| Arete Quarterly Q408 |
Welcome
The fourth quarter was difficult any way you look at it and left many investors confused and seriously challenging many deeply-held beliefs. This was captured well in a recent conversation with a friend about the markets and the economy when he remarked, “This doesn’t look like anything I’ve seen before.” I think this straightforward comment captures a lot of what people are feeling right now and reveals a great deal about many of the difficulties facing investors.
For one, there is widespread loss of confidence in the financial system and loss of trust in business leaders. We have seen a great deal of evidence that far too many of those who got ahead were not better, but simply more aggressive and/or less ethical.
I absolutely appreciate these very real concerns and share more than a few of them myself. The prevailing deep sense of concern, however, seems disproportionate to some of the real opportunities that exist. While I do not believe there are any obvious answers or clear forecasts, I do very much believe investors have tools at their disposal that can help improve their situation. The following are some ideas and guidelines intended to help make the most out of these market conditions.
For starters, it has never been clearer that there are enormous differences in quality of investment advisors. But how can one tell the difference? Even in the in the best of times, it is very difficult to evaluate a professional service such as investment management. Every investment manager says they are good and of high quality, but how can an investor make a reasonable judgment?
One of the most important tools people use to make such decisions is that of proxies. Many people use referrals as proxies for competence and trustworthiness. For example, “if my friend/ family member/ colleague trusts ABC Advisors, then maybe I should be able to trust ABC.” The advantage of using proxies is that they are much more widely available and often do contain information. The disadvantage of using proxies is that they can be poor representations of quality and can be not only deceptive, but outright wrong.
So are some proxies better indicators of quality than others? The answer to this question is a resounding YES! The following ideas should also serve as a strong message of empowerment to investors frustrated with much of the financial system and its leaders right now.
We argue that one of the most important proxies of quality investment management is that of organizational structure. By this we do not mean reporting structures, but rather the combination of various types of businesses. There are several reasons why this is important. First, it can give some indication as to the level of complexity of the operation. If it is hard to for you to make sense of it all, it may also be hard for the adviser’s managers to manage it all. Second, it can give a very important indication as to the potential for conflicts of interest.
The potential for conflicts of interest are important because it provides insight into the context of where things can go wrong. In The Tipping Point, by Malcolm Gladwell, he reports that honesty is not a fundamental trait, specific to certain people. Instead, people deceive in some situations and not in others. In other words, people succomb to temptation, and that happens more in some situations than others.
Not too surprisingly, when people are monitored, and subject to checks and balances, and have little to gain, they tend to be more honest – because the costs are large and the payouts small. By contrast, when people work under the shroud of secrecy, and benefit directly from deception, the payoffs can be large and the risks small.
Investors can do themselves an enormous favor in their quest to find quality by looking for advisors that have straightforward business models, minimal potential for conflicts of interest, and significant disclosure of business practices. It is not a trivial point that the SEC incorporates the same factors in order to assess the potential risk of an adviser and to help calibrate the appropriate level of enforcement.
Another proxy for quality management is diligence. Certainly as an investor, you want to know that your adviser is doing a lot of research on investments. But this is hard to evaluate if you aren’t a stock-picker yourself. It highlights the asymmetry of information which makes evaluating any “expert” difficult.
Since diligence manifests itself in all of the little things an adviser does, there are plenty of proxies available to investors. Does the adviser communicate clearly? Does the strategy make sense? Is the website updated regularly? Do numbers have adequate disclosures such that they can be meaningfully compared? While these indicators do not guarantee diligence with investment research or acumen with stock selection, they often represent an overarching firm attitude that indicates the adviser cares about getting things right, and is willing to fight those fights on behalf of its clients.
Finally, another useful proxy for quality is transparency. Transparency is a useful proxy because it sends a signal that the adviser has nothing to hide and is confident in its business model. For example, at Arete we registered as an investment advisor from day one in order to allow regulators to keep an eye on us, and to enable all clients and prospects to learn more about us in our Form ADV. We also sponsor a website which provides a great deal of information about us and our investment philosophy and process, and we produce this newsletter each quarter which provides investment updates. How much do you know about other advisers?
So is all of this effort in trying to find quality in an investment adviser worth it? Recently, I was evaluating a business which is having difficulty getting paid for all of the “quality” work they are doing in the form of quality assurance standards, safety checks, and the like. Many competitors are not performing the same checks and can therefore compete on price. In good times, these “extras” are nice, but often customers are not willing to pay for them. When things go wrong, however, all of a sudden, these “extras” seem essential.
