What’s my line? 

I have average grades from an average college. While I compete with thousands of others, we all agree to not compete on price. As a result, I make about twice as much as I could with the same education and capital in any other profession. What’s my line?

If you guessed financial adviser, you would be correct. Last quarter I addressed the issue of inefficiency as manifested in many actively managed funds. This quarter I’m addressing a strain of inefficiency that’s probably even more important to most investors. The pricing of most financial advisory services is an extremely important factor in determining investment outcomes because a large proportion of investors pay for advice and because a huge chunk of it is significantly overpriced.

Just as I noted that inefficiency among active managers is a prevailing trend rather than a blanket condition, this by no means implies that all advisors overcharge or that they aren’t decent people. It merely identifies an economic reality that has serious implications for your financial health.

In the recent article, "How to avoid the coming crunch on advisor compensation", Dan Richards discusses in public what very few have dared to before: He tries to establish a reasonable basis for advisor compensation. He starts with the facts. According to Investment News, normal compensation for a partner at a financial advisory firm is $324,000 and for an advisor who operates a sole practice it is $217,800.

Richards also conducts a fair amount of research on compensation for other jobs with similar responsibility levels and educational and capital requirements. According to his comparisons with norms for similar professionals, financial advisers should earn about half of what they do now.

While the title of Richards’ article forebodes downward pressue on advisor compensation, it also begs the question of how it became so disconnected from the rest of the economy in the first place. One likely cause is that advisers commonly structure fees as a percent of assets under management (AUM) rather than on an hourly basis as most other professions do. As a result, advisors benefit from both their clients' capital and from the natural upward bias in capital market returns, neither of which is directly related to the adviser’s contribution.

Another likely cause of the disconnect is that adviser compensation is also largely protected due to oligopolistic competition. Despite there being thousands of advisors, Richards reveals, "The major players in the advice business compete fiercely on everything except price, where there is recognition that cutting prices would lead to a downward spiral in which no one would benefit except customers." This doesn’t sound much different than the insular environment Michael Lewis described regarding high frequency trading reported in the Q114 Arete Quarterly, "The deep problem with the system was a kind of moral inertia. So long as it served the narrow interests of everyone inside it, no one on the inside would ever seek to change it.”  

While this state of affairs may seem like just one more obstacle for investors to overcome, there are glimmers of hope. For one, just like there are some active managers fighting the legacies of inefficiency to provide better value, so too are there some advisers working hard and experimenting with fee structures in order to deliver great value to their clients.

In addition, there are some good roadmaps already established by some of the larger and more sophisticated institutions. They have confronted many of the same issues and have developed constructive responses, many of which can fairly easily be replicated by individuals and small institutions.

This opportunity is corroborated by Dan Richards in another piece, "Four Inevitable Changes that Threaten Your Business". He describes that, "Closing the gulf between smart money and dumb money" is a "fundamental structural shift" imminent in the investment industry. According to him, such a "yawning gap between more informed and less informed buyers isn't sustainable in any business."

One easy place to start to close the “yawining gap” is with price negotiation. Clearly larger clients have more leverage to negotiate, but you can always make the effort. Is there a good reason to pay a percentage of AUM or can an hourly rate be agreed upon? Also, if it doesn’t work the first time, you can always keep trying and keep evaluating alternatives. Things are changing and there’s a good chance persistence will pay off.

Also, if you can't find reasonably priced advisory services, you might consider doing some of the work yourself. There is a lot of good information available for free. Further, there are a lot of emerging technology solutions that aim to disrupt the industry by making basic services available for extremely reasonable prices.

Finally, as I noted in the Q413 Arete Insights, many institutions are turning to their best active managers for advice. Realizing that many existing relationships are no longer fit for purpose, these institutions are leveraging expertise where they find it. It is easy for individual and small institutional investors to follow this lead by asking their active managers to share their insights into the investment landscape. 

In conclusion, advisory services can be extremely important in managing one’s financial affairs; nobody is arguing that they aren't. The price of such services is in question, however, and poses the distinct threat of gradual but persistent erosion of wealth. Indeed, the Economist stated the case clearly in a recent briefing on fund management: "Good advice is certainly worth something ... but an investor should not pay 1% to 1.5% a year to an adviser."

Governance: I can see [more] clearly now

Fresh on the heels of tax season and extending through some of the most pleasant weather of the year, proxy voting can seem like an ill-fated endeavor. Mounds of dense material add insult to injury and can challenge even the most industrious shareholders.

There are rewards for going through the proxy materials though. One is that the proxy statement reveals a great deal about the primacy of interests of the board and often of management too. As such, it is like a code book that can be used to decipher hidden messages in the company’s financial statements and other communications.

In addition, since very few investors meaningfully integrate proxy voting with research, doing so transcends conventional functional silos so as to provide a broader and truly differentiated perspective. This especially resonates with those of us who have served on boards and understand the links between what goes on behind the scenes and what gets communicated.

It is also important to highlight that the process of reviewing and voting proxies is far less cumbersome than it used to be. Logistics have improved a lot as receiving emails and voting online is a lot easier than dealing with paper forms in the mail. Although proxy materials can still be dense and overloaded with legalese, many companies are making efforts to highlight important changes and key information in easy-to-read tables. Further, with a clear focus on potential conflicts of interest, one can be fairly selective in reading proxies and still derive disproportionate benefit from the exercise.

In regards to corporate governance itself, the trend is unmistakably one of improvement. While I have generally been fairly skeptical of much change in governance, I happily acknowledge that there are a lot fewer staggered boards today, there are meaningful discussions with top investors regarding executive compensation, the most egregious compensation features have been explicitly terminated, and there has been a healthy amount of board member renewal/refreshment.

Further, it seems as if the entire tenor of the relationship between boards and shareholders has improved. Whereas the norm used to be more of an adversarial relationship between the board and shareholders, it is much more common now for boards to engage in an ongoing dialogue with shareholders. Management teams are increasingly, though still not commonly, asking for feedback on important issues in meetings with shareholders. These are all welcome improvements to which I can say I have been pleasantly surprised.

None of this is to say, however, that governance is suddenly outstanding. It would still be hard for me to give a grade of higher than B- to the companies I review.

In order to assess governance quality, I often conduct a thought experiment by which I imagine an “ideal” communication from the board. In that ideal, the board wants nothing more than to provide me, as a shareholder, with the most relevant information in the most concise and digestible way possible. They will provide context and support materials when necessary, but they won’t distract me from key issues. Out of respect for my time and my duty to clients, they will do everything possible to facilitate my decision making. Any result that deviates from this ideal reveals either incompetence or intentions other than faithfully representing me.

Clearly by this standard, many board communications fall far short. Normally it doesn’t take long at all in reviewing a proxy statement to get a solid sense of whether the intention is to truly communicate, to obfuscate, or to abdicate responsibility by only exerting the least effort possible to comply with legal and regulatory requirements. Anything other than clear, concise communication suggests intent on the part of the board other than that of fulfilling its responsibility to shareholders.

That said, the one specific proxy decision for which I find the most deficient communication involves executive compensation. There is no doubt it is a complicated subject, but the key issues really aren't: Did the CEO do a good job? If so, what is the value of that good job to the company? If not, what is the value of a subpar job?

Many companies provide a litany of performance metrics without even the slightest mention of why particular thresholds were selected. Consultants contribute large frameworks with lots of variables. The only missing ingredient seems to be critical thinking -– why?

One particular aspect of CEO compensation that needs serious review is the concept of “at risk". At best it is a euphemism for getting paid more, at worst it is a deliberate attempt to rig the compensation game in favor of the CEO and at the expense of shareholders. To you and me, "at risk" means you get an incentive bonus if you do especially well. If you perform poorly, you're out of a job. "At risk" for CEOs allows huge upside but almost completely eliminates downside risk. Shareholders rightfully expect that awful performance that results in losses for them should entail the risk of loss for the CEO as well.

In general, the purpose of governance structures is to oversee executive decision making and risk management so as to allow managers to focus on day-to-day operations. When boards of directors not only allow, but endorse, such sloppy work, it sends a signal that there may be other things which are escaping their attention.

In summary, the proxy statement can provide a great deal of insight into a company’s culture, power structure, and decision making processes. As such, it serves as something of a code book from which to decipher hidden messages in the company’s communications. In doing so, it also provides a window into how value may ultimately get realized in the stock. This valuable guide can solve a lot of puzzles for those who are diligent enough to study it.

The invisible hand

One of the most frustrating situations for a stock analyst is when a stock moves against its fundamentals. Normally, markets are fairly efficient in discounting new information. When they are, analysts who are close to their stocks usually have a pretty good feel for how a stock will react to news.

Sometimes, however, stocks don’t behave so predictably and this has been happening more frequently lately. Increasingly, stock performance is moving against fundamental performance which is causing many analysts to scratch their heads. It seems like there is something else going on; it seems like some “invisible hand” is at work.

The truth is something less mystical but no less real. As momentum has pushed valuations to high extremes and Fed policy is evermore in the spotlight, the cost of capital is increasingly the marginal variable affecting prices. Since the cost of capital tends to move in very long cycles, it is all but “invisible” to an analyst following company moves from day to day.

As a valuation factor, the cost of capital is important for a few different reasons. First, it has a long-term and pervasive effect on valuation because it affects each year’s cash flows. As a result, changes can have an enormous impact on a stock’s valuation. Second, as mentioned, it tends to move in long cycles and thus can introduce a very significant “tailwind” or “headwind” to valuations.

The graph below from Applied Finance Group shows that the general trend in cost of capital has been downward ever since 1980. Not only has this produced cost of capital levels so low as to seem surreal, but has created a massive tailwind for equity valuations over this time period.

This leads to a third reason why the cost of capital is so important: It is a risk factor that can be managed. The imminent threat of a reversal in trend combined with the large impact cost of capital can have on valuations suggests the distinct possibility of a new regime of higher and persistently rising cost of capital. This condition is like a coiled spring; once unleashed it can be quick and powerful.

Such conditions certainly warrant caution regarding equity exposure in general, but also suggest risk mitigation measures that can be taken on a security level basis. In fact, different business models and different patterns of cash flows have different sensitivities to a change in the cost of capital, much like long-term bonds are more sensitive to changing interest rates in the fixed income world.

The types of companies that are most affected by rising capital costs are those with cash flow prospects far out into the future. Biotech stocks and internet startups are extremely sensitive. Large companies with relatively low costs of capital are also very sensitive to increases. Many of the attributes commonly associated with quality such as strong competitive advantages and strong returns are also vulnerable because so much of their valuations are attributable to future cash flows. Companies that do or can monetize assets in a fairly short period of time tend to be less affected.

In summary, although beta (market exposure) chasing behavior has been well rewarded the last few years, the downward trend in the cost of capital which has facilitated these moves can’t continue forever. As such, it is a good time to start managing the risks of change if you haven’t already. For those oblivious or indifferent to the direction of the cost of capital, the invisible hand may well turn into the invisible fist.

Welcome

With this edition of Arete Insights I am testing out a slightly different format. While the nature of the content still focuses very much on issues and insights that I believe investors can benefit from, I will make a greater effort to target specific “pain points” for investors and also suggest actions that can be taken to address those challenges.

My intent in this exercise is to make Arete’s insights more practicable and “user-friendly”. One possible path to this ongoing improvement effort is to post these articles in a blog that will facilitate more frequent communication. Whether it’s regarding content, format, or anything else, I would very much appreciate hearing any feedback you have that can make Arete’s insights more useful. Please always feel free to reach me at drobertson@areteam.com with comments or suggestions.

