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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.”

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.

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.