Certainly this same dynamic is playing out in the investment management business. It occurred to me that the dynamic was similar to a commodity being bundled with some type of insurance. In other words, quality is in some sense, an insurance policy assuring that the product holds up under adverse conditions.
What I find so especially striking about this environment, is that at the same time it is becoming phenomenally obvious that there are big differences in investment managers, many investors are retreating from professional help for fear of hiring one of the “bad” ones.
We would argue this is a perfect time to evaluate managers; there are few occasions when the differences will be so clear and the implications so obvious. If you have any long-term interest in equities at all, this is a great time to start doing the work on finding the right advisor(s). Certainly everything about Arete has been designed to be a terrific value and we would love to show you how we do things differently than many other managers out there today.
We hope you find our proposition compelling and as always, welcome any feedback you may have!
The fourth quarter was difficult any way you look at it and left many investors confused and seriously challenging many deeply-held beliefs. This was captured well in a recent conversation with a friend about the markets and the economy when he remarked, “This doesn’t look like anything I’ve seen before.” I think this straightforward comment captures a lot of what people are feeling right now and reveals a great deal about many of the difficulties facing investors.
For one, there is widespread loss of confidence in the financial system and loss of trust in business leaders. We have seen a great deal of evidence that far too many of those who got ahead were not better, but simply more aggressive and/or less ethical.
I absolutely appreciate these very real concerns and share more than a few of them myself. The prevailing deep sense of concern, however, seems disproportionate to some of the real opportunities that exist. While I do not believe there are any obvious answers or clear forecasts, I do very much believe investors have tools at their disposal that can help improve their situation. The following are some ideas and guidelines intended to help make the most out of these market conditions.
For starters, it has never been clearer that there are enormous differences in quality of investment advisors. But how can one tell the difference? Even in the in the best of times, it is very difficult to evaluate a professional service such as investment management. Every investment manager says they are good and of high quality, but how can an investor make a reasonable judgment?
One of the most important tools people use to make such decisions is that of proxies. Many people use referrals as proxies for competence and trustworthiness. For example, “if my friend/ family member/ colleague trusts ABC Advisors, then maybe I should be able to trust ABC.” The advantage of using proxies is that they are much more widely available and often do contain information. The disadvantage of using proxies is that they can be poor representations of quality and can be not only deceptive, but outright wrong.
So are some proxies better indicators of quality than others? The answer to this question is a resounding YES! The following ideas should also serve as a strong message of empowerment to investors frustrated with much of the financial system and its leaders right now.
We argue that one of the most important proxies of quality investment management is that of organizational structure. By this we do not mean reporting structures, but rather the combination of various types of businesses. There are several reasons why this is important. First, it can give some indication as to the level of complexity of the operation. If it is hard to for you to make sense of it all, it may also be hard for the adviser’s managers to manage it all. Second, it can give a very important indication as to the potential for conflicts of interest.
The potential for conflicts of interest are important because it provides insight into the context of where things can go wrong. In The Tipping Point, by Malcolm Gladwell, he reports that honesty is not a fundamental trait, specific to certain people. Instead, people deceive in some situations and not in others. In other words, people succomb to temptation, and that happens more in some situations than others.
Not too surprisingly, when people are monitored, and subject to checks and balances, and have little to gain, they tend to be more honest – because the costs are large and the payouts small. By contrast, when people work under the shroud of secrecy, and benefit directly from deception, the payoffs can be large and the risks small.
Investors can do themselves an enormous favor in their quest to find quality by looking for advisors that have straightforward business models, minimal potential for conflicts of interest, and significant disclosure of business practices. It is not a trivial point that the SEC incorporates the same factors in order to assess the potential risk of an adviser and to help calibrate the appropriate level of enforcement.
Another proxy for quality management is diligence. Certainly as an investor, you want to know that your adviser is doing a lot of research on investments. But this is hard to evaluate if you aren’t a stock-picker yourself. It highlights the asymmetry of information which makes evaluating any “expert” difficult.
Since diligence manifests itself in all of the little things an adviser does, there are plenty of proxies available to investors. Does the adviser communicate clearly? Does the strategy make sense? Is the website updated regularly? Do numbers have adequate disclosures such that they can be meaningfully compared? While these indicators do not guarantee diligence with investment research or acumen with stock selection, they often represent an overarching firm attitude that indicates the adviser cares about getting things right, and is willing to fight those fights on behalf of its clients.