Thanks in advance for your help!

David Robertson, CFA
CEO, Portfolio Manager

The efficient frontier

Many investors cast a suspicious eye to any form of active management and instead opt for index funds or exchange traded funds (ETFs). Many other investors, however, intuitively sense that there must be opportunities for active managers to outperform, but can’t quite put their finger on why so many fail to keep up with their benchmarks. If Arete’s outlook for low future returns is anywhere close to being correct, many passive investors will be extremely disappointed with those low returns and active management is likely to attract a lot more attention.

What has been fairly well appreciated in academic and some professional circles, but not well covered for individual investors, is that there are very specific and identifiable structural flaws that handicap many active managers. When you do the research, it becomes incredibly clear that the correct conclusion is not that active management cannot be done successfully, but rather that a majority of active managers do not offer good value but somehow still manage to get by with it. 

The most important structural flaw of most active funds, in a word, is inefficiency. As consumers we have experienced the forces of efficiency improve our lives in many ways from Walmart’s “Everyday low prices” to CarMax’s “No haggle” pricing and to  innumerable websites and blogs that post free content. The internet and other technologies have disintermediated inefficient supply chain components almost everywhere. Nonetheless, the realm of active management in particular (and investment services broadly) remains curiously inefficient.

The two areas ripest for improved efficiency are fees and portfolio construction. Regarding fees, most of the important costs to run a money management operation have come down substantially and fees will need to better reflect these savings.

Further, a significant, and often majority of fee structures, are allocated to marketing and distribution costs.  In an age when one can access a website or view a Form ADV (Advisor’s regulatory statement) essentially for free, there is no good economic rationale for paying so much for these functions.

Whether fee reductions happen quickly, as a critical mass of investors push back on existing fee arrangements, or gradually, as progressively more Gen Xers and Millenials prefer to avoid legacy infrastructure burdened with unecessary costs, doesn’t matter much for the big picture. Change is afoot.

In addition to fees, there is likely to be increasing pressure for more efficient portfolio construction. The vast majority of active mutual funds have a majority of equity exposure that overlaps their benchmarks. In other words, when you hire an active manager, you may be expecting to benefit from all of their best ideas, but typically, you’re not. You’re getting some of their best ideas along with a lot of average ideas and you’re still paying full price. It’s like buying a basket of apples with three good apples on top and three bad apples on the bottom, but still paying for six apples. On that basis, those three good apples are not cheap.  

Until these changes become much more pervasive, there are a couple of things you can do to help yourself out, and both focus on efficiency. A really good place to start is to look for very high active share – preferably above 80% or so. That way you truly get the best ideas the manager has to offer. Some institutional databases are now allowing active share to be reported; you should look for it too.

The second thing you can do is to screen funds and managers by the reasonableness of their fees. Part of this is looking for relatively low fees, but part is also comparing those fees to active share. For example, a fund with fees of 1% could be attractive, and especially so if active share is very high at 90-95%. If that fund’s active share is only 33%, though, it translates to an active fee of 3% which is extremely high. One hint: If you have an extremely hard time getting the information, or if it’s not available at all, the answer is not likely to be good.

Investor advocate

Very few people would dispute that the arena of investing is fraught with challenges. Tons of information, waves of sales pitches, endless lines of “fine print”, and a massive proliferation of services all serve to make the important task of investing one that most people would prefer to avoid.

I always felt the same way about the subject of politics. This was an interesting anomaly because I tend to be a pretty curious person and I enjoy learning about most subjects. The realm of politics, however, seemed so overtly manipulative and impenetrable that it didn’t seem worth the effort.

There aren’t many things I say “Never” to, though, so when I got introduced to Meet the Press when it was hosted by Tim Russert, my interest really blossomed.  A political insider himself, having worked with Senator Daniel Moynihan and Governor Mario Cuomo, Russert had a deep understanding both of how politics worked and what it could accomplish.

Through his interviews and intense questioning on the show, Russert was always working to get his guests to reveal what they meant by forcing them to define what they said. Noticeably, he was never mean or uncivil, but he could be extremely demanding. His mission seemed to be in revealing the issues, not in promoting particular positions.

Through his translation of what had previously sounded like unintelligible rhetoric, I began to understand its meaning. After a while, I started seeing more clearly what was really going on and in most cases I could see how both sides had valid points that needed to be considered. In essence, he created a lens of understanding.

While these exercises were intellectually stimulating, they also served a far greater practical purpose. Before discovering Russert, I had often felt that the process of voting was agonizing. I knew I was getting hugely biased information but I also knew I didn’t have the tools or the time with which to fairly evaluate it. It was an unfair fight made worse by the realization that if I took too strong a position, I could inadvertently support someone averse to my interests. Armed with the knowledge of political reality, Russert allowed me and the rest of his audience to make better electoral decisions.

This experience is especially relevant to investors now that economic and financial information is taking on ever-greater political importance. Excessive debt burdens are being shifted from the private sector to the public sector making them everyone’s problem now. In the process, it is subjecting nearly every economic and financial statistic to potential for some degree of deception through reporting, interpretation, or both.

It is annoying that information is being so widely misappropriated, but this is the world we live in. PR people know perceptions can be manipulated and also know that most of us are too busy to take on yet another project. The best we can do is to recognize the situation for what it is and to apply the resources we do have to the task.

One constructive response to the investment challenge is to find one or more “investor advocates” to help sort through the vast amounts of economic information and misinformation. In looking for advocates, credentials count big: Does the person have the skillsets to analyze the numbers? Does the person, or has the person, worked in the trenches, as Russert did, to really learn the landscape? Do they have an educational and experiential background that demonstrates strong analytical skills? If not, they are unlikely to understand what is going on any more than anyone else.

Another trait that you want in an investor advocate is nonpartisanship. A big part of what made Russert so effective was that he did not play sides (except for his Buffalo sports teams!). He knew that if he did, he would lose credibility. Regarding investor advocates, it is fair to ask if they can articulate both risks and opportunities for various positions. The clarity of their answers, or lack thereof, will be revealing. It is natural for someone to talk their own book, but if they do not or cannot acknowledge the potential downside of their views, they may very well be flying blind.

A third trait that is extremely important in an investor advocate is accessibility. Many people in the business are knowledgeable and some are fairly nonpartisan. It is extremely rare, however, to find someone who is both - and can also be easily reached. Unless you can get perspective “from the horse’s mouth” in regards to how the environment affects you, an otherwise knowledgeable viewpoint may not be very helpful.

The downside to a politicized economic environment is that it increases the costs of processing and understanding information. Further, it increases the probabilities of very poor outcomes for those who do NOT make the effort to understand and manage to the circumstances. Ignorance is rarely blissful for long in capital markets.

On the other hand, greater challenges create an environment amenable to greater performance differentiation. Those of you who develop strong relationships with investor advocates will be well positioned to harvest good returns when and where available and to manage risk in whichever way is most appropriate for you. And finally, you just might end up finding the investment issues pretty darn interesting!

A risk by any other name …?

Anyone who has spent time evaluating investment services is familiar with the goal of “risk adjusted return.” The concept is intuitive enough: Return should be calibrated by risk rather than judged on its magnitude alone. Too often, though, the comfort of this self-evident tradeoff belies the multiple challenges in fully understanding either term. The unfortunate consequence is that it becomes all too easy for investors to unwittingly take on risks of which they are not fully aware.

A good example of one such risk resides with valuation. Over suitably long investment horizons, a great deal of evidence and a wide array of analytical methods exist to support the case that US equities, in general, are quite expensive at current levels. In simple terms, the more prices rise relative to underlying earnings power, the riskier they become. In other words, a great deal of valuation risk exists right now.

Risk in this sense means that the intrinsic value for stocks (as a group) is significantly lower than the current price of market indexes. Since market forces tend to pull prices back to intrinsic value over time, it is fair to think of intrinsic value as an anchor, or a quasi-permanent condition. Conversely, when prices deviate from intrinsic value substantially, it is fair to think of those situations as more “transient” in nature. For long-term investors, this is a critical distinction to make in preserving your wealth.

Another risk that is often under-appreciated is that the global financial system allows extremely fluid movement of credit and liquidity across national borders. As a result, the effort by much of the developed world’s central banks to keep interest rates artificially low means that a lot of investors have been desperately searching to maintain investment income by reaching for yield in other places. Incoming flows of credit and liquidity can keep pushing valuations in such places higher, but when those flows reverse, the whole system can lock up. This is a big part of the problem in many emerging markets right now.

The nature of this risk may be hard for reasonable, valuation-based investors to fully appreciate because they would never engage in such crazy behavior themselves. Unfortunately, just as in all aspects of life, some people behave in a way that affects all of us. Usually it’s a minority and we absorb those inconveniences with the realization that others more than make up for it. What is different now is that easy money policy is actually encouraging dangerously aggressive behavior.

To illustrate, you may be a perfectly safe driver, but if you are on road jammed with people going 120 mph and darting in and out of lanes, it’s not going to be a safe drive for anybody. So it goes in emerging markets. Now imagine that the pavement suddenly runs out and turns into a windy, potholed, gravel road. It will be incredibly dangerous for everyone there and people will get hurt.

Many concerns about risk are often gently shoved aside by the use, and we would argue abuse, of statistical models. The problem lies in the assumption of normal distributions in a huge proportion of “risk” models. Here the risk isn’t endemic to the market itself, but in the false security that bad models can provide.

One of the very interesting characteristics of markets is that they are complex and adaptive systems. This means that participants act not just on the basis of information, but also on the basis of what other participants are doing. An extremely important consequence of this type of system is that feedback loops can develop which lead to extreme situations.

This is important because it tells us that the shape of outcome distributions actually change over time. Further, it is right at the times that feedback loops are forming and growing that normal distributions tend to be most inaccurate. As a result, it is also at these times that investors are likely to be exposed to much greater risk than they realize despite the comforting messages of “risk management” they may hear.

In wrapping up, risks are inherent to investing and as such cannot be completely avoided. They can be much more thoroughly understood, however. One way to do so is to develop expertise in valuation and other risk types or to find someone with such expertise. Unless you know what you’re really getting into, it’s hard to know how much you might lose.

Finally, whether you believe our assessment of risks or not, we propose a test. Ask of yourself: What would you regret more – missing out on a rally that might continue a while longer, or losing a lot of money due to risks that were completely foreseeable? How you answer this will reveal a great deal about your investment goals and personality.

Welcome

As an equity analyst, I normally prefer to focus the vast majority of my efforts on company-specific valuation and fundamental analyses because that is typically what delivers the best results for clients.  When things aren't normal, though, I adapt to whatever activities will produce the best returns for clients.  Given Arete's long-term investment horizon, it is hard for me to conclude right now that anything is more important than understanding the credit system and the nature of money. 

This may seem like more than a modest digression for a person trained in equities research, but there are some fundamentally sound reasons why it is less of a stretch than it first appears.  First and foremost, I consider myself a steward of capital before any particular brand of analyst.  As a result, I’m always going to be on the lookout for things that can especially help, or hurt, Arete’s clients.

In addition, I believe credit is poorly understood as a driver of stock prices.  Stocks, like anything else, are driven by supply and demand.  When more money and more credit are available, prices go up. This was especially true of housing in 2006 and is especially true of equities now.  

