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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

28.04%

38.92%

7.53%

0%

Between +2 and +1 Std Dev

10.41%

43.85%

-13.11%

26.4%

Between +1 and 0 Std Dev

7.54%

34.29%

-38.86%

23.8%

Between 0 and -1 Std Dev

6.93%

52.23%

-44.75%

30.0%

Between -1 and -2 Std Dev

-4.47

15.24%

-24.85%

64.3%

 

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.
 
Why?
 
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
2015
17.50%
-47.42%
2014
2.05%
-6.32%
2013
1.36%
4.46%
2012
5.63%
-2.48%
2011
-6.27%
21.54%
2010
1.35%
30.77%
2009
5.40%
-24.54%
2008
-4.17%
38.66%
2007
-6.56%
13.41%
2006
-1.48%
18.38%
2005
0.80%
38.98%
2004
-8.46%
36.25%
2003
-13.91%
18.68%
2002
-4.14%
8.17%
2001
5.18%
-14.08%
2000
9.76%
58.82%
1999
1.53%
39.46%
1998
2.30%
-28.79%
1997
10.66%
-4.72%
1996
4.09%
18.22%
1995
-7.42%
6.93%
1994
-2.79%
-4.05%
1993
8.56%
-13.28%
1992
-3.28%
0.29%
1991
4.11%
-9.37%
1990
-10.79%
21.10%
1989
4.27%
26.75%
1988
-0.55%
-13.23%
1987
-12.49%
33.15%
1986
-19.37%
-39.48%
1985
-5.23%
-8.99%
1984
11.96%
-5.89%

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.