AIM13 Commentary - 2019 Q2
“Those who have knowledge, don’t predict. Those who predict, don’t have knowledge.”
Many investors wrongly believe that successful investing is only about predicting the markets or guessing right about a particular opportunity. Regrettably, no one knows the future (and if you did, especially in investing, you would be wise not to give away the advantage by sharing it!). We were reminded of this recently when we read about a study conducted by Larry Swedroe, from The BAM Alliance, of investment analyst forecasts for the year ahead. Since 2010, of the forecasts that were characterized as “sure things,” only 32% came true, while 64% were dead wrong. (The remaining 4% were viewed as a “tie.”) With the markets going through another cycle of volatility here in August, we are reading a lot of predictions that range from the most dire to the most optimistic. Anticipating future events is an integral part of investing, however we believe successful long-term investing is more about reducing the chance of negative outcomes. Minimize the risk of a “left tail” event – such as by having a repeatable and thorough diligence process, gathering as much information as you can, and identifying as many risks and concerns as possible – and the power of compounding will take care of the returns.
The second quarter provided more reason for caution, with another roller coaster ride for the S&P 500 TR. The index was up 4.05% in April, down -6.35% in May, and back up again 7.05% in June. June was a strong month, which was fortunate since the S&P 500 TR needed a 6.78% return in the month to make up its losses in the prior month. Indeed, we were reminded of the power of negative numbers recently when we looked at the S&P 500 TR’s 6-month and 12-month performance in mid-August. Through August 23rd, the market was up 15.08% since the beginning of the year but up only 1.53% over the prior twelve months. Again, we do feel that many people do not realize the impact of losing money during the fourth quarter’s pullback had on their portfolios and what is needed to recoup that loss.
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“Control is an illusion, you infantile egomaniac. Nobody knows what’s gonna happen next: not on a freeway, not in an airplane, not inside our own bodies and certainly not on a racetrack with forty other infantile egomaniacs.”
To paraphrase Warren Buffett, we think that forecasts say more about the forecaster than they do about the future. Mark Hulbert, writing for MarketWatch in July, expressed this view when he noted that “when an analyst makes a prediction, he is less interested in being right than he is in gaining notoriety and new subscribers. Being outrageous and an outlier is therefore a virtue.” The reality is that in the age of clicks, views, and likes, short-term investors reward investment professionals who can offer the most interesting and seemingly compelling predictions. Of course, this only further undermines the value of the prediction and increases our skepticism of forecasts generally.
All investment strategies have some element of anticipating future events and allocating capital to take advantage of opportunities as they arise. Our approach, however, is to focus more on avoiding negative outcomes that could arise rather than “guessing right” about market swings or a particular manager or investment opportunity. To do that, we use what we have learned over decades and execute a repeatable process, some highlights of which are below, to create a form of “structural alpha.” We have used this phrase before, but since it seems to have no established definition, it bears repeating our view of the concept: By evaluating a manager in a disciplined way with a focus on avoiding losses, we believe our process – which we are constantly monitoring and trying to enhance – provides a structural edge (or “alpha”) that over the long term increases the odds of better risk-adjusted returns than other alternatives to investing. This is similar to investing with a manager with locked up capital; that structure reduces the chance of investors pulling money spontaneously during a drawdown when the better approach would be to ride out the short term volatility. The “alpha” is derived from the structure or in our case the process we employ.
Fundamental to our approach is asking the right initial and follow-up questions. We do that in a number of ways:
Gather the facts: The following hypothetical illustrates something that we try very hard to instill in all the investment analysts we hire at AIM13:
We would guess you said no… But what if we told you that the plane was on the ground??
We go to great lengths to gather as much information and facts as possible, and to ask the right follow-up questions, before making any manager or investment decision. Sometimes managers are surprised when we do not stop at the first answer. While not every fact is actionable or indeed meaningful, we have found that being thorough and pursuing inquiries by asking the same thing in different ways (and verifying it with data) can yield insights about a manager that would have been unforeseen at the outset.