Finally, another useful proxy for quality is transparency. Transparency is a useful proxy because it sends a signal that the adviser has nothing to hide and is confident in its business model. For example, at Arete we registered as an investment advisor from day one in order to allow regulators to keep an eye on us, and to enable all clients and prospects to learn more about us in our Form ADV. We also sponsor a website which provides a great deal of information about us and our investment philosophy and process, and we produce this newsletter each quarter which provides investment updates. How much do you know about other advisers?
So is all of this effort in trying to find quality in an investment adviser worth it? Recently, I was evaluating a business which is having difficulty getting paid for all of the “quality” work they are doing in the form of quality assurance standards, safety checks, and the like. Many competitors are not performing the same checks and can therefore compete on price. In good times, these “extras” are nice, but often customers are not willing to pay for them. When things go wrong, however, all of a sudden, these “extras” seem essential.
Certainly this same dynamic is playing out in the investment management business. It occurred to me that the dynamic was similar to a commodity being bundled with some type of insurance. In other words, quality is in some sense, an insurance policy assuring that the product holds up under adverse conditions.
What I find so especially striking about this environment, is that at the same time it is becoming phenomenally obvious that there are big differences in investment managers, many investors are retreating from professional help for fear of hiring one of the “bad” ones.
We would argue this is a perfect time to evaluate managers; there are few occasions when the differences will be so clear and the implications so obvious. If you have any long-term interest in equities at all, this is a great time to start doing the work on finding the right advisor(s). Certainly everything about Arete has been designed to be a terrific value and we would love to show you how we do things differently than many other managers out there today.
We hope you find our proposition compelling and as always, welcome any feedback you may have!
Insights
Just as there are tools available to help investors make good, informed decisions about an investment advisor, so too are there guidelines which can prove useful in coping with a volatile market for individual stocks.
The first guideline to making better decisions about stocks that we’ll mention is to stay focused on stocks, and to resist trying to pick the market bottom. Did it make sense to stay out of the market in September, October, and November? Sure. Does anyone who bought stocks in September or October look dumb for not waiting to buy them in November or December? You bet.
For most people, however, the purpose of owning stocks is to benefit from the superior returns stocks generate over longer periods of time. Although extreme market volatility presents the illusion of profit potential, it is a very, very difficult game for anybody to win. Low trading volumes, rapid and violent changes, and a high degree of randomness in short time frames conspire to substantially limit any investor’s ability to materially benefit from timing a bottom. As a result, one guideline for investors is to adhere to a long-term strategy of equity exposure and to avoid the siren calls of market timing.
Another guideline for investing in stocks is to not get too hung up on today’s prices. Are prices lower today than last year? Yes. Is a slowing economy going to reduce revenues and earnings? Yes. One challenge we face is that in our overarching effort as humans to make sense of things, we have a natural tendency to assume a strong correlation between price and value. When markets are functioning well, there should be a high correlation. The markets we have experienced since the middle of September, however, have not been functioning well.
In other words, a dominant factor currently affecting market prices is the supply and demand dynamic for stocks as opposed to the intrinsic value of stocks. There is no doubt that a lot of stocks are worth a lot less than they were a few months ago on a fundamental basis. This is quite clearly the case with many banks and financials. However, as leveraged investors and others rushed for the exits to sell anything liquid, virtually all stocks have suffered. Insofar as this is the case, an investor’s primary challenge is to do, and to have done, enough research to differentiate between the bargain stocks and the permanently impaired ones.
In order to visualize this better, let’s conduct a thought experiment. Imagine instead of stock, there is a material item you want to purchase. Imagine it is on clearance at the store for 50% off. You’ve always wanted it and now it’s cheap! Do you buy it, or do you wait, hoping that the price may go down more? Are you more likely to think, “If it’s down 50%, how do I know it won’t be down 75% next week?”, or, “What if the sale ends unannounced and suddenly the price goes right back to where it was? Then I will have missed a bargain.”
The last guideline I will mention here is something I always recommend, but is especially relevant now, and that is to balance the information you receive. It is no secret that most television is supported by advertising, that advertising generates higher fees for bigger audiences, and bigger audiences are generated by negative news. Is it any wonder that we hear a lot of negative news?
There are two lessons. One, if you want to hear less negative news, turn off the television. Two, television delivers information only insofar as it can be manufactured into entertainment. If you want information and want to learn, look to more objective information sources, not entertainment vehicles.