The gentle but persistent effect of credit growth is much like a trailing wind when you are riding a bike.  You don’t even really notice it when it is at your back.  It just seems fun because it’s not very hard and you are going a little faster than usual.  When you turn around, though, you get a surprise as to exactly how much help you were getting.  If you aren’t careful, it can be really hard to get back with all of the extra energy you need to ride into the wind. 

I’ve noted in the past that credit has provided a strong “trailing wind” for equities.  More specifically, total credit in the U.S. (from the Fed’s Z.1 release) grew at 9.5% per year from 1964 to 2007.  During the same period, income (nominal GDP) only grew a little over 7% per year.  When we turn around, it’s going to feel a lot different than it has for the last few decades.

This basic message is illustrated much more comprehensively by Chris Martenson in his "Crash course" webcast series at www.peakprosperity.com.  According to Martenson, the accumulation of debt at a much faster pace than income over the last 30 years is unsustainable and will lead to a major "reset" in the financial system. 

This reset will create an environment extremely different from our recent past.  As government debt increases well beyond levels that are serviceable, it is quite likely that significant inflation will be used as a policy mechanism to reduce the real value of that debt.  As this happens, massive amounts of wealth will be transferred from those who save cash to those who own real assets.  Martenson sums up his outlook with the assessment that “the next twenty years are going to be very different than the last twenty years”. 

Radical positions like Martenson’s can often be easily dismissed as the ramblings of a crank or a crackpot.  In the case of Martenson, however, he makes such a spectacularly lucid and reasoned case, it is hard to dismiss without serious consideration.  Perhaps because of his academic training as a Ph.D. in toxicology, he intuitively understands how excessive debt can poison the financial system.

At very least, a future that is very different from our past will require very different planning.  Certainly real assets will need to be considered as part of that plan and equities will likely play an important role too. Preserving wealth will be imperative.

As such, calibrating exposure to stocks is likely to be an ongoing challenge. While it would be easy and probably more profitable, at least in the short-term, to keep my head down by just researching stocks and ignoring the implications of a major credit disruption, I can’t in good conscience say this is the best thing for Arete’s clients.  The stock market has been riding a long time with the wind at it’s back. Arete continues to serve as an antidote to the silliness that pretends otherwise.
Best regards,

David Robertson, CFA
CEO, Portfolio Manager

Insider’s View

For better and worse, the remarkable growth of most asset prices over the past thirty years has also had a powerful influence on investment service providers. Driven by demographics, rapid credit growth, and strong asset returns, each part of the services eco-system has adapted business models, services offerings, and revenue structures that thrive in this environment.

A natural consequence has been that many providers are essentially designed to ride the "wave" of capital markets growth.  One manifestation of this condition is that an unusually large proportion of providers base revenues on assets under management (in order to benefit disproportionately from attractive equity returns) regardless of economic logic for doing so. Another manifestation is that there are lots of undifferentiated offerings. Indeed, offerings that are truly different can stand out in an awkwardly undesirable way. 

Such unchecked growth and uniformity has its downside, though.  Anything that thrives in one very narrowly defined environment almost by definition is not well suited to a very different environment. Indeed it’s not surprising, as John Kay recently noted in the Financial Times that, "The established firm more often responds by using its market and political power to resist change." 

It’s not unfair to hypothesize that in the event of a significant change in the investment environment, most incumbent firms will actually be handicapped by their past success.  "We are all reluctant bulls now, say fund managers" is a recent Financial Times headline that speaks volumes about the resistance of many money management practices to change. According to the article, "Summing up the research, BofA says investors are 'like a bull in the headlights', unable to move from a potentially dangerous situation."

If it is accepted that the investment environment is likely to change materially at some point, long-term investors will care less about whether that change happens over a few years or whether it happens tomorrow.  The important thing to know is that almost all the old rules of thumb and old business practices will be wrong.  

This presents yet another challenge, and opportunity, for investors.  Not only must special consideration be given to one’s portfolio construction, but also to one’s service providers.  Among these, who can handle a major market disruption? Who is working to create new and better solutions as opposed to resisting change? Who can help you navigate the complex investment landscape?  

It is hard to understand how a permanently bullish perspective serves clients’ long term interests, although it is likely to help grow revenues for many firms.  In a competitive landscape muddled by such self-serving and counterproductive blather, it will be useful to search for new and fresher sources of help.  The alternative is to wax nostalgic and hope things don’t change.

Insights

“It’s a tough old world out there, not least for institutional asset owners. Complexity and volatility combined with a low-return environment are forcing asset owners to reconsider their traditional ways of managing investments. It’s a situation that has been a long time building.” This was the message delivered in the article “Outsourcing hits its stride” from a recent Pensions & Investments supplement. As the process of investing is becoming progressively more difficult, more and more organizations are looking for help with some or all of the various functions.

While this message rings true for many individuals and small institutions, those looking for help through outsourcing extend into much large organizations. “More sophisticated, larger clients are looking at outsourcing because the process of managing complex investment portfolios has become much harder,” says Russell’s Macy.  “Markets are volatile and dynamic. Decisions cannot be made at quarterly meetings. It’s a real-time job. So even clients with $1 billion or $2 billion portfolios are looking outside for expertise.”  The challenges are affecting everyone.

Given the economies of scale in the investment management industry, many of the most sophisticated approaches are only implemented at the very largest funds.  The good news for smaller funds, though, is that these approaches offer roadmaps to best practices and improvement. Further, with rapid and ongoing improvements in both technology and knowledge management, such best practices often don’t have to take long to become much more broadly accessible to individuals and small institutions.

The providers that are most naturally positioned to deliver outsourced investment services are investment consultants and money managers because the strengths of both groups overlap naturally with many of the demands for outsourcing. Both groups have weaknesses as well, though.

“Many consultants saw outsourcing as a good business opportunity,” says Russell’s Macy. “Many have 30 years experience of giving investment advice to asset owners – plan sponsors, endowments – but just three years of implementation experience. This presents huge challenges. Money managers on the other hand are really good at money management, but do they have the experience of mapping out long-term strategic advice for clients? Not a lot of firms are equally strong in both areas.”

The question of whether or not one should consider outsourcing depends on a couple of factors. Most fundamentally, owners should ask, “Are our current arrangements fit for purpose in today’s financial market environment? And further, can we move fast enough to take advantage of short-term investing opportunities and to stem a tide of losses?” In short, the volatile and fragile nature of today’s markets often demands a fresher and more robust approach.

In addition, asset owners should determine which skills and expertise they need most. Outsourcing can span a wide array of activities including evaluating vendors, reviewing investment policy, assessing asset allocation, as well as educating and training fiduciaries about the financial markets.

The really good news in all of this for investors is that outsourcing is one area in which the investment industry seems to be changing for the better – because it focuses on outcomes. Very specific and narrowly defined service offerings are likely to have a shrinking role in a very complicated environment challenged by limited return opportunities. Conversely, service providers that can forgo a narrow focus on returns and actually help investors achieve desirable outcomes are likely to become ever more important.

Welcome 

One of the debates that most investors confront at some point is whether to pursue active or passive investing.  As an investor myself, I have always been fascinated by the tradeoffs in seeking to do the best I can with what I have.  In this pursuit, I have come to see the active/passive decision significantly influenced by two under-reported factors: 1) Understanding and appreciating the symbiotic relationship between active and passive investing, and 2) Understanding and managing one’s emotions relative to these decisions.

A recent article in the Financial Times highlights the symbiotic relationship nicely.  In “Passive parasites do not cure all financial ills,” David Smith describes that, “Passive management is, inevitably, a parasitic industry … and every smart parasite knows a healthy host is crucial.” He elaborates, and accurately in my opinion, that passive investing works best when the markets are broadly efficient. 

This insight introduces the notion that the active/passive decision is not a black and white, either/or decision.  Rather, it is contingent on the health of the market.  In turn, the market’s “health” is determined by the concentration and diversity of active investors.  When there are a lot of different investors, none of which holds commanding positions in the market, buying and selling, haggling over prices, those prices tend to be fairly accurate representations of underlying value. This creates an attractive environment for passive investing. 

Conversely, when market diversity breaks down and becomes dominated by similar strategies, prices can drift far, far away from their intrinsic values.  As assets under management of index funds and exchange-traded funds (ETFs) have exploded over the last several years, it is distinctly possible this has occurred. Somewhat ironically, the great success of passive investing may be sowing the seeds of its own destruction.

The balance, or lack thereof, in the market’s ecosystem is also affected by behavioral tendencies. As Smith describes in his article, “Humans mostly suffer the same behavioral biases, so they compound each other rather than offset each other.” So as indexes go up, they attract more interest, and on and on … until something bad happens.  At the end of the day, passive investing is a good idea, but in moderation.

The behavioral dynamic is one that influences the active/passive debate in another interesting way.  In “Hello passive, goodbye active: fund investors make the switch” (Financial Times), Owen Walker describes “The trend for savers to turn their backs on active funds and favour low-cost passive investment funds is mainly due to feelings of dissatisfaction with active fund managers.”

While I wouldn’t be surprised if much of this dissatisfaction was well deserved, there are some very interesting insights into that dissatisfaction. Walker reports, “Another advantage that passive products have over their active counterparts is they do not attract the same feelings of blame from unfortunate investors. In a recent study … academics at the University of Southern California found that investors are far more likely to blame and pull out of active funds following poor performance than with passive funds.”

Really!  Now that sounds to me like there are some serious trust issues between investors and active managers — and I’m sure that’s the case in many instances.  Nonetheless, it also suggests that many investors are much more willing to accept losses in index funds than in active funds. Of course anywhere there is potential for investors to willingly accept losses, Wall Street can’t be far behind.  I have no doubts this at least partly explains the wild proliferation of index funds.

In summary, both passive and active investing can make sense depending on one’s particular circumstances, the balance between passive and active management in the market, and one’s level of trust with his or her manager.  Given the prominent levels of passively managed assets, I suspect the scales will be tipped toward active management for some time. 

If you decide to pursue active investing, though, it is very important to develop a strong relationship of trust.  If an active manager does not provide substantial disclosure and transparency and is not easy to work with, it will be hard to maintain trust in the tough times (which will always happen). 

Finally, the industry and the market constantly change and adapt.  Arete was formed to lead change by creating a better package of active management for investors.  If you are disappointed with a manager, but still believe in the prospect for active management, or are increasingly leery of index funds, please let me know.  I suspect you may be surprised by how much more you can get.

Best regards,

David Robertson, CFA
CEO, Portfolio Manager

Insights 

Every once in a while a big transformation occurs that disrupts old ways of doing things and demands new ways of thinking.  Right before the millennium the internet was the big story.  The story of information and mobility has dovetailed into one of power being disrupted across the world.  More specifically: Size is rapidly losing its prominence as a key determinant of power.

The dimension of size was discussed in the Q1 13 edition of The Arete Quarterly with the illustration of “generals fighting the last war”.  It is afforded much greater attention in Moises Naim’s new book, The End of Power: From Boardrooms to Battlefields and Churches to States, Why Being in Charge Isn’t What it Used to Be. As Naim describes, “Power … is undergoing a historic and world-changing transformation.”

Size became equated with power for good reasons.  Early businesses, for example, were typically very small and specialized. As such, they typically paid a relatively high percentage of revenues for materials and for skilled job functions.  

