AIM13 Commentary - 2023 Q2
“It never occurred to you that picking girls
solely on their looks may not be the best way to go about it?”
At the beginning of this year, the average year-end S&P 500 price target among 23 analysts surveyed by Investing.com was 4,080. At the end of June, just six months into the year, the S&P had reached 4458 and even went to 4594 by the end of July. The fact is that virtually no one predicted a nearly 17% first half return for the S&P 500 Total Return (“S&P 500 TR”). Most investment portfolios, however, are lagging far behind, and a lot of investors are unhappy with their returns.
This dynamic reminded us of the movie quoted above, in which the main character (Jack Black playing Hal Larson) is only attracted to beautiful women and needs to be hypnotized to see the true beauty of the people around him. Like Shallow Hal, investors often draw a conclusion from an incomplete picture and just see what they want to see, making decisions based solely upon what is on the surface.
We are not surprised that most equity managers have not stayed abreast of the market this year. The fact is that the S&P 500 TR returns in the first half of 2023 have been largely driven by a small group of the largest stocks by market cap. As the chart below demonstrates, the seven largest companies in the index as of June 30 (Apple, Microsoft, Amazon, Nvidia, Tesla, Meta, and Google – the so-called “Magnificent Seven”), which represent over a quarter of the index’s total market cap, have significantly outperformed the overall index:
Without the seven stocks above, the S&P 500 TR returns this year have been lackluster. At one point in mid-May, year-to-date returns for those 493 stocks was actually negative, according to S&P Global Market Intelligence data. Another way to look at the market performance is the trailing twelve month return, and in mid-August, over the prior twelve months, the S&P 500 TR had only gained about 2%.
We do not want to take the risk of owning an overweighted and concentrated group of stocks that historically have experienced large drawdowns. That is not our approach, and for good reason. In the first week of August alone, the Magnificent Seven reversed course and lost $632 billion in market cap, accounting for more than 50% of the S&P 500 TR’s market loss in the period, as reported in Investor’s Business Daily.
For people (or more accurately, gamblers) who want to take a directional bet on a small group of stocks, we say, Good luck! Unlike gamblers, as we have said many times before, investors recognize that how you make returns (i.e., how much risk you take) is just as important as the returns you make.
“Just because you got away with it
doesn’t mean you didn’t take any risk…”
* * *
Almost everyone has an opinion about the future and almost everyone has gotten 2023 wrong (so far, at least). We think this reinforces an important lesson about investing: nobody knows where the market is going, either up, down or sideways, and it is a waste of time to try to predict the future. It is better to spend time on your process (i.e., how you make investments) and improving that process with what you learn over time. Be disciplined, but not dogmatic; consistent but also pragmatic. That is how we invest, and those are the qualities we look for in the managers we partner with.
“The greatest wisdom is seeing through appearances.”
Like the iceberg that looks small and easily avoided from the surface, we think the positive market headlines this year disguise a much more troubling picture. A lot of surface-level indicators – a six-month S&P 500 return of nearly 17%, a long run of low volatility, etc. – represent precisely the kind of siren song that can lure the unsuspecting investor onto the rocks of permanent capital loss. As investors lose patience with strategies that materially underperform “the market,” they will chase returns looking only in the rear view mirror and pivot to what has worked over the last 6-12 months. That would be a mistake.
“Ignoring facts does not make them go away.”
The risks out there are almost too many to count – continued high inflation, mortgages resetting to the higher current rates, a powder keg of partisan hostility in D.C., numerous geopolitical threats from Russia, China, Iran, etc. Those risks, which go beyond an S&P return buoyed by a handful of stocks or low volatility, complete the picture and inform our outlook and decision-making.
“A good decision is based on knowledge and not on numbers.”
For nearly 25 years, we have strived to be the “anchor to the wind,” maintaining discipline and a long-term view. We guard against euphoria in more conducive environments (like in 2019-2020) and impatience in more challenging periods (like the most recent two years). We are especially skeptical when, as now, many investors fail to see the entire picture.
Successful long-term investing requires digging into what is behind the headline numbers and understanding what is really driving returns. There is definitely more risk out there than what meets the eye, but there are also opportunities and our managers remain optimistic. Despite our approach of always focusing on the downside, we are optimists and do not need to be hypnotized to see the beauty of the world around us. However, we also accept that, especially now, superior returns will take patience, hard work, and selectivity – all of which are often in short supply.
due diligence tip
“Do what you say you’re going to do.
And try to do it a little better than you said you would.”