Part of the effort to balance information (which is an important part of any analytically rigorous dialogue) is to evaluate both confirming and disconfirming evidence. We have all heard the negative news about the economy and the markets. There are real problems, no doubt. However, it behooves us to actively seek a balanced view. There are also real positives.
One of the positives we see today is that valuations are far lower than they have been for decades, and are entering the territory of levels experienced only at major bear market bottoms. In addition, there is an enormous amount of cash and money market assets on the sidelines. Virtually nonexistent returns to cash are essentially daring investors to remain withdrawn from the market. The current average gas price of $1.78 per gallon versus over $4 per gallon in the middle of last summer provides the equivalent of a tax cut of about two hundred billion dollars. It all helps. Finally, what if the numerous Fed programs, the Troubled Asset Relief Program, fiscal stimulus and other measures actually start working? There is no doubt there is risk to all of these, but how much success is the market discounting? I would argue very little.
With these guidelines in our toolbox, what do we see for the upcoming year? As a matter of practice, we do not make point predictions; nobody knows what is going to happen. However, we do try to identify significant risks and understand probability distributions. As intimated by the foregoing discussion, we believe there is evidence to support a significant rally during the year. However, we do not disagree that there are very serious risks to the economy and the markets that could last for several years. It will be exceptionally difficult to time. In short, we expect 2009 and perhaps beyond to be a wild ride. This is likely to be difficult and challenging for many, but is also likely to present once-in-a-lifetime types of opportunities for the well-prepared.
Just as there are tools available to help investors make good, informed decisions about an investment advisor, so too are there guidelines which can prove useful in coping with a volatile market for individual stocks.
The first guideline to making better decisions about stocks that we’ll mention is to stay focused on stocks, and to resist trying to pick the market bottom. Did it make sense to stay out of the market in September, October, and November? Sure. Does anyone who bought stocks in September or October look dumb for not waiting to buy them in November or December? You bet.
For most people, however, the purpose of owning stocks is to benefit from the superior returns stocks generate over longer periods of time. Although extreme market volatility presents the illusion of profit potential, it is a very, very difficult game for anybody to win. Low trading volumes, rapid and violent changes, and a high degree of randomness in short time frames conspire to substantially limit any investor’s ability to materially benefit from timing a bottom. As a result, one guideline for investors is to adhere to a long-term strategy of equity exposure and to avoid the siren calls of market timing.
Another guideline for investing in stocks is to not get too hung up on today’s prices. Are prices lower today than last year? Yes. Is a slowing economy going to reduce revenues and earnings? Yes. One challenge we face is that in our overarching effort as humans to make sense of things, we have a natural tendency to assume a strong correlation between price and value. When markets are functioning well, there should be a high correlation. The markets we have experienced since the middle of September, however, have not been functioning well.
In other words, a dominant factor currently affecting market prices is the supply and demand dynamic for stocks as opposed to the intrinsic value of stocks. There is no doubt that a lot of stocks are worth a lot less than they were a few months ago on a fundamental basis. This is quite clearly the case with many banks and financials. However, as leveraged investors and others rushed for the exits to sell anything liquid, virtually all stocks have suffered. Insofar as this is the case, an investor’s primary challenge is to do, and to have done, enough research to differentiate between the bargain stocks and the permanently impaired ones.
In order to visualize this better, let’s conduct a thought experiment. Imagine instead of stock, there is a material item you want to purchase. Imagine it is on clearance at the store for 50% off. You’ve always wanted it and now it’s cheap! Do you buy it, or do you wait, hoping that the price may go down more? Are you more likely to think, “If it’s down 50%, how do I know it won’t be down 75% next week?”, or, “What if the sale ends unannounced and suddenly the price goes right back to where it was? Then I will have missed a bargain.”
The last guideline I will mention here is something I always recommend, but is especially relevant now, and that is to balance the information you receive. It is no secret that most television is supported by advertising, that advertising generates higher fees for bigger audiences, and bigger audiences are generated by negative news. Is it any wonder that we hear a lot of negative news?
There are two lessons. One, if you want to hear less negative news, turn off the television. Two, television delivers information only insofar as it can be manufactured into entertainment. If you want information and want to learn, look to more objective information sources, not entertainment vehicles.
Part of the effort to balance information (which is an important part of any analytically rigorous dialogue) is to evaluate both confirming and disconfirming evidence. We have all heard the negative news about the economy and the markets. There are real problems, no doubt. However, it behooves us to actively seek a balanced view. There are also real positives.