As Naim points out, “High transaction costs create strong incentives to bring critical activities … inside the organization.” Size brought an ability to reduce transaction costs as well as to increase professional management (managers, marketers, accountants, etc.). For a long time, size became a virtuous cycle: Get bigger and proportional costs come down.  Lower costs allow one to gain share and get bigger.  All the while, this cycle progressively increases barriers to entry making it that much more difficult to be challenged.

Size has been especially influential in shaping the investment business. Because many costs are essentially fixed for an investment firm, their proportions become much smaller as assets grow. This created a mandate at many firms to do just that: Grow assets.  In times of high commission costs, high computing costs, high data costs, high communications costs, high back office costs, and high marketing costs, it made sense to bring these functions in house and to amortize them over a large base. 

There have always been challenges to size, though, and especially in the investment business.  It is well documented that performance benefits tend to diminish rapidly with size.  Further, smaller firms tend to have proprietors with more skin in the game and who care a great deal more about the performance of their clients.

In addition, times have changed — a lot.  Now the costs of commissions, computing, data, communications, back office, and marketing in most cases are tiny fractions of what they used to be.  Technology has dramatically changed the economics of the investment business, vastly mitigating the economic justification for size. 

Technology has changed much more than just the investment business; it has changed almost every facet of our lives. “Today … what is changing the world has less to do with the competition between megaplayers than with the rise of micro powers and their ability to challenge megaplayers.”  This ability to challenge has been wrought partly because technology reduces barriers to entry. 

Importantly too though, technology also provides the tools by which to express discontent.  Whether an underclass is frustrated with a political regime or a customer has had a bad experience with a product or service, it’s never been easier to get the word out on a global scale.  The tides have changed and large players have never been so vulnerable. 

Despite the countervailing evidence from virtually every part of our lives, many people still cling to equating size with power. While nostalgia and habit are likely factors behind this inertia, an objective assessment must also consider the advantages of being smaller.  At the end of the day, the internet and digital revolutions are making things cheaper, better, and faster.  This is absolutely true in the investment world and will be a great boon for those willing to consider smaller players that are trying to pass on these benefits to their investors.  

Lessons from the Trenches

One of our goals with the Arete Insights newsletter is to share our insights into how the investment management business really works.  “Lessons from the Trenches” highlights our approach to stock research.  Our intent is to share with you some of the tips, tricks, and other tools we have incorporated into our work that may provide you some insights into how we engage in our craft.

One of the most sensitive variables in any long-term discounted cash flow model is the discount rate or cost of capital.  This is so because it affects the calculations for each time period and therefore has a compounding effect. 

Despite the critical importance of cost of capital to a valuation assessment, it is too often given inadequate consideration.  Sometimes models employ formulaic derivations for the discount rate that have little resemblance to the real world.  Sometimes cost of capital estimates are glossed over because they are so hard to quantify.  Regardless, it’s not uncommon for this critical variable to be wildly off the mark.

Arete addresses these important issues through its implementation of a long-term discounted cash flow valuation model licensed from the Applied Finance Group (AFG).  AFG uses a market-derived cost of capital estimate which captures changes as the market moves.  In this way, it avoids the risk inherent to static models of being slow to incorporate market changes and ultimately being seriously off the mark. 

In order to provide greater insight into the cost of capital, it is also useful to consider different scenarios.  Since stocks are long-term investments, it is likely that at some point over the life of the investment, capital costs will be different, and perhaps very different.  This process was illustrated in the Q1 12 edition of Arete Insights.

Henny Sender highlighted a very similar process in her article, “Fed’s easy money has reined in M&A animal spirits,” for the Financial Times.  In it, she notes that the private equity world very explicitly incorporates the possibility of changing capital costs over the life of their investments:

“For some potential masters of the universe, the problem is precisely the artificially low cost of debt – despite almost $1tn of dry powder. Every Monday, for example, when the private equity firms hold their weekly investment meetings and consider potential deals, one of the first data points they look at is where the 10-year rate is and where it will be in five years’ time when the life cycle of private equity funds dictates that it is time to let go of companies bought now.”

Not only does private equity address the potential for a change in cost of capital, but many important participants seem to view the likely change as an increase.  “’Nobody wants to bet the ranch now because where the Fed is setting the 10-year today isn’t going to be where the market sets it in the future,’ says the head of buyouts at one important private equity company. ‘Since I don’t know what the long-term cost of capital is, I have to be conservative.’” In addition, another acclaimed private equity investor, Leon Black, recently stated that his firm is “Selling everything that isn’t nailed down.”

Wow – very interesting! On one hand public markets are essentially saying that things have never looked so good and that the cost of capital may even decline from here.  On the other, very accomplished private equity investors are more focused on selling than on buying.

While the theory of cost of capital is taught in every finance and investments textbook, the real world application often gets shortchanged.  The fact is that capital markets have benefited from over thirty years of tailwinds from a declining cost of capital. Not only is this not likely to continue, but when the cost of capital starts rising, valuations may be severely impaired.  Either way, it makes sense to consider the possibilities and one’s exposure to them.  

Welcome


One of my personal characteristics is that I tend to gravitate to issues that are particularly uncertain and challenging.  I do this partly because I always learn more from challenging issues and partly because it is more fun and more rewarding to find or create a way through a path of obstacles than to sit and do nothing.  Needless to say, I get bored easily!

One consequence of these tendencies, however, is that they can send the wrong signals.  Although my attention to potentially adverse outcomes is normally rooted in curiosity and concern for Arete’s investors, I know that it can easily be (mis)perceived as a commentary on the probability and magnitude of such risks. 

To be sure, I think there are plenty of chances for investors to lose money in the markets at these levels.  That said, I also have a very significant part of my net worth tied to the long-term opportunities for active management of stocks.  I wouldn’t make those commitments if I wasn’t extremely optimistic about the longer-term opportunity to improve one’s well-being.

This partial paradox creates an opportunity to discuss some of the things I see on the horizon that I think will bode well for the economy and for stocks.  While part of my optimism is rooted in my belief in the ability of humans to successfully adapt to a wide variety of conditions, these particular comments will focus on content from the short but powerfully insightful book, Race Against the Machine: How the Digital Revolution is Accelerating Innovation, Driving Productivity, and Irreversibly Transforming Employment and the Economy, by Erik Brynjolfsson and Andrew McAfee.

We have all seen technology improve and dramatically alter our work environments.  Some have had their jobs threatened by technology.  But did you know that the best chess player in the world right now is not a person or a computer, but “a team of humans using computers?”  It turns out, in the words of Brynjolfsson and McAfee, “Weak human + machine + better process was superior to a strong computer alone and, more remarkably, superior to a strong human + machine + inferior process.”  In short, the thoughtful combination of human skills, technology, and process are pointing the way to ever-higher levels of performance and productivity.

One of the reasons why people often get intimidated by technology is because the exponential trajectory of its advance quickly outdistances simple linear development.  This trend is well captured by Moore’s Law which has accurately forecast the doubling of transistors on integrated circuits every 18 to 24 months.   

While this is true, it is also true that “Combinatorial explosion is one of the few mathematical functions that outgrows an exponential trend.”  This ends up being terrific news for us non-machines: “Because the process of innovation often relies heavily on the combining and recombining of previous innovations, the broader and deeper the pool of accessible ideas and individuals, the more opportunities there are for innovation.”  The authors conclude that “combinatorial innovation is the best way for human ingenuity to stay in the race with Moore’s Law.”

Finally, it is useful to step back and view technology in the context of history.  Economist Paul Romer described in the book: “Every generation has perceived the limits to growth that finite resources and undesirable side effects would pose if no new … ideas were discovered. And every generation has underestimated the potential for finding new … ideas. We consistently fail to grasp how many ideas remain to be discovered … Possibilities do not merely add up; they multiply.”

Romer also makes the point that “perhaps the most important ideas of all are meta-ideas—ideas about how to support the production and transmission of other ideas.” Indeed, “The digital frontier is just such a meta-idea—it generates more ideas and shares them better than anything else we’ve ever come up with.”  Not only do ideas multiply, but we seem to be right on the threshold of enjoying technologies that enable more and better multiplication. 

None of this is to say that we human beings can just ride this wave and have our needs taken care of.  We will need to actively participate, invent, and adapt ourselves to avoid obsolescence.  For those who are up to this challenge, however, the world of tomorrow is quite likely to be far better than that of today.

Best regards,

David Robertson, CFA
CEO, Portfolio Manager

Insights

Let’s say there is a game in which you repeatedly ante up some money and – BAM! -– you lose it; it’s gone.  Every once in a while you win a big pile, but over time you always lose more than you win.  This may seem like a gamble and not a sensible thing to do with money and you’d be right: it is essentially the model for slot machines.

It’s a bad game in that regular play will always induce losses.  Most people who are serious about investing can’t think of anything less enticing than throwing their money away like this.  They may also harbor similar sentiments about the stock market and to some degree they would be right given the investment landscape today.

Consider an analysis of the landscape from John Hussman in his recent weekly letter: “When overbullish conditions have been in place [in combination with favorable trends and overvaluation – as they are today], the overvalued, overbullish conditions have dominated, producing a negative excess return averaging -3.3%.”  In other words, investing in the market in conditions that persist today is likely to produce negative returns over an intermediate time horizon.  You are essentially throwing money away. Although the payoff structure is different, current market conditions make the proposition of investing in equity indexes something similar to playing slots.

Framed this way, index investing seems almost ludicrous.  Yet in reality it often feels like an extremely difficult choice:  If I’m not investing in stocks, where can I go?

As with many challenges, it often helps to return to first principles.  Hussman also writes, “The core structure of nearly all optimal portfolio allocation models is that investment exposure should be relatively proportional to the excess return that can be expected per unit of risk.”  In other words, what we’re really trying to do is determine where and when to take risks. 

So in one sense, the question of where to go is easily answered: if expected excess return is negative for some period, investment exposure should, at best, be zero.  You always have a choice and if one alternative is a bad one, you can always refuse to play. 

The fact that the “just say no” option is not strikingly obvious speaks volumes about today’s investment landscape.  One factor that explains the willing acceptance of a poor risk/reward tradeoff is the enduring effect of the “equity culture.”  The strong returns on stocks from 1982 through 2000 still live happily in the memories of many of today’s investors.  As a result, strong equity returns are considered “normal” by many and an entitlement by some.  Positive emotions about stocks can serve to soften or even completely obstruct the perception of risks.

Another reason why more investors don’t accept the “just say no” alternative is because they feel coerced by the Fed’s quantitative easing measures.  To be sure, The Fed has continued to strongly support risk assets ever since the financial crisis emergency in 2008.  While it may be tempting to ride the Fed’s quantitative easing “wave”, that wave will crash -- but nobody knows where or when to step off safely.  This does not sound like a particularly good proposition for long-term investors to accept either.

The differences between weak economic fundamentals and booming equity markets will be reconciled and when they do, it will dramatically change the perceptions of investing and risk.  It will also have a huge effect on the investment industry.

Gary Shilling addressed this issue in his latest Insight newsletter by predicting that “Low investment returns will discourage do-it-yourself investing and encourage the use of professionals.”  As people eventually realize that returns are not an entitlement and that investment mistakes can be incredibly costly, we believe Shilling’s forecast will prove prescient.

Shilling’s forecast for the investment business recognizes important obstacles as well.  He describes, “The challenge, however, is for these asset managers to be profitable at fees that don’t consume major shares of investment returns.”  Further, “At the retail level, the trick is for asset managers to make customers feel like individual clients but at low costs.”

