 earnings, mostly through the effect of lower headline rates.

Second, the combined effects of corporate deregulation and foreign cash repatriation are likely to be considerable.  Combined, these could yield an extra $2 to $4 in S&P 500 earnings.

Third, and I believe this to be very underappreciated, inflation is likely to rise in the coming years, and a small bit of inflation (not too much) is likely to be very beneficial to corporate earnings - at least in the short run.  Let me explain.  The aggregate net profit margin of the S&P 500 is about 10% - meaning that shareholders keep a dollar out of every 10 dollars of revenue.  Now, as a thought experiment, let’s add an extra – and unanticipated – 1% to the existing inflation rate.  That means that in the short run, prices – and revenues – rise by 1%.  If all of that unanticipated revenue fell straight through the income statement, then earnings (assuming 10% net margins) would grow by an unanticipated 10%.  Though inflation can be quite harmful in excess, in modest mounts it can be a powerful driver of corporate earnings.  What this means is that if earnings were likely to grow 6-7% prior to the inflation uptick, they might see a burst of 10-15%, at least for a year or so.  In S&P 500 earnings terms, this is equal to $13 to $19.  That’s big. 

Putting it all together, $10-$15 from corporate tax reform, $2-$4 from deregulation and repatriation and $13 to $19 from an uptick in inflation, you have the potential (underscore potential) for something like $160 in S&P 500 earnings at some point in the next year or two.  Assuming today’s 17 multiple holds, that would yield a target of a bit over 2700 on the S&P 500, or slightly more than 20% upside.  While I am purposefully being vague on the timing and likelihood of these developments, it does underscore the answer to “How High is Up?” is “pretty darn high.” 

A final word of caution.  This is an exercise that yields a plausible high level scenario, not a forecast we are betting the ranch on.  It does show, however, that for the first time in some years investors may need to start paying a bit more attention to the right-hand tail of the probability distribution – geek speak for good news.

And Now For Something Completely Different - Thursday, November 10 2016

If you are a Monty Python fan, you will get the reference above.  At transition points in the show, a member of the team, usually John Cleese, would say in his best BBC voice, “and now for something completely different.”  It was a moment in the show that signaled something unexpected was about to happen.  Following the surprise election of Donald Trump, markets have been in a “and now for something completely different” mode.  Reversing a several year-long trend, cheap, cyclically oriented stocks have risen dramatically and more expensive perceived safe havens have fallen.  Interest rates have begun to rise meaningfully.  As I mentioned in last month’s letter, we have made, and are not planning to make, major changes to the Fund’s positioning based on our view of what will, or will not, happen during a Trump administration.  Instead, we are continuing to do what we have always done, focusing our efforts on uncovering great companies trading at a material discount to intrinsic value.

None of this is to suggest that a Trump administration and a Republican Congress will be irrelevant.  I do think that much can, and will, change.  The distinction is that, most of the time, a company’s long term value is not significantly impacted by legislative and regulatory changes.  However, what legislative and regulatory changes can do is to meaningfully accelerate the realization of that hidden value.  That is precisely what we have seen this month.  Nowhere is this more true than in the financial services industry.

Who's Buried in Grant's Tomb? - Thursday, November 10 2016

As host of the 1950’s game show, You Bet Your Life, Groucho Marx would often ask guests, “who’s buried in Grant’s Tomb.”  It was a classic Groucho Marx gag where the punchline is embedded in the question and the joke actually is on you.  If Groucho were alive today and interested in the stock market, he would be asking: “How many stocks are in the Wilshire 5000?”  Like the answer to the Grant’s Tomb question, one would expect the answer to be “5000.”  But that would be dead wrong.  A bit of explanation is in order.  Pension consulting firm Wilshire Associates has since the mid-1970s published the Wilshire 5000 index.  This market cap weighted index is meant to track all U.S. publicly traded companies – the entire investible universe.  Today, that universe ranges from companies with market caps from over $600 billion to under $1 million.  But the most interesting statistic is that the Wilshire 5000 today has only 3510 companies in it.  This is no recent phenomenon.  The last time the Wilshire 5000 had 5000 stocks in it was in 2005.  What happened?  In my view, new, rapidly growing companies don’t go public anymore.  The IPO market is a fraction of its former size.  Though there are many reasons for this, over regulation is one of the biggest.  One major regulatory culprit: The Sarbanes Oxley Act of 2002.  Numerous academic studies have shown that the cost of SOX compliance have been substantial and have fallen disproportionately on smaller companies.  The point is this: a vibrant and robust equity market is vital to a growing economy.  Excessive regulation has helped foster the opposite.  That is likely to change during a Trump administration