One of the positives we see today is that valuations are far lower than they have been for decades, and are entering the territory of levels experienced only at major bear market bottoms. In addition, there is an enormous amount of cash and money market assets on the sidelines. Virtually nonexistent returns to cash are essentially daring investors to remain withdrawn from the market. The current average gas price of $1.78 per gallon versus over $4 per gallon in the middle of last summer provides the equivalent of a tax cut of about two hundred billion dollars. It all helps. Finally, what if the numerous Fed programs, the Troubled Asset Relief Program, fiscal stimulus and other measures actually start working? There is no doubt there is risk to all of these, but how much success is the market discounting? I would argue very little.
With these guidelines in our toolbox, what do we see for the upcoming year? As a matter of practice, we do not make point predictions; nobody knows what is going to happen. However, we do try to identify significant risks and understand probability distributions. As intimated by the foregoing discussion, we believe there is evidence to support a significant rally during the year. However, we do not disagree that there are very serious risks to the economy and the markets that could last for several years. It will be exceptionally difficult to time. In short, we expect 2009 and perhaps beyond to be a wild ride. This is likely to be difficult and challenging for many, but is also likely to present once-in-a-lifetime types of opportunities for the well-prepared.
Business Update
In the last edition of this letter, I remarked that one of the key features of the business plan for Arete is to tightly manage operational costs. I argued that “by closely managing costs and converting some normally fixed costs into variable ones, I believe the chances for the sustainability of Arete’s business are vastly improved.”
After the fourth quarter, that statement couldn’t be any truer or more heartfelt. Thus far, I am extremely pleased with the execution of our business plan and am very comfortable with Arete’s financial position. While other firms are cutting staff and restructuring, and employees are more worried about their jobs than in running the business, we are able to keep our focus on serving our clients and on growing the business.
One precept of our business management is that of applying the lessons we have learned in the business to the business. One way in which this has been manifested has been to tightly manage costs in order to make the business more efficient, and more durable. When all expenses are subject to scrutiny and to demands for adequate returns, there is very little “fat”. These characteristics describe some of the best stocks we have followed, and serve as “role models” of sorts for our own business.
Along those lines, we avoided taking out permanent office space when we started operations. The logic was simple; we thought it made more sense to defer the costs of office space until there was more immediate visibility on getting a return on that expenditure. We visualize the effort as scaling up expenses in a fairly linear way with business needs. This can’t always be done, but we try.
Now that we have gotten the Mid Cap Core strategy firmly launched, have taken on external clients, and expanded our efforts to market to individuals and institutions, our needs for space have changed. As a result, we started sub-leasing office space in November. The space is small, but very affordable (it is a good market to be looking for office space in Baltimore!) and gives us access to a conference room for client meetings.
So, if you are going to be in downtown Baltimore, please stop in and see us. We’d love to get together and talk about what we can do for you.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
In the last edition of this letter, I remarked that one of the key features of the business plan for Arete is to tightly manage operational costs. I argued that “by closely managing costs and converting some normally fixed costs into variable ones, I believe the chances for the sustainability of Arete’s business are vastly improved.”
After the fourth quarter, that statement couldn’t be any truer or more heartfelt. Thus far, I am extremely pleased with the execution of our business plan and am very comfortable with Arete’s financial position. While other firms are cutting staff and restructuring, and employees are more worried about their jobs than in running the business, we are able to keep our focus on serving our clients and on growing the business.
One precept of our business management is that of applying the lessons we have learned in the business to the business. One way in which this has been manifested has been to tightly manage costs in order to make the business more efficient, and more durable. When all expenses are subject to scrutiny and to demands for adequate returns, there is very little “fat”. These characteristics describe some of the best stocks we have followed, and serve as “role models” of sorts for our own business.
Along those lines, we avoided taking out permanent office space when we started operations. The logic was simple; we thought it made more sense to defer the costs of office space until there was more immediate visibility on getting a return on that expenditure. We visualize the effort as scaling up expenses in a fairly linear way with business needs. This can’t always be done, but we try.
Now that we have gotten the Mid Cap Core strategy firmly launched, have taken on external clients, and expanded our efforts to market to individuals and institutions, our needs for space have changed. As a result, we started sub-leasing office space in November. The space is small, but very affordable (it is a good market to be looking for office space in Baltimore!) and gives us access to a conference room for client meetings.
So, if you are going to be in downtown Baltimore, please stop in and see us. We’d love to get together and talk about what we can do for you.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
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