We are heartened by these comments from such an insightful and successful market participant because they corroborate our thesis for founding Arete.  It has always been important to distinguish “bad games” from “good games” when putting money into equities. Our valuation work has been an ongoing effort to differentiate good games from bad ones on a company-specific basis.  Now, in the context of extremes of credit consumption and monetary policy, it is also important to actively manage exposure to various risk assets.

While unusually loose Fed monetary policy has masked the value of these features the last few years, they will be gold when market prices and fundamentals reconnect.  Much like a well-built house, the quality of construction is its own insurance when the storm hits.

Lessons from the Trenches

One of our goals with the Arete Insights newsletter is to share our insights into how the investment management business really works.  “Lessons from the Trenches” highlights our approach to stock research.  Our intent is to share with you some of the tips, tricks, and other tools we have incorporated into our work that may provide you some insights into how we engage in our craft.

An important part of the job of an analyst is to filter through piles of information efficiently in order to aggregate enough tidbits to generate a unique insight or perspective on a stock.  One of the surprisingly robust sources of such tidbits is the proxy statement.  Partly because it provides such a rich seam of information and partly because its value is much greater in the context of other analysis, I have integrated proxy reviews with the research process at Arete.  While there is usually a lot of legal boilerplate language to wade through, there is also a great deal of information content awaiting the diligent analyst.

Some insights are fairly straightforward.  For example, when executive incentive plans list operating targets and rewards for the fiscal year in progress, these numbers can be used to calibrate estimates.  More often, operating targets are posted for the past year, but even then they can be reviewed for their degree of difficulty.  In other words, you can gauge how high (or low) the bar is for executives to receive their “pay for performance.”

Such revelations can say a great deal about how ambitiously the board engages its fiduciary duties.  Ultimately, I think this is one of the most important variables in company valuations, even though it is extremely subjective and qualitative.  Because it shows the degree to which board members embrace or eschew their responsibility to shareholders, it gives a strong indication of the extent to which shareholders can expect to benefit from the economic functioning of the company.

Some of the other questions I ask when reading proxies include: Does the company operate in an industry which involves a lot of assumptions to determine earnings per share (such as managed care organizations) AND use earnings per share as a metric for incentive compensation? This may point to a conflict of interest.  Does the company provide substantial stock options as part of the compensation package?  This can encourage risk-taking with a lot more downside for investors than for executives.  Does the board seem too “cozy” with several board members serving more than ten years, or having lots of interrelationships, or including many former executives of the company?  Any of these factors can suggest less than complete dedication to shareholder interests.

There are also a few items that I take special issue with.  For example, I don’t believe there is any good reason to maintain a classified board.  In this day and age of instant access to information, why would any responsible board want to intentionally delay feedback on board members by only asking for a vote every three years? 

In addition, some companies report a relationship with their current auditor lasting decades.  Some pay auditors very substantial fees for non-audit activities.  Both of these situations suggest a high likelihood of conflict of interest that can forebode problems.

It is important to note that none of these items in isolation necessarily means very much.  There are rarely black and white issues regarding the nature of the board, the quality of governance, or the attractiveness of the investment opportunity.  In fact many of the better investments involve ambiguous or apparently negative situations. 

There are cases, for example, in which a CEO also serves as chairman of the board but runs the business so well that shareholders benefit from that expertise.  There are also examples of executive teams that are significantly overpaid but are outstanding operators and stewards of capital in every other respect.  There are also poor performing boards overseeing poorly performing businesses that happen to own great assets.  These can be very attractive candidates for takeover or for improvement by activists.

The bottom line is that proxies are often replete with information that can provide nuance and texture to quantitative analysis.  These insights can lead to a more accurate set of expectations and can also inform better risk management.

Welcome 


Technology is a great force that has been sweeping through the economy and labor market and in doing so, has been imparting big changes in business models.  While these changes can no doubt be disruptive and detrimental to certain individuals and companies, in a broader sense they are undeniably beneficial to society as a whole.   Nobody complains any more that there just aren’t enough jobs turning grindstones.  

I am especially interested in how technology has, and has not, created benefits for investors along the way. What advantages have been gained and what great opportunities await us?  In short, I believe we are on the cusp of a new generation of businesses which I'll dub Investment Management (IM) 4.0.  These new organizations will combine new and existing technologies in unique ways in order to provide fundamentally better value propositions for investors.  Once adapted, nobody will want to go back.

First, let's look back at earlier versions of investing.  In the early twentieth century, for example, simply having access to stocks was a costly privilege. Commissions weren’t cheap.  That system of access was vastly improved by discount brokers and mutual funds, which I’ll call IM 2.0.  This gave smaller investors much cheaper access to the market, but also provided access to professional management and diversified portfolios.  The next major improvement, IM 3.0, came with index funds and ETFs.  These vehicles gave investors very cheap access to a wide variety of market exposures.

A key element of each phase was that technological and organizational development combined to facilitate better and cheaper access to investment products.  This benefit arose in large part because technology created efficiencies which reduced waste. In doing so, investing became much more democratized by making benefits that had only been available to the relatively select few available to a much broader array of people.

Another key element of each phase was that none of the transitions were fast or comprehensive.  Partly it just took time for the value of each new version to bear out.  Partly though, individuals and companies whose business models were being disrupted resisted the change.  They each had a vested interest in maintaining the old ways because their existence depended on it.  Unfortunately, this resistance served both to perpetuate inefficiency and to milk excess fees from naive or passive clients.

Of course different technologies have different effects on business and society and the giant technology of our era is the internet.  The broader implications of the internet were captured brilliantly in a recent book, Race Against the Machine, by Erik Brynjolfsson and Andrew McAfee. 

The authors describe, “The economics of digital information, in short, are the economics not of scarcity but of abundance.  This is a fundamental shift, and a fundamentally beneficial one.  To take just one example, the internet is now the largest repository of information that has ever existed in the history of humankind.  It is also a fast, efficient, and cheap worldwide distribution network for all this information.  Finally, it is open and accessible so that more and more people can join it, access all of its ideas, and contribute their own.”

The "economics of abundance" suggests an entirely new source of value creation.  Since information and market access are so readily available, these factors no longer provide incremental value to investors. Rather, what investors need is a resource that can leverage technology to effectively filter through vast amounts of information, manufacture that information into knowledge, and then convey that knowledge in a way that makes them noticeably better off. Essentially the question becomes not how do we race against the machine, but who can run with the machine? In other words, who is developing IM 4.0?” 

Other than Arete, I really don't know.  I don't know of anyone who has leveraged technology so comprehensively in order to confer benefits to investors.  Arete’s clients get intensive stock selection in the dynamic mid cap universe in separate accounts for a lower fee than most mutual funds. They benefit from transparency in costs, holdings, and research.  This combination of benefits used to only be available to investors with tens of millions of dollars. 

If and when you want to test out the new version of IM, I suspect you're going to be amazed at how much better it is.

Best regards,

David Robertson, CFA
CEO, Portfolio Manager

Insights 

Seventy is the new fifty and beta is the new alpha.  In the parlance of investing, beta is the measure of market exposure and alpha is the measure of active management, often security selection.  In normal times, market forces function well enough such that the primary opportunities to outperform the market are confined to a relatively small number of instances of inefficiently priced securities.  In other words, through alpha.  The Fed’s determined policy of loose money supply has turned market logic upside down, however, rewarding (at least short-term) aggressive exposure to the market as a whole instead of through studied security selection.

One clear result of Fed policy is that the excess liquidity is flowing into nearly all asset markets and is certainly boosting stock prices.  With many participants worried more about losing their investment job or missing the market than analyzing risk or exercising investment discipline, the valuation of the market has become significantly detached from underlying fundamental reality.  John Hussman reported the consequences in his recent weekly letter in a directly practicable way: “As for valuations, our present estimates indicate the likelihood of sub-4% 10-year total returns (nominal) for the S&P 500 . . . and negative total returns over horizons of 5-years and shorter.” 

This comment corroborates and complements our own valuation work.  We see precious few companies which look cheap and several that look downright dangerous.  The key point for investors is to exercise significant caution regarding exposure to risk assets right now.  If your horizon is less than five years, be prepared, financially and psychologically, to end up with less than you started with.  That is the risk.  If your horizon is longer, consider the option value of waiting for cheaper prices that may emerge between now and then.

The low rates engineered by the Fed (and other central banks) end up doing more than just compelling people to buy risk assets in the short-term, however, it affects how they opt for exposure.  On one hand, persistently easy monetary policy has artificially subdued risk perception for the market as a whole.  On the other, monetary policy itself does nothing to solve structural labor problems or deficient demand.  As such, the nasty realities of business often still have unnerving consequences for individual stocks. 

As a result, traders have had an unusual opportunity to benefit from Fed policy by taking on exposure to the market as a whole through index funds and ETFs while eschewing individual stocks.  For the last few years anyway, beta has been the new alpha.

Not surprisingly, the herding of lots of people into similar buckets of market exposure has consequences.  These were addressed in a paper entitled, “How index trading increases market vulnerability” by Rodney N. Sullivan, CFA, and James X. Xiong, CFA in the Financial Analysts Journal. 

Sullivan and Xiong found that with the proliferation of index trading, "the average beta for all equity segments over 1997–2010 shifted meaningfully higher."  They determined: "In short, the growth in trading of passively managed equity indices corresponds to a rise in systematic market risk. From this finding, we can infer that the ability of investors to diversify risk by holding an otherwise well-diversified U.S. equity portfolio has markedly decreased in recent decades...All equity investing, indexed or otherwise, is thus plainly a more risky prospect for investors."

Thus, another key point is to be aware of the increasing risk associated with the market as a whole.  For one, this means that a fixed amount of market exposure today is far riskier than it was 15 years ago.  Your portfolio may not have changed much in terms of holdings, but it may very well be much more volatile.  In addition, just as we saw in 2008, when things change, they can change too fast for most investors to react to.  You need to be positioned ahead of time. 

Finally, Bridgewater Associates has done some nice thinking about managing through all types of market environments with their “All Weather” fund.  They start with a very simple exercise of deconstructing returns by recognizing that: Return = Cash + Beta + Alpha.

This is also an especially useful exercise for investors today.  With returns on cash essentially at zero, one can’t count on that for long-term returns.  With valuations and correlations at historical highs, raw exposure to markets through beta also looks like a very risky endeavor, at least over the next few years.  This really just leaves active management (alpha) as a reasonable source of future returns.

The Financial Times recently also reported on opportunities for active management: “A ‘risk-on, risk-off’ herd mentality could create opportunities for active investors who take time to scrutinize fundamental factors that should determine bond or share prices over the long-term.  Paul Woolley, from the London School of Economics, elaborates, “It suggests things are being mispriced.  If your valuation model is good and seriously applied, then rising correlations are a wonderful opportunity,” says Paul Woolley.

A final key point, then, is that returns of the past three years or so have largely been driven by simple exposure to the market, which is becoming ever-riskier.  The best opportunities to realize future returns will come from alpha -– from finding undervalued stocks and by being selective in only allocating capital to projects likely to produce attractive returns.

Lessons from the Trenches

One of our goals with the Arete Insights newsletter is to share our insights into how the investment management business really works.  “Lessons from the Trenches” highlights our approach to stock research.  Our intent is to share with you some of the tips, tricks, and other tools we have incorporated into our work that may provide you some insights into how we engage in our craft.