Regulation has also impacted the fixed income markets.  Most of the borrowing that larger companies do is in the public bond markets.  Because there is no central “stock exchange”-like entity in the corporate bond market, dealers – banks and brokers – are necessary to facilitate buying and selling.  In the same way that a grocery store needs to have a certain level of inventory to encourage sales, the bond market does as well.  Can you imagine going to the store to buy milk and the clerk says, “we’ll have to go milk the cow first – we can have your milk ready tomorrow.”  That isn’t much different from the way the corporate bond market works today.  Ten years ago, the corporate bond market was $3.2 trillion in size and dealers held $250 billion in inventory.  Today, the corporate bond market is nearly 50% larger and dealer inventories are 80% smaller – largely thanks to the Volcker Rule section of the Dodd Frank Act.  Investors report that “getting trades done” in the corporate bond market these days is quite difficult.  This is important.  The entire point of a public capital market is liquidity – and we have nearly regulated it out of existence.  This too will likely change under a Trump administration.

Finally, regulation has hampered the money markets. That market, nearly $1 trillion in size several years ago, now is nearly 80% smaller due to recent SEC rules which have had the effect of forcing fixed $1 NAV money funds to invest only in government securities.  This has made it much more difficult for banks and corporations to raise short term funds and has thrown parts of the foreign exchange market into turmoil.  Again, regulation born in the aftermath of the financial crisis has gone too far. Again, change is likely coming under Trump.

We have a good sized portion of the Fund in banks and asset managers that will benefit from this coming regulatory change.  The ones we own have great franchises and trade at a significant discount to our estimate of intrinsic value.  Much of the adverse regulation detailed above can be streamlined through the rule making process – and that can happen reasonably quickly.  As mentioned above, regulatory changes can meaningfully accelerate the recognition of the intrinsic value in our holdings that is already there.  That is precisely what we saw during this month and I think that process has further to run.

A Remembrance of Things Past - Sunday, October 09 2016

Few people, have actually read Marcel Proust’s A Remembrance of Things Past.  I am a card-carrying member of that unlearned group.  It’s a seven-part novel, after all, and no one has enough time and motivation to take that on except for a few Comp Lit grad students.  I am told, though, that the work does explore how memory can shape our perception of reality.  A year ago, our short term memories were painful ones.  A big market decline in August, followed by another in September, both driven by macro concerns stemming from China.  In last August’s letter, I looked at prior market selloffs of similar magnitude and concluded “as painful as these episodes can be, buying during panic is a very good strategy. While these statistics do not mean that the news can’t get worse and markets decline further, it does highlight that with the appropriate time frame….the odds favor good returns going forward.”     That is precisely what happened.  Markets generated double digit returns over the subsequent year, even in the face of major oil price declines, unprecedented central bank experimentation with negative interest rates, Brexit, and the chaotic Presidential election circus in the U.S.  Successful investing often means perceiving things differently than most other investors.  In my view, the memory of a prior decline, though painful, is often more than outweighed by the prospect of better future returns.

