| Arete Insights Q113 |
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
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.
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.
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.
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