Leverage our network: LinkedIn recently reminded us of their limit on connecting with people through their platform since the number of our connections likely exceeds the vast majority of their users. Perhaps we use it and other platforms like Relationship Science more than most, but we do think that identifying connections and triangulating references and points of contact over a person’s entire life is the best way to get the real story of who someone is.
“Show me your friends and I would tell you who you are.”
Beyond simply identifying a manager’s former work colleagues, we have been known to identify a manager’s campmates, fraternity/sorority brothers/sisters, personal assistants, neighbors, and fellow board members for a better view of the manager. We think this is unlike most investors and provides a distinct insight into a manager’s character and ability to make money over time.
Understand a manager’s philosophy and motivations: We read in July that a co-founder of WeWork, which is about to go public in one of the biggest IPO’s of the year, cashed out more than $700 million ahead of its public offering. Indeed, that might be a very smart strategy for the individual, but it should tell you something about the motivation of the company’s founders and management. We want to understand a manager’s philosophy and motivations, or really what gets them out of bed in the morning. That provides an enormous insight into how they might behave in the future. When a manager’s AUM quadruples and the portfolio position count goes from 10 stocks to 40 stocks, we need to understand the motivation for the change. Is it about not being able to size up the original ten or reducing risk (and return potential) for the larger pool of capital?
“The measure of intelligence is the ability to change.”
Equally important is how a manager’s philosophy and motivations have changed or evolved over time. We sometimes test new managers with the following question: If a $100 stock has 30% upside, will you sell when it reaches $130? What if it reaches $120, and therefore the upside is significantly reduced but the risk may not have changed? The answers are not yes or no; rather, it would only depend on the circumstances at the time the stock rose towards its price target. The point is that things change, and we want managers to be flexible and not dogmatic.
Likewise, no one starts with a perfect process, and experience should inform a manager’s investment approach and produce continuous improvement. We ourselves are also constantly faced with the challenge of adapting – and revising or even reversing our views of a manager. One of the hardest things we do as investors is to change course because it suggests (wrongly) that there was an error in the original assessment. We have written at length about how managers change over time, some for the better, many for the worse. Only with constant, ongoing due diligence can we get out ahead of a manager who no longer meets our standards.
No investment strategy is risk-free, and every investor makes mistakes. Ted Williams batted .406 in his best year (which means he got out about six out of every ten tries) – and he is a Hall of Famer! Accepting that getting something wrong is inevitable, we think these processes (among others) help us achieve our objective of reducing the negative impact of any mistakes.
Unfortunately, we feel that too many investors either want to be the smartest person in the room – by telling others what the future holds – or just be different solely for the sake of being different. Too many forget the old saying that if you think you are the smartest person in the room, you are in the wrong room. This may be why so many investors have unrealistic return expectations. Mebane Faber, the market podcaster, cited a study in early July that found that investors expect on average a 10.7% annual return over the next five years. Moreover, one in six investors expect at least a 20% annual return on their portfolio. With interest rates as low as they are, even a 10% return requires a fair amount of risk – which of course increases the chances of lost capital. We think that what these investors are missing is that investing is more about hard work and the returns one should expect should be about as exciting as watching paint dry. Unfortunately, that approach will not get us many clicks, views or likes – but so be it!
Market Observations
The Economist went with this cover for their August 17th edition, and we think it captures well current market sentiment. Despite investing during the longest period of economic expansion in U.S. history (a milestone we crossed in July), many investors are particularly nervous. In fact, Reuters reported on August 21st that U.S. money market funds reached their highest asset level since October 2009. We hear this anecdotally more and more: investors are shifting cash into low-risk products amid worries about a global economic slowdown and trade tensions.