The Risk of Safety - Saturday, August 06 2016

Can investments thought to be safe become risky?  Can supposedly risky investments become safe?  At the wrong price, yes.  Last month, with mounting concerns over Brexit, the European banking system, China, and elections in the U.S. (did I miss any?), I observed that the prices of “safe” assets had become exceptionally expensive.  I called out a few notable ones – government bonds with negative yields and utility stocks in particular.  The fund now carries small short positions in both.  This month let me add to that list of overpriced safe investments by calling out so-called “low volatility” stocks in general.  A perfect case in point is the S&P Low Volatility ETF (SPLV).  This ETF passively owns the 100 stocks in the S&P 500 with the lowest realized volatility over the last 12 months.  Currently, nearly half of this ETF is comprised of Utility and Consumer Staples stocks and has returned nearly 15% over the past year – 10% better than the S&P 500 as a whole. As a result, the stocks in SPLV now carry an average dividend yield of 2.3% and trade at a 2 P/E multiple premium to the S&P 500.  Contrast that with the perceived riskier part of the S&P 500 – the stocks exhibiting “value” characteristics – ones that we tend to favor.  These “riskier” stocks now sport both a higher yield (2.6% vs 2.3%) and a much lower multiple (18 vs 22) than SPLV.   As a result, the stock market is in something of a “through the looking glass” state where “risk” has become safe and “safety” has become risky.  Our stance: a company’s earnings and its’ valuation matter more than anything else.  The labels that get attached to stocks matter far less and the portfolio is positioned to benefit when “the looking glass” finally breaks.

Brexit Schmexit - Sunday, July 03 2016

I don’t profess to be an especially accurate forecaster of macro events.  And when it comes to forecasting events like the Brexit vote and its aftermath, I am not sure forecast accuracy matters in the long run.  Why?  Because investor behavior has changed since the financial crisis of 2008.  Investors now react to anticipated events before they happen to an unprecedented degree.  Basically, when perceived risk looms on the horizon, investors overwhelmingly herd into safe haven assets.  The effect of this is to mute much of the market turmoil that investors were worried about in the first place.  Never has this been more true than in the lead up to the Brexit vote and its aftermath.  In my view, because the financial system is far more resilient than in 2008, these risk-off eruptions generally are opportunities to be pursued rather than risks to be avoided. 

All of this has had the effect of pushing up the prices of assets viewed to be “safe” – government bonds, utility stocks, and consumer staples to name a few.  Lately, this has reached historic proportions.  I find the following examples to be somewhat shocking:

·       Nearly $12 Trillion of global government bonds trade at negative yields.  This means that $12 trillion in supposedly safe assets – government bonds – are guaranteed to lose money if held to maturity.  How is something safe if you are guaranteeing a loss?

·       In the U.S., supposedly safe 10-year Treasury bonds now carry a yield equal to a mere 64% of the dividend yield on the supposedly more risky S&P 500.  This is a comparison not seen since 1955.

·       Utility stocks in the US now trade at 20-22 times earnings, the highest multiple ever.  Over most of my career, electric utility stocks traded at single digit multiples. Utilities are still highly regulated providers of electricity that grow earnings at 2-4% per year.  If I ever pay 22 times earnings for a company in a regulated industry that grows earnings at less than the growth in nominal GDP, please call a doctor – I must have taken leave of my senses.

My conclusion:  we are at one of those times where the most risky thing you can do is to own so called safe assets.  The Fund is positioned accordingly.  In the short run, this pro-risk stance hurt results.  In the long run, given the price of “safety,” it is the right thing to do.

Where have you gone Joe DiMaggio? - Thursday, February 11 2016

Three years ago today, Shorepath began operations.  In passing that milestone, I wanted to stand back and survey the broad investment landscape, which, as of this morning, is in turmoil.  Most global stock markets and many indices here in the US are in bear market territory.  Government bond yields, a traditional safe haven, are nearing all-time lows.  With a reflection on the past and an eye toward the future, my thoughts are below.

Where have you gone Joe DiMaggio, Our nation turns its lonely eyes to you

In 1968, Paul Simon and Art Garfunkel released what would become a chart topping song - “Mrs. Robinson” – alongside the iconic film “The Graduate.”  We all know it (at least those of us of a certain age) and can recite its lyrics by heart.  In the topsy-turvy world of 1968, Joe DiMaggio gave the song an iconic image of what then felt like a forever bygone era – an era of stability, strength, and optimism.  The Joe DiMaggio of the 1940’s – The Yankee Clipper - stood in stark contrast with the unstable world of 1968.