As we have mentioned repeatedly, we believe one of the best ways to produce superior performance over time is by buying cheap stocks.  We apply a variety of means to establish “cheapness” and it makes sense to better understand some of these methods and why they tend to be more effective than others.

First, it’s important to appreciate that stocks are long-term assets.  Corporations have no pre-set expiry and technically can last forever.  Therefore, any valuation process ought to represent a long period of time and incorporate the vicissitudes of business cycles, competitive markets, and changes in the cost of capital.

Second, it helps to understand the nature of the task at hand.  Investing is fundamentally a process of deferred gratification.  The concept is that a small sacrifice today will provide something enough bigger and better tomorrow to be worth waiting for.  Since short-term swings in prices contain a great deal of noise, investing is best-suited to those with long time horizons.

The best model we have found that incorporates these tenets is one we license from the Applied Finance Group (AFG).  While it involves significantly more work than glancing at a P/E ratio,  it allows us to do things most models and metrics cannot.  First, since it specifically integrates pro-forma income statements, cash flows and balance sheets, it directly ties forecasts to returns on capital.  Those returns are then decayed in a way that fairly accurately represents the real world of business competition.  Second, the AFG model allows us to adjust any of the key valuation drivers in order to conduct “what if” scenarios.  This allows us to identify specific risks and opportunities for future stock performance. 

A big part of why the model works so well is because it provides such a nice complement to some human weaknesses.  People tend to be pretty good at spotting big contrasts -– like stock prices jumping up or down.  We aren’t as good at keeping track of changes that occur only very slowly over longer periods of time.  In this sense, the AFG model provides a terrific “corrective lens” through which to better see stock valuations.  Because we can see with greater clarity, we can have greater conviction in our ideas.

The strengths of the AFG model and how we use it also helps highlight many of the mistakes made by other market participants.  One common mistake is to rely heavily on a P/E ratio.  Many do this because it is quick and easy -– and it is.  Unfortunately it can also be worse than inaccurate; it can be downright misrepresentative.  Businesses with any variability in profitability, any cyclicality, or any variance in capital spending can be significantly misrepresented by a single year’s P/E ratio. 

Another common mistake which we increasingly see is that of applying today’s artificially low discount rate to the entire long-term stream of cash flows.  The argument goes something like, “When rates are this low, P/E ratios deserve to be higher.”  This flawed logic masks over a huge risk: We don’t know when rates will change or by how much.  Since these rates are used to discount cash flows over a very long period of time, the overall valuation is very sensitive to this variable.  If rates go up a lot, and in just a few years, the discounted value of cash flows will be very substantially lower.  Applying a very short-term perspective to a very long-term proposition can result in painful disparities when things change and these misperceptions are preventable.

The AFG model is very sophisticated and we continually update and refine our work with it.  This effort gives Arete an enormous advantage in calibrating what to pay for various stocks.  Nonetheless, the basic lessons of our valuation work are very accessible: Beware of undue emphasis on short-term metrics that do not reflect the patterns and volatility that can be expected over the life of the asset. 

While there are many investment management shops with different strengths, it really is amazing how superficial most valuation work is.  Most people care a lot about not spending too much on things.  They should make sure their investment managers are just as frugal in buying stocks for them.

Welcome 


One of the great things about living in the times we do is that it is so cheap and easy to get information.  For an admitted “lover of wisdom” and data geek like me, these conditions could hardly be more favorable; it’s like a playground.  For more “normal” people, however, the flurry of information can seem like a blizzard that often obscures important issues.

Realizing this, I have begun testing a new tool to help people navigate a clearer path through the investment landscape.  I mentioned this in the last Arete Quarterly when I mentioned “a knowledge database constructed out of the pieces of information I gather on a regular basis.”  I am happy to report that I am making significant progress on this initiative and look forward to getting comments and feedback to make it as useful as possible for investors.  If all goes well, I will plan on offering it as a subscription service.

The database takes the form of a wiki and is designed to be an amalgamation of information, insights, and knowledge.  It is also designed to help investors gain perspective and to better address a wide variety of common investment issues.  It is easiest to think of it as a digital extension of the files and information I already manage on a regular basis.

The wiki project originated out of a desire to be able to serve investors who are facing a number of challenges but have limited resources with which to meet them.  Since so many investment services are “sold”, investors often only hear one side of a story, and generally a very biased one at that.  This situation further exacerbates the challenges wrought by a difficult investment environment that demands more attention.  A common theme I hear is that people would like to be better able to get their arms around things so they can get more confident in their investing.

This project is also an attempt to address what I perceive are some important bottlenecks in the investment services industry.  Given the vast number of financial services employees and offerings there is a lot of noise and it can be hard to tell the bad stuff from the good.  Even among the higher quality organizations and advisors, investors are often disappointed with how little of the expertise trickles down to them in the form of material benefit. 

In other words, there seems to be a problem with either the delivery of investment expertise, or with the conversion of expertise into realized benefits.  For a number of reasons, I sense there is an opportunity to more effectively provide useful and objective insights and I hope the AreteResearch wiki can address some of the challenges investors face.

There is no doubt that I have fun doing investment research and that I truly enjoy sharing insights, both of which make a project like this easier.  If you have an interest in taking a look, please let me know; I’d love to hear your feedback.  If there are simple things I can do to make it more useful, it will help everybody.  Hopefully, together, we can keep making this challenge called investing better!

Best regards,

David Robertson, CFA
CEO, Portfolio Manager

Insights 

Turn on the TV and you’re likely to hear “Stocks are cheap!” mainly from equity managers and “Beware deflation!” mainly from bond managers.  How can you tell who’s telling the truth?  Importantly, what does it suggest as to what you should do?

Our qualified assessment is that stocks are decent long-term investments, but a great deal of selectivity should be exercised.  This assessment belies a great deal of nuance which can provide useful context for investors, however.

One part of the analysis is clear: At current yields, bonds are terrible long-term investments.  Jim Grant, the thoughtful and widely respected editor of Grant’s Interest Rate Observer dubbed Treasurys as “return free risk.”  While there may be some opportunities outside of the US, by and large, we do believe that stocks are far more attractive than bonds.

That makes stocks relatively attractive, but it does not necessarily make them attractive on an absolute basis.  This is an important distinction too often glossed over in television soundbites.  More specifically, just because stocks are better long-term investment propositions than bonds right now doesn’t mean one should back up the truck either.   

The real question, and the crux of fiduciary duty, is to determine which assets have favorable risk/return tradeoffs and therefore make attractive investments.  The unfortunate truth, which we have mentioned several times over the past couple of years, is that there are significant risks to owning stocks and some of these risks are rising.  These risks serve to mitigate the attractiveness of stocks on an absolute basis. 

One risk is that a set of long-term valuation measures that have proven very effective in the past point to stocks being very expensive right now.  While many pundits and practitioners bandy about metrics that corroborate their views, far too often these metrics fail to withstand the test of efficacy (i.e. they don’t work; they are not useful in framing future performance). 

Another risk is that corporate profitability is exceptionally high now which flatters already expensive valuations.  Since a stock is a long lived asset, an appropriate valuation should normalize profitability over the life of the asset.  The current market, to the contrary, appears to be discounting the indefinite continuation of record profitability.  Receding profitability levels and valuations are both likely to likely to impede future stock performance. 

Finally, one of the most important lessons to emerge from the financial crisis of 2008-09 is that credit affects valuation.  The more money that is available to buy assets, the higher prices go.  Between 1964 and 2007, total credit in the US expanded at a rate of 9.5% per year, far greater than nominal economic growth of 7.35%.  The excess went to inflating assets like stocks in 2000 and house prices in the mid 2000s.  Now that deleveraging is underway, the process will reverse and less credit will put downward pressure on asset prices.

There are a couple of key lessons from this analysis.  One is that favoring stocks over bonds may lead to a better investment, but not necessarily to a good investment.  This doesn’t mean things are hopeless, only that one needs to be patient until better opportunities arise.  Second, the major stock indexes are not cheap which means there is a high probability that future returns will fail to compensate adequately for bearing the risk.  Finally, despite these caveats, there are interesting stock ideas out there.  The opportunities to generate distinctive performance through opportunistic stock selection are becoming quite significant.

Lessons from the Trenches

One of our goals with the Arete Insights newsletter is to share our insights into how the investment management business really works.  “Lessons from the Trenches” highlights our approach to stock research.  Our intent is to share with you some of the tips, tricks, and other tools we have incorporated into our work that may provide you some insights into how we engage in our craft.

In the last edition of Arete Insights, we discussed the usefulness of having valuation landmarks in order to navigate a landscape of uncertainty successfully.  Another useful skill set for navigating an uncertain environment is a better understanding of oneself.  Behavioral economics has gone a long way in explaining why we do a lot of the (sometimes unhelpful) things we do.  More recently, research in neuroscience reveals how our physiological reactions to the environment affect both our perception and interpretation of information around us. 

The recent book, The Hour Between Dog and Wolf: Risk Taking, Gut Feelings, and the Biology of Boom and Bust, by John Coates, provides wonderful insights from neuroscience and Wall Street trading to show how our bodily responses to stress (and success) affect both what we see and how we think.  

Coates describes, “As cortisol levels rise, and our exposure to the hormone becomes chronic, we increasingly recall the events that were stored under its influence. Scott [fictional trader] now finds he recollects mostly disturbing memories. He tends to dwell on nasty events— failing high-school calculus, a locker-room fight, losses during the dot-com crash— rather than pleasant ones, like meeting his girlfriend, vacations in Verbier or trades he got right. Importantly, when assessing a trade, Scott now increasingly draws on negative precedents in determining the risks, and such a selective recall of things going wrong may promote an irrational risk aversion.”

Unfortunately this largely automatic response leaves us ill-equipped to deal with the stress of uncertainty.  Coates continues, “Scott needs to think clearly about his position and the market, but oddly, inappropriately, his body has atavistically prepared him to fight with or run away from a bear. The stress response is prehistorically hamfisted in this regard. It does not distinguish very clearly between physical, psychological and social threats, and it triggers much the same bodily response to each one. In this way the stress response, so valuable in the woods, can prove archaic and dysfunctional when displaced onto the trading floor, or for that matter any workplace. We need to think, not run.”

As the body’s stress response inhibits our cognitive activity, the thinking we can conjure is often misdirected.  “One of the main jobs of consciousness is to keep our life tied together into a coherent story, a self-concept. In other words, we make things up.”  As a result, when we are pressed and scrambling to make sense of things, we tend to focus more on contriving a positive spin on the situation rather than resolving a challenge.   

If these challenges are not enough, we also seem virtually incapable of even knowing whether we are in a state of stress or not.  “What I [Coates] found was that their [traders’] opinions on how stressed they were had little if anything to do with reality, nothing to do with the fact that they might be losing money, or that their trading results seemed more than usually uncontrollable, or with market uncertainty as measured by its volatility. In fact, their opinions had little to do with anything I could discern.”

While the insights from Coates’ work may seem daunting, they provide a very useful lesson to investors.  Namely, when people think of factors that generate lasting benefits to investment performance, they often think of things like access to information and analytical skills.  Coates’ work suggests that we also need to add our physiological responses to the top of the list of factors that can affect investment performance. 

It is normal for any of us to experience some degree of stress when confronted with novelty and uncertainty.  This isn’t necessarily bad when the level of stress is manageable.  However, when the risks rise and more is at stake (like our ability to retire or to maintain a standard of living, for example), stress can rise to unhealthy levels.  When it does, our physiological responses cloud our vision of any landmarks we may have established.