We often borrow the saying that past performance is not necessarily indicative of future returns – unless you are talking about someone’s character. This holds true not only for what a manager has done in the past, but also for what a manager has said in the past about what he or she will do in the future. When a manager launches a fund, the manager has a clean slate to describe the strategy and what he or she will or will not do to generate returns. The manager is trying to raise money, and within reasonable limits might say anything to attract capital. For instance, the manager will say its optimal size is $1 billion and that the fund will close when it reaches that limit. Or the manager will put risk limits on numbers of positions, leverage, market cap range, etc. Unfortunately, a few years later after launch, for whatever reason – be it to earn more fees through a larger asset base or to take more/less risk given the opportunity set at the time – these pre-launch commitments are often forgotten.
When this happens, we think there are at least two notable dynamics at work: First, there is the strategy shift or “style drift” that results in being invested in something that you did not sign up for. Second, and equally important, is the character aspect and what Jimmy Dean is talking about above: At the end of the day, investors need to trust their managers to represent things as they are and to follow through on promises for the future. Without that trust, it becomes impossible to stay invested.
How do we “trust, but verify” under these circumstances? We rigorously archive manager presentations and materials, even if we do not invest, so that we are in a position to run a “doc compare” between earlier and current versions. We have seen significant changes in investment philosophy and risk management parameters relating to the types of things mentioned above. Sometimes these are explainable and justified, as managers evolve and learn from experience. There are plenty of firms that evolve but our view is that many do not get better. There is no hard and fast rule, and understanding why they have changed and whether it will make them better requires going beyond just one layer of questions. We do not want “drift” but we do want people who wake up every day and ask themselves, how do I get better?
Unfortunately, a mentality of saying just what works at the time to raise money, which many refer to as “marketing,” is a common practice If that is what a manager is focused on, then we do not want to partner with them, and these doc compares help us identify those whose actions match (or do not match) their words.
market observations
As noted above, there are opportunities for patient investors, and our managers remain optimistic about the opportunity set. However, risks abound and just a few things that keep us up at night include:
Commercial office space. We have been talking about our concerns about commercial real estate (CRE) for several quarters now, and everything we continue to see only raises our concerns. Property owners are facing a double whammy of rising vacancies at the same time as the cost of capital to support these buildings has almost doubled. With occupancy down, the value of these properties likewise falls, and it is even hard to tell what properties are worth because capital market activity in the space has stalled – largely as a result of the fact that no one really knows what the true value of properties really is.
Source: Cushman & Wakefield, FDI Intelligence
“If you owe your bank a hundred pounds, you have a problem.
But if you owe a million, it has.”
There is also a contagion dynamic to what is playing out in commercial real estate given just how large and important the sector is to the economy and the budgets of cities across the country. Regional banks’ exposure is enormous. A study published in May by Trepp, the real estate data provider, of 4,760 banks' public regulatory data found that 763 have either a CRE or construction loan concentration ratio that exceeded FDIC thresholds that trigger greater regulatory scrutiny. J.P. Morgan said in a March report it expects about 21% of outstanding office loans in commercial mortgage-backed securities will eventually default, according to a Reuters report. Municipal governments will also be stressed. In New York City, property taxes generate approximately 40% of city revenue, as reported in The Atlantic in June, and that revenue is at risk as more properties face financial stress. All in all, what happens in CRE could be the next great crisis of the 21st century.
Student loan payments resuming. On September 1st, the three-year hiatus on student loan payments ends. A CNET report in early August said that according to a new survey from Credit Karma, 45% said that they expect to fall behind on their loan payments once the forbearance ends. The Federal government has initiated a number of programs to help borrowers, but the staggering size of the debt and its impact on consumers cannot be overstated.
Source: Financial Design Studio
Mortgage rates resetting. Home borrowers are often lured into adjustable rate mortgages since the initial rate and monthly payment is often as low as it can be. With rates having spiked over the last 24 months (and now have reached their highest since 2002), a lot of ARM borrowers are now regretting that decision. In fact, according to a survey by U.S. News & World Report at the end of 2022, about 43% of those who took out ARMs later regretted it. That number undoubtedly is higher as more and more loans reset to the current higher rates. With rates on the rise, household debt service has ticked up:
Source: JP Morgan
What this all means for markets and the economy remains to be seen – and as noted above we are never one to predict the future – but all of these pressures on lower and middle class consumers will create additional headwinds for companies dealing with higher interest rates, labor shortages, and a host of other problems.
We welcome any questions or thoughts you may have.
Sincerely,
AIM13