In some ways, the investment landscape today feels like the social and political landscape of 1968 – upside down and decoupled from the environment we have grown accustomed to.  For much of the past 15 years, we have grown used to an investment landscape dominated by the growth in the developing world, especially China, and strong commodity prices.  Today we stand in the midst of a great commodity bust and emerging market upheaval – much like the social and political upheaval in 1968.  What we thought would hold true forever, no longer does.  China, the formerly dependable leader of global economic growth, now looks unsteady.  Interest rates are below zero in large parts of the world.  Stocks now sport dividend yields in some cases well in excess of bond yields.  Much as our parents felt lost in 1968, investors feel lost today.

George Ross Goobey: Did he play for the Yankees?

I would wager that most of you have never heard of George Ross Goobey.  Since I mentioned DiMaggio, your first guess might be that he was an obscure member of the Yankees, perhaps the batboy.  Not exactly.  Unless you are an aficionado of the history of managing pension plan investments (admittedly a club with a very small membership  – ping me for an application), you probably aren’t aware that he was the quiet revolutionary who in the 1950s and 60s managed the Imperial Tobacco Company’s pension plan - one of  UKs largest plans.  Goobey’s revolution started on August 30th 1955 when he penned a memo to his plan’s trustees.  That memo, which the plan adopted, laid out the case for investing 100% of plan assets in the UK stock market.  Up to that time, both the Imperial Tobacco plan as well as most of the UK pension investment industry invested nearly all of their plan assets in government bonds (Gilts).  Coming from that starting point, Goobey’s recommendation was nothing short of revolution.

Goobey’s logic was simple.  Not only were stocks a better “duration match” for very long term pension liabilities than were Gilts, they also at that time carried dividend yields higher than the yield on Gilts.  He wrote:

The yields on equities as a whole are greater than those on fixed interest securities, and one would surely prefer to be limited to this higher return than to that obtainable on fixed interest securities.  One must not overlook, of course, the possible decreases in dividend during a period of dividend limitation, but I maintain there is sufficient margin between the income received from equities and the income received from fixed interest investments for us not to be alarmed that such income might fall below the income from fixed interest investments.  In might not be inappropriate to mention here that even fixed interest securities do sometimes default on their interest payments.

As a footnote, Goobey had two main concerns with his 100% equity portfolio, one he alluded to in the quote above – dividend limitation.  Little remembered today, Labour Party governments in the late 1940s and early 1950s in the UK explicitly called for, and briefly enacted, a limit on the dividends that companies could pay to shareholders.  Dividends above that limit were to be shared with workers.  Bernie Sanders and Occupy Wall Street would have felt right at home with this policy.  The other fear he had was that companies would be nationalized with little compensation for shareholders.  In today’s context, these fears are breathtaking and almost unimaginable – even in formerly communist China.  Still, Goobey felt, the numbers made too much sense, even in the face of these risks.  It is a sobering reminder for us today that shareholder friendly capitalism, something we take for granted, was then subject to existential threats.

Today, with little fanfare, we again have re-entered Goobey’s world.  Government bonds, in most of the developed world, yield far less than their corresponding stock markets, a situation that, outside of 2008 and the 2011 the U.S. has not seen since the 1950s.  As with society in 1968, investors today feel unmoored and uneasy – not knowing exactly what’s next and feeling as though it likely won’t be good.  If Simon and Garfunkel were to rewrite “Mrs. Robinson” today, they might change the Joe DiMaggio line to “Where have you gone George Goobey – oh, investors turn their lonely eyes to you.”  Clearly, there are risks today – perhaps global central bank policy is the biggest.  But are these risks greater than the existential threats to shareholder capitalism that Goobey faced?  I doubt it.