As can be imagined from the discussion, there are no easy answers.  It is possible, however, to increase one’s resilience to challenges through training, and this should be considered by anyone who is regularly tasked with making important decisions.  That said, it is also important to be aware that extended exposure to stress (or success) can affect our perception of things.  This should be considered a risk and a limit to what we can “know”.  

Welcome 


The money management industry is undergoing what may be its most fundamental change since I’ve been in the business.  Nowhere is this more apparent than with the enormous outflows from actively managed mutual funds.  

While there are surely several reasons for this mass migration, there is no doubt that one big impetus is dissatisfaction with the poor value proposition that many mutual funds offer.  Costs to manage funds have come down substantially, but management fees have remained stubbornly high.  And this doesn’t even begin to address performance and service issues.

A good deal of money is flowing into passive equity funds because they are cheaper.  Money is also flowing into bond funds because they are perceived to be safer.  These are certainly reasonable responses, but I also strongly suspect that these actions more accurately represent the beginning of a fruitful journey rather than a destination.

The recent activity especially highlights the debate between active and passive management.  While I very much believe in the value of passive investing in providing cheap and easy access to market exposures, index funds and ETFs are not perfect and will not solve all investment challenges.  Further, as an ever-higher proportion of equities are held by passive funds, the tradeoffs between active and passive management will become increasingly important.

One of the most intuitive and effective ways to appreciate the value of active management is simply by observing the universe of 1500 mid cap stocks.  These stocks vary in market cap from $1 billion to $20 billion, span all economic sectors, range from young companies to those over a hundred years old, and have growth rates and returns on capital that span the spectrum.  It defies all reason and experience to expect all of these extremely diverse stocks would be anything but substantially differentiated in attractiveness as investments. 

Given the countless ways in which differentiated performance permeates our lives (the Olympics is a great example!), it never ceases to amaze me how strongly some people feel that it can’t happen with investing.  I founded Arete partly because I believe it makes sense to profit from these disparities and partly because I see active management as one of the best ways to invest my own money.

In contrasting active and passive management, it is also useful to look closely at the way index funds work.  An important and often overlooked aspect of most indexes is that they are weighted by market caps.  This has the deleterious effect of overweighting overvalued stocks on one hand and underweighting undervalued stocks on the other.  As such, most market indexes represent a systematic implementation of valuation errors.  When market participants buy certain stocks simply because they are going up (momentum investing), it compounds the valuation errors inherent to market cap weighted indexes.  This is an important risk with index funds.

Another important difference between active and passive investing regards corporate governance.  Some activist investors use the combined levers of stock ownership (or sales of stock) and corporate governance to agitate for change at poorly performing companies.  While passive fund managers can send a message to management teams through the proxy process, they are completely powerless to reinforce the message with action.  I am quite sure that corporate boards and managers are well aware of how much pushback they may or may not get from investors when formulating executive compensation and other policies.  Active investing is necessary to hold managers to task for upholding their responsibilities to shareholders.

Finally, for the sake of argument, let’s imagine a world in which everyone owns index funds.  No-one owns stocks directly or through active funds.  When a company launches a new product, or makes an important discovery, or adds a huge new client, who would be there to adjust the price to reflect the change in underlying value?  If all investors were passive index investors, these fundamental changes would never get reflected in the stock price. 

Now let’s assume a less extreme situation.  Let’s assume there are just a handful of active investors and everyone else is passive.  This would produce enormous profit opportunities for a small number of investors at the expense of everyone else.  The lesson is that active investors are essential to doing the bidding in order to keep markets reasonably efficient.  Too many of them and there will be too few opportunities to support them.  Too few, and prices will become wildly inefficient. At the end of the day, just like in any other system, there needs to be a balance. 

Philosophically, I see important benefits to both active and passive methods.  I don’t at all dispute that many active funds provide poor value and that many index funds provide useful and cheap access to market exposures.  I think it is extremely important though, for investors to be aware that there are tradeoffs and therefore no easy rules-of-thumb. 

It will be important for investors to appreciate that simply having exposure to markets may not provide enough return for them to meet their financial goals.  It is also important to understand that in an environment of low expected returns and significant risks, it will be ever-more important to seek out the opportunities that do emerge.  If you or someone you know is interested in learning more about the opportunities for active management, I’d be happy to discuss how Arete might be able to help out.

Best regards,

David Robertson, CFA
CEO, Portfolio Manager

Insights 

The value investment philosophy has proven to be extremely successful over long periods of time and across many different markets.  While there are many strategies that can work at various times, valuation has proven to be an extremely robust way of making money.

As happens periodically, however, the excellent historic record of valuation-based strategies has been noticeably challenged recently.  For the two years since July 2010, the Russell Midcap Growth index has outperformed its value counterpart by over 2% per year.  While such periods of performance differentials are not uncommon, this particular one foots suspiciously well to the initiation of quantitative easing by the Federal Reserve beginning in the latter half of 2010.

It is clear that the Fed has engaged in such actions with the intent of keeping the economy humming along by staving off deflationary forces.  Despite these extraordinary efforts, however, the US has experienced one of the weakest economic recoveries in its history, unemployment remains extremely high, and recent data points to further slowing from already anemic levels. 

We believe the continued economic limbo, and underperformance of valuation strategies, can be at least partly explained by a behavioral response to changes in the business landscape.  Specifically, Gillian Tett discussed the role of investors’ assumptions about risk in a recent Financial Times article. 

Citing the research of anthropologist Michael Thompson, Tett describes two important dimensions of assumptions about risk.  For one, power can be concentrated vertically in an organization or government at one extreme, or broadly distributed across a crowd horizontally at the other extreme.  High levels of government intervention in the market since 2007 have “trumped the power of the crowd in ways that feel alien to investors.”

A second important assumption about risk regards the way in which power is exercised.  Societies can operate anywhere on a spectrum between a benign, accountable manner and a capricious and harmful one.  As power gets exercised in more capricious ways, people become more fatalistic, and adapt their risk management strategies accordingly. The two assumptions are captured by the questions, “Do we assume anybody is in charge, and is the power structure benign?”

We believe an unintended consequence of “extraordinary” action (as relates to the Fed and other government policies) is the perception of ever-greater capriciousness.  This is particularly harmful to the economy and markets in a couple of ways.  First, an important part of the valuation-based investor’s credo is to include a margin of safety in one’s assessment of value.  In a world of capriciousness and whimsy, this is excessively difficult to do.  The downside is almost always in the ballpark of zero if you just don’t know what law might be created to render your business uneconomic or which policy might unfairly advantage your fiercest competitor.  Investors and entrepreneurs don’t avoid risk, they avoid bad risks.

Second, value investors are the “sheriffs” of the market in an important sense.  In a chaotic and desolate landscape (picture the Wild West, for example), there is virtually no limit to human behavior.  In the market, the floor to valuations is normally provided by value investors who, in their own self-interest, see significant opportunities for profit.  In doing so, they act out of principle rather than following the herd and these actions establish downside limits to valuation.  In the absence of such investors, however, there are virtually no downside limits.

This is often intuitive for entrepreneurs, business managers, and anyone tasked with allocating scarce resources to risky projects.  When the rules are clear, the referees are fair, and the goalposts can’t be moved, the game is known and dynamic competition can ensue.  When these conditions do not apply, however, it makes little sense to accept unknown risk for unknown reward.  The consequence is that many participants withdraw.

This behavioral dynamic is useful in more than just explaining our economic limbo.  This understanding also informs us as to how the situation can improve.  In the context of too much debt and weak economic growth, and assumptions of increased capriciousness in policy-making, it will be incredibly beneficial to have a clear and credible roadmap for reducing the debt and deficit.  An environment of more benign and accountable exercise of power would facilitate much more normal levels of business activity and investment.

Further, despite rich valuations for the market as a whole, there are several cheap stocks and many of the fundamental strengths of the US economy remain in place.  Once the reins of capriciousness are released, we expect the drivers of healthy economic growth to return.  When that happens, a much more fertile landscape will also be available to valuation-based investment strategies. 

Lessons from the Trenches

One of our goals with the Arete Insights newsletter is to share our insights into how the investment management business really works.  “Lessons from the Trenches” highlights our approach to stock research.  Our intent is to share with you some of the tips, tricks, and other tools we have incorporated into our work that may provide you some insights into how we engage in our craft.

In a landscape of uncertainty, it helps to have as many landmarks and signposts as possible in order to navigate successfully.  In efficient markets, prices generally serve as good landmarks because they generally represent underlying value fairly accurately.  When prices do not serve as very good landmarks for value, however, it is easy to get lost or to head in the wrong direction.  As a result, it is extremely useful to be able to judge the quality of available landmarks. 

Most of the time, most prices in US markets fairly accurately represent underlying values.  This happens because there is a large and diverse group of active participants, each with the intent of making money.  The lively interaction that ensues among participants ensures that information gets discounted in market prices very quickly and efficiently. 

Under these conditions, prices can deviate from fair value, but tend to do so only sporadically, over relatively short periods of time and on an idiosyncratic basis.  In other words, most landmarks are useful most of the time. As long as you can take an occasional false signal in stride, you should be able to find your way fairly comfortably.

There are times, however, when the market does a poor job of establishing useful landmarks in the form of accurate prices.    It is extremely important for investors to recognize when this happens so they can switch to other navigational methods and stay on track.

The conditions which reduce the quality of landmarks are exactly the opposite of those that provide for accurate prices.  For example, when money flows out of a market, it tends to reduce activity (lower volume).  Also, when certain types of investors opt out of market activity, the market becomes more homogeneous. 

The situation that arises out of these conditions is like a boat full of people.  A market with a lot of volume is more stable, like a large boat.  A market with a broad mix of people is also more stable, like a boat with people distributed fairly evenly across it.  When people on a small boat all tend to rush to one side at the same time, however, it creates a dangerous imbalance that can cause the boat to tip over. 

It’s important to beware that when a small boat like a canoe tips over, it often says more about the clumsiness of the paddler than it does about the turbulence of the water. In the context of the market, this means that under certain conditions, prices and price moves often say more about the market and its participants than it does about underlying value.

This provides a useful background for better understanding some recent market activity.  Market volumes have been coming down for some time and are even lower now amid the late summer slowdown (picture the small, unstable canoe). 

We also know there are market participants that can act in a uniform fashion.  One example of potential homogeneity is algorithmic trading.  These are software programs designed to implement trades. Index funds, for example, use algorithms to manage positions when investors buy or sell shares.

At the end of July, Knight Capital Group (a market maker comprising about 10% of market volume) implemented new software.  When it did, the program automatically, and inadvertently, started transacting swaths of stocks that were much larger than intended (picture a paddler shifting all of his weight to one side of the canoe).  The result was a big imbalance that caused a “splash” in the form of several stock prices being significantly affected.  Notably, the mechanisms involved were similar to those in the “flash” crash of May 2010.

When situations like this occur, it is easy to see how prices can be significantly affected by factors wholly unrelated to underlying value.  As such, they can produce periods of wild and seemingly capricious stock moves that can be confusing and disheartening for many investors. 

Fortunately, one need not wander aimlessly when markets prices do not provide useful landmarks.  If you know a market has low volume and is vulnerable to herding, the first order of business is to be extremely skeptical of prices as accurate landmarks. 

