| Arete Insights Q212 |
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
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.
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.
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.
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