What if we were to follow Goobey’s advice today?  If the long sweep of history is any guide, and if we had sufficient patience, things are likely to work out quite well.  The following page offers some comparative statistics on the dividend yield of the S&P 500 versus the yield on the 10 Year US Treasury since 1954.  Today the ratio of S&P 500 yield to the 10 year Treasury yield is nearly 2.5 standard deviations above its 60+ year average – a comparison not seen since Goobey’s time and higher even than in 2008 and 2011.  Additionally, the next page provides a chart of one year forward returns on the S&P 500 predicated on the yield comparison between stocks and bonds.  As you can see, as the yield comparison becomes more favorable to stocks, the average one year return for the S&P 500 goes up strongly and the odds of having a losing year sharply decreases.  Today, we stand squarely in the best tier of this chart with historical average 1 year forward S&P 500 returns of 28% and zero years where you lost money. This is the very definition of better return with less risk.  So while the next few months may be volatile, history shows us that investing when things look bleak is a very good idea and is at the heart of our investment thinking today.

S&P 500 Dividend Yield vs 10 Year U.S. Treasury

Since 1954 - monthly data


Average 10 Year Treasury Yield         5.96%

Current 10 Year Treasury Yield          1.55% (2/11/2016 am)

Average S&P 500 Dividend Yield        3.12%

Current S&P 500 Dividend Yield         2.39% (2/11/16 am)

Average Yield Ratio (SPX/10YrUST)    .62

Current Yield Ratio (SPX/10YrUST)     1.54 (+2.49 std dev)


1 Yr forward S&P 500 returns grouped by SPX/10YrUST yield ratio:


Yield Ratio (SPX/10YrUST)

Average 1 Yr Return

Best 1 Year Return

Worst 1 Year Return

Proportion of Losing Years

>+2 Std Dev





Between +2 and +1 Std Dev





Between +1 and 0 Std Dev





Between 0 and -1 Std Dev





Between -1 and -2 Std Dev






Recent dates above 2 std dev SPX/10YrUST yield ratio (with 1 Yr forward SPX returns):

December 2008 (+23.99%), March 2009 (+43.85%), November 2011 (+23.34%), July 2012 (+19.05%)

Laggards to Leaders for 2016 - Wednesday, November 11 2015

I am always looking for interesting anomalies.  Things that don't make sense.  Extreme highs and lows relative to historical averages.  There are two I have noted recently - energy stocks and small caps.

Because energy stocks have volatile and somewhat unpredictable earnings it is best to look at their price/book multiples and compare that to the broader market.  Using that "relative price to book" metric, energy stocks in aggregate are the cheapest they have been since 1990 - the oldest data I have easy access to.

Small caps, while not quite as cheap as energy stocks, rank in the cheapest quintile of valuation compared to the broader market when measured over the past 5 years.  

Both look compelling for market beating performance next year.