The next order of business is to find a way to validate existing signals and/or find a better set of landmarks.  This is exactly what makes a valuation-based investment strategy so useful.  Valuation provides an analytical basis for determining what things are worth.  As such, it is insulated from the market conditions that can periodically distort price signals.    

Since most of us have not arrived at our retirement destination, we will be continuing a journey to reach our investment goals.  When it’s hard to navigate by traditional landmarks, inaction is not a useful option; it will only guarantee you won’t reach your destination.  Arete’s valuation process can help show the way.

Welcome 


People can do a lot of funny things and perhaps nowhere is this more evident than in the realm of investing.  Oftentimes these funny things are simply a function of not having much background knowledge.  Just like I benefit from the expertise of professionals in other fields to help me out at home and work, I believe many investors can benefit from the investment expertise Arete provides.

A great example of what can happen when people contend with challenges outside their realm of expertise appeared in the Financial Times a few weeks ago.  The article featured Yale professor, Robert Shiller, who discussed the housing crisis.  He noted:   

“In a survey of home-buyers in four U.S. cities that Karl Case and I carried out in 2004, at the peak of the housing expectations, we found that the (trimmed) mean home price increase expected for the succeeding 10 years was 12.6 per cent a year.  Maybe our respondents didn’t quite understand what they were implying: that would mean more than a tripling of home prices in the succeeding 10 years from an already high level.”

This is interesting for several reasons.  For one, the expectations defied all historical experience.  Historically, home prices have risen in the low single digits.  The 12.6 per cent was hugely anomalous to anyone with even passing familiarity of the historical experience.  In addition, the implication of a tripling in prices should have provided a useful reality check.  While the math is not something most people can do in their heads, it only takes a few seconds on a calculator.  It seems like a fairly small effort to protect what comprises the largest investment for most people.

Finally, despite having incredibly high estimates of home price appreciation in 2004, home buyers’ adjusted their expectations only very slowly and gradually.  Shiller continues, “Already eight of those 10 years have passed, and the actual rate of increase in U.S. home prices on average for the eight years was minus 3.6 per cent a year.”  Despite this realized experience, expectations for annualized 10-year price increases over the same period dropped only to 5.6 per cent a year.  This estimate still implies a doubling of home prices in about a dozen years!

I don’t consider such misplaced expectations, by themselves, to be anything especially bad, let alone unforgiveable.  We can’t know everything and we’re going to make mistakes.  What we can control, however, is how we manage expectations, especially regarding matters that are outside our realms of expertise. 

In fact, this is exactly why expertise is valuable — because it helps us establish more reasonable expectations — which provides for better decisions and fewer costly problems.  I don’t think I am different from most people when I take my car in to a mechanic to have it checked out if it is making a funny noise.  The problem is that I just don’t know if the sound represents a serious problem or not.  I don’t have the knowledge from which to base reasonable expectations of the seriousness of the problem.  This modest effort in advance may very well save a breakdown on the highway later.

People seem to be able to go through this basic exercise with some things, but then have trouble with others.  Unfortunately, as evidenced by Shiller’s study, many people in the mid 2000s appeared to have some fairly unrealistic expectations for house prices.  Stock prices are another area where people seem vulnerable to engendering unrealistic expectations.

Fortunately, Arete is very well positioned to help investors manage expectations in the realm of equity investing.  The most important way is through a sophisticated valuation process that allows us to measure the expectations for individual stocks that are implied by current market prices.  Once expectations are parsed out, we can direct our research to determine how reasonable the expectations are.  This allows us to avoid stocks that are priced with overly optimistic expectations and also to target stocks that discount overly pessimistic expectations.

When it comes to expectations about stocks, Arete provides two advantages that are extremely rare in combination.  One is a very sophisticated valuation model that helps us translate market prices into specific expectations for fundamental performance.  These expectations can then be confirmed or disconfirmed by research. 

The other advantage is the firm’s independence.  What this means is that I have the freedom to focus only on what I believe to be in the best interest of Arete’s clients.  If market expectations seem overly optimistic, I get to say so.  Ultimately, this means the quality of Arete’s work is unencumbered and undiluted by considerations that are not related to investment merit.  

In conclusion, in the absence of good data, any of us can make mistakes as to what can be considered a reasonable expectation.  What is clear is that these mistakes can be extremely costly and are often absolutely avoidable.  By applying our investment expertise and extensive knowledge of mid cap companies, we substantially reduce the chances of falling prey to many of the subjective forces that can lead to unrealistic expectations.

Best regards,

David Robertson, CFA
CEO, Portfolio Manager

Insights 

Last quarter we talked about some of the “nonsense” in modern investment practice and how many behaviors and incentives have evolved which can subvert the goal of serving the best interest of investors.  One of the most important but least appreciated forms of nonsense is career risk. 

Jeremy Grantham, one of the smartest and most brutally honest active investors, recently addressed this subject in his quarterly letter:

“The central truth of the investment business is that investment behavior is driven by career risk.  In the professional investment business we are all agents, managing other peoples’ money.  The prime directive, as Keynes knew so well, is first and last to keep your job.  To do this, he explained that you must never, ever be wrong on your own.  To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing.  The great majority ‘go with the flow,’ either completely or partially.  This creates herding, or momentum, which drives prices far above or far below fair price.  There are many other inefficiencies in market pricing, but this is by far the largest.”

The implications of career risk in the investment industry are extremely important for investors.  For one, it by no means suggests that professional investors are a homogenous group of bad people that are only looking out for themselves.  Many, arguably most, care a great deal about their clients. 

It does suggest, however, that career risk can color a professional’s views and affect his or her investment behavior.  As a result, it can be extremely difficult for investors to get completely unbiased assessments of return and risk tradeoffs.  This is extremely unfortunate because it raises yet another hurdle for people trying to be smart about investing.  Not only do they need to identify the limits of their own ability to establish appropriate expectations for investments (see “Welcome”).  They also need to find a source of investment expertise, and find a source that can be completely objective.

The implications of career risk are further articulated by Grantham: “Picking cash or ‘conservatism’ against a roaring bull market probably lies beyond the pain threshold of any publicly traded enterprise.  It simply cannot take the risk of being seen to be ‘wrong’ about the big picture for 2 or 3 years, along with the associated loss of business.”

Another well-respected writer and analyst, John Mauldin, put it a slightly different way in his recent newsletter, “Wall Street is like the carpenter who only has a hammer: everything looks like a nail.”  In other words, investors just need to buy more investments — at least as seen through the eyes of most investment people.  “The problem with Wall Street,” according to Mauldin, “is that most of what it sells does poorly in secular bear markets, so most traditional portfolios have suffered since 2000.”

These insights really highlight the natural tension that resides between any agent’s fiduciary duty to his or her client and the agent’s own self-interest.  How this tension gets resolved speaks volumes about the degree to which the agent really serves his or her client.  In the case of the law profession in the U.S., for example, such conflicts of interest are considered to be such an important threat to the profession’s integrity that non-lawyers are prohibited from becoming shareholders in law firms. 

We also take the issue of conflicts of interest very seriously at Arete and seek to avoid them to every extent possible.  As an independent money manager, Arete is completely free from interests other than those of serving our clients.  In addition, we try to go even further in serving our clients and other investors as well.  For example, the primary purpose of this newsletter is to share some of our knowledge of the industry in order to help all investors navigate the difficult, and crowded, landscape.

The market for investment services is a large one and a lot of different offerings with different tradeoffs can be appealing to different types of investors.  For those who are looking for objective and accessible expertise, Arete represents a unique choice in a very crowded field of investment firms.  In fact, two of the words we most often hear from people who are new to Arete are “refreshing” and “different.”  We find this very encouraging feedback because we are working hard to give investors a better choice.  We invite you, or anyone you know who may be interested, to check us out.

Lessons from the Trenches

One of our goals with the Arete Insights newsletter is to share our insights into how the investment management business really works.  “Lessons from the Trenches” highlights our approach to stock research.  Our intent is to share with you some of the tips, tricks, and other tools we have incorporated into our work that may provide you some insights into how we engage in our craft.

One of the most visible parts of the investment process is the purchase of new securities.  This is partly due to the fact that most managers trade their portfolios much more actively than Arete does and as a result always have a lot of new things to discuss.  In addition, the novelty appeal of new stocks tends to garner interest which also increases visibility.

It is a shame that new ideas so often steal the spotlight because there are many other factors that can have an equally great impact on portfolio performance.  One of the most important and under-appreciated drivers of performance is the set of stocks that are researched, but not purchased.  Sometimes these are great investments that just don’t make it into the portfolio for whatever reason.  Sometimes these are ideas that are initially compelling but upon further investigation, fail to satisfy rigorous criteria for purchase.

As part of our ongoing effort to evaluate new companies, we recently took a look at Tempur Pedic (TPX).  We have been keeping an eye on the company for over a year marveling at its incredibly high economic returns on capital and impressive growth rates.  The company sells unique mattresses and pillows and has been growing many times faster than the industry as a whole.  Fundamentally, the stock looked interesting. 

When we first ran TPX through the valuation model in February, we ran a scenario assuming that it could grow as fast as its internally generated cash flow would allow.  This resulted in growth rising from mid teens to 26% over the next five years and produced a price target of $100.  Relative to the price of $71 at the time, there appeared to be significant upside.

While this upside was certainly significant enough to get our attention, there were reasons to investigate further.  For one, it was a troubling that the model implied that 83% of the valuation was attributed to the value of future investments.  It isn’t rocket science to figure out that cash flows to be produced from investments that haven’t even been made yet are a whole lot riskier than cash flows from existing assets.  This suggested the $100 target was more of a “suggestion” than a concrete measurement of value.

One of the great things about companies with high economic returns on capital is that much of their destiny is under their own control.  Most importantly, they can fund very high growth on their own; they don’t need to rely on banks or the capital markets for financing.  This makes very high rates of growth possible.

The greater and more important analytical challenge, however, is determining what range of growth rates is reasonable.  The challenge is exacerbated in companies like TPX because the combination of high returns and high growth is essentially multiplicative to the firm’s valuation.  In other words, the valuation is extremely sensitive to the expected growth rate and therefore it is important to focus on establishing reasonable bounds for growth. 

As a result, we went back to the valuation model and challenged our original assumption of growth ramping up to 26%.  Industry growth rates are only low single digits.  How long can TPX outperform the industry by that much?  Further, since growth is comprised of both volume and pricing, such high revenue growth implies that not only must unit growth continue, but the company’s premium pricing must be maintained as well.  We ran another, more modest, scenario which started with similar mid teens growth rates the next two years, but which scaled back growth rates to 8% in the out years of the five year forecast horizon. 

With these changes, the target price for TPX dropped from $100 to $45.  Since the assumptions behind the $45 target still seemed somewhat generous, we decided to forego purchasing TPX, at least for the time being. 

At first we watched the price of TPX continue to climb, along with many other stocks early this year, from $71 to over $87 in mid April.  Then, in early May, the stock fell below $50 in just a few days based on concerns about mattress prices being discounted.     

While this is by no means the end of the story for TPX, it does provide a really good example of the importance of Arete’s valuation-based investment philosophy and process.  In the grander scheme of things, there is very, very little we can know with any certainty regarding short-term stock movements.  What we can evaluate with much greater certainty, however, is the set of expectations implied by stock prices.  This is a task which often makes the difference between temporary movements in price and permanent impairments of capital.  It is also one which Arete is especially well-equipped to manage.