Among other things that are keeping us up at night, it is worth highlighting the following:
Problems in China. Last year, China experienced its slowest economic growth in three decades, according to a report in Foreign Affairs published in March of this year. The country now faces the consequences of years of debt-fueled growth, and it will not be pretty. As indicated in the graph below, Chinese household debt as a percentage of GDP has risen fast, almost five-fold since data was first collected in 2006:
Source: Wolf Street
Matthew Klein, writing in the Financial Times last year, put the trend into context in this way: “The rapidity and size of China’s debt boom in the past decade has been almost entirely without precedent. The few precedents that do exist—Japan in the 1980s, the U.S. in the 1920s—are not encouraging.” Added to the debt problem, China is also dealing with a rapidly falling Yuan, an overheated real estate market, and an aging population. As the trade war between the U.S. and China escalates, China finds itself in the unenviable position of trying to negotiate against the world’s largest economy (in terms of GDP) while its own economy is under its greatest pressure in modern times.
Negative Yield Debt. We have written in the past about the surging levels of almost all forms of debt – consumer, corporate, and sovereign – but what is equally startling is the low (or even negative) yield investors are willing to accept.
Source: Bianco Research; Bloomberg
About one-third of tradeable bonds in the world now have negative yields, according to a report on CNBC in August. Most analysts attribute the explosion of negative yield debt to the flood of money central banks have pumped into the global economy. When it comes to sovereign debt, Germany may provide the starkest example of negative rates. Its yields all along the curve trade below zero, which has pushed prices up dramatically. Buyers were recently paying the equivalent of $195.87 for every $100 in 20-year German bunds, all for a technical yield of -0.386%. The U.S. is not immune – the 30-year bond hit a record low of 1.91% in August – and many see negative yield U.S. treasuries in the future. Falling yields are usually taken as a bad sign for the economy. They often represent a flight to safety that happens alongside expectations for subdued growth and inflation. As Andre Severino, head of global fixed income at Nikko Asset Management, said to the Wall Street Journal on August 11th, “It’s kind of like Armageddon is being priced in.”
Liquidity in Bond Funds
“Morningstar suspends rating on H2O fund due to illiquid bonds.”
-Financial Times, June 19, 2019
We chuckled when we read this headline (and we are not sure if even the FT realized the paradox). The problems, however, about liquidity inside bond funds is anything but funny. As bond fund managers search for yield in a low rate environment, the risk is that more and more traditionally safe bond funds are being invested in investments with lower creditworthiness and less liquidity. The trend has led Morningstar to break out its intermediate bond fund category into two separate subcategories, intermediate “core bond” and “core-plus bond,” with the latter holding more BBB debt, bank loans, and emerging market debt. We think this is a disaster in the making, and it reinforces the importance of valuation in investment strategies like investing in thinly traded bonds with subjective pricing. Mike Terwilliger, a portfolio manager who runs the Resource Credit Income Fund, put it this way in a Bloomberg report in early July: “When the market turns, those assets are going to be exceptionally challenging to trade relative to their bond equivalents,” he said. “What the illiquidity premium provides, the illiquidity premium will take away in the downturn.”
Manhattan Home Prices. The slowing economy is often seen first at the high end of the real estate market, and so we pay particular attention to luxury home sales across the globe. In mid-August, Barron’s ran a report about plunging high end home sales, noting that major financial centers like Manhattan and London saw prices fall in recent quarters by 3.7% and 4.9%, respectively. The trend is a continuation of what Manhattan prices have experienced since the mortgage interest deduction was capped in 2018:
Source: Skenderbeg Investment Management; Deutsche Bank
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Closing Thought: We were reminded again recently of the threat of terrorism and mass shootings when on August 6th a motorcycle repeatedly backfired in Times Square. Mistaken as gunfire, the sounds caused a mass stampede injuring more than 25 people and causing Broadway shows to end early. Unfortunately, this is not just indicative of the public’s fragile state of mind in the wake of mass shootings and terrorist attacks. It also is a frightening example of how something as simple as an engine backfire can lead to injury and property damage. Knowing how quickly people respond to any indication of a threat, we shudder to think of that knowledge in the mind of a terrorist. For instance, what if a drone flew over Times Square and released baby powder? The episode only reinforced the importance of constant vigilance and situational awareness in public places. While we do not want to be an alarmist, there is a lot of risk out there that we cannot control and we should not lose sight of. Unfortunately, we think a lot of people have become numb to the risk, and the media is not carrying the stories for as long or as prominently as they once did.
We welcome any questions or thoughts you may have.