Thinking About Earnings - Tuesday, October 20 2015

2015 has been a tough year for the U.S. stock market.  As of today, the S&P 500 is roughly flat for the year with a much higher level of volatility than most (including me) expected.
Some of the answer lies in the fact that economic growth has been disappointing compared to expectations at the beginning of the year.
But a bigger part of the explanation perhaps lies in the fact that the market has been going through an “earnings recession.”  At the beginning of the year, S&P 500 earnings expectations were for 7-9% growth.  We may end the year at zero.  Third quarter earnings in fact may show a slight decline year over year.  “Stocks follow earnings.”  True this year as ever.
How do we reconcile the apparent contradiction of a strong U.S. consumer (strong employment, rising wages, record auto sales, an improving housing market) with an earnings recession?  A major answer: lower oil prices and a stronger dollar.  While these two forces have many first and second order effects on earnings, a few simple observations make sense to me.  First, energy stocks comprise about an 8% weight in the S&P 500 index.  Oil prices are down about 50% in 2015 compared to 2014.  If we assume that the decline in energy prices impacts energy companies’ earnings on a 1 for 1 basis (it’s actually greater than that, but let’s keep it simple), then the simple math would say that a 50% decline on an 8% index weight yields a 4% impact to earnings for the overall index.
Second, for the rise in the dollar, let’s assume that S&P 500 companies have 1/3 of their sales outside the U.S.  In 2015, the dollar (as measured by the DXY index) is up 18% versus 2014.  Let’s also assume that only ½ of the currency translation effect on sales drops through to earnings (due to things like hedging or costs also being denominated in foreign currency).  The simple math here points to a 3% impact on overall earnings for the S&P 500. (33% of sales x 18% rise in the dollar x 50% mitigation)
On this simple math, oil and the dollar account for a 7% hit to S&P 500 earnings for 2015 – the lion’s share of the gap between 7-9% growth expectations at the beginning of the year and a likely flat result for the whole year.
A few more interesting observations.
First, the rise in the dollar and the decline in oil seen in 2015 are completely unprecedented.  Using data back to 1984 (the oldest data I have easy access to), and comparing the calendar yr/yr change in the average value of oil and the dollar, 2015 is by far the most extreme on both measures (data below).  The 18% rise in the dollar in 2015 dwarfs the next biggest rise (12%) seen in 1984.  The 47% decline in crude oil seen in 2015 is also much greater than that seen in other oil busts (1986=39%, 1998=29%, 2008/9=24%).
Second, looking back at prior major moves in oil and the dollar, subsequent moves are either in the opposite direction (mostly for oil) or are in the same direction but of much smaller magnitude (mostly for the dollar).  As a result, the 7% headwind seen in 2015 is very likely in 2016 to become neutral to perhaps even a slight positive for S&P 500 earnings.
Third, though the “oil/dollar headwind” has been blowing all year, it reaches its maximum effect now.  3rd quarter earnings (or possibly 4th qtr) should see the worst headwind.  It’s gets easier from here.
Fourth, if we assume oil prices and the dollar remain flat from here when, exactly, does the headwind turn into a neutral/tailwind?  Answer: February 2016. 
Fifth, a good rule of thumb is that stock prices tend to discount things about 2 quarters in advance.  The recovery in prices we are seeing now from the August lows could be read as discounting the end of these headwinds, and resulting yr/yr earnings acceleration we will see in 2016 (assuming the global economy doesn’t stumble).
To summarize: 2015 earnings have been punk and stock prices have followed suit.  Oil and the dollar are major culprits.  We are at the worst of it now.  It gets better from here and likely becomes neutral early next year.  Assuming the global economy doesn’t stumble (I assume it doesn’t), then 2016 earnings will accelerate vs 2015.  If so, 2016 should be a decent year.
avg y/y chg DXY
avg y/y chg WTI

Anomaly watch: Skew makes a new all-time high - Tuesday, October 13 2015

It is always good to be on the lookout for anomalies....all time highs, lows, weird stuff that doesn't make sense.  Usually a good time to make (or lose) money.  Yesterday, the "skew" of the S&P 500 hit an all time high - 148.  What is skew?  Skew is the relative prices of put and call options.  A high skew indicates that puts are expensive relative to calls - meaning that there is a high demand for "protection" and a correspondingly high degree of "fear."  
Some stats for you since 1990 (the oldest data I have easy access to).
The average return for all rolling 12 month periods for the S&P 500 = 8.27% with a standard deviation of 15.7%.  You lost money in 21% of all 12 month periods with a max loss of 44% (in the financial crisis).  
If you look at rolling 12 month returns for the S&P 500 only for those periods where the skew is in the top 20% of all months - i.e. when "fear" is high relative to history - your odds of success improve significantly.  During those high skew periods (17% of all 12 month periods), the average 12 month return is 9.47% with a standard deviation of 7.8%.  You lost money in only 11% of all 12 month periods with a max loss of 11%.
These stats are the definition of better returns with less risk....usually pretty hard to find.
Look at it this way - if everyone is already fearful, there aren't many people left to sell.  Clearly the future could be radically different from the past and these stats are useless.  However, that seems like a tough bet to make, at least to me.