| Arete Quarterly Q410 |
Welcome
For years, the mark of an outstanding business has been a “sustainable competitive advantage.” Unfortunately, competitive advantages are often bandied about as cavalierly as if they were fashion accessories. “Where did you get that proprietary model? Really? Wow, it looks great on you!”
Needless to say, with our analytical bent, it is not unlike us to be skeptical, curmudgeonly, or even unfashionable. As such, we often find ourselves being quite skeptical of the nature, quantity and duration of competitve advantages in the real world.
We are arguably even more skeptical when we evaluate the money management business, and we don’t take it any easier on ourselves. Sure we do a lot of modeling and valuation work, for example, but we are not the only ones. Does this really consitute a competitive advantage?
A recent article in the McKinsey Quarterly frames the issues nicely. In Have you tested your strategy lately?, Chris Bradley, Martin Hirt, and Sven Smit describe competitive advantages, in one sense, as “distinctive competencies” which consist of things a company does especially well. The authors are careful to note that special capabilities must “be critical to a company’s profits and exist in abundance within [the firm] while . . . scarce outside.”
This helps create an important context for many of the things we do. For example, if the question is, “Is valuation and modeling something Arete does especially well, something that is critical to profits, and something that exists in abundance at the firm?”, then our answer is a resounding, “Yes — absolutely!” We have over twenty years of experience in learning, adapting, and refining our approach to valuation. In addition to being crucial to generating superior returns, our valuation work also helps us avoid permanent impairments of capital.
The final part of the test for distinctive competency is the degree to which it is scarce outside of the firm. But what is meant by scarce? Relative to Arete’s goal of fuctional excellence, we are the first to admit that there are clearly other examples of very high quality money management firms that do an excellent job of valuation. This, however, defines scarcity too narrowly to be useful.
The measure of a quality active manager is outperformance, after all, and more than one firm qualifies. These managers outperform because their skills are scarce relative to all other market participants. Indeed, regarding valuation work, progressively larger proportions of the market don’t even attempt to do it. Based on the standard of having skills that are scarce relative to all market participants, it is fair to say that our valuation expertise is extremely scarce, and that it qualifies as a distinctive competency.
Another issue regarding competitive advantage is that one distinctive competency is almost never enough to ensure success in money management. While we do absolutely consider our skills at valuation, fundamental analysis, and managing knowledge as being special advantages, we also view them as individual “ingredients” that alone, are insufficient to ensure Arete’s success. The cold, hard truth is that other firms have done the same thing in the past and failed to deliver superior performance or a successful business.
So what is missing? We believe the success of a money management operation is contingent upon demonstrating several dimensions of quality and competitive advantage. Having good “ingredients” is important, but so is having a good “recipe” to combine them in just the right proportions.
An important example of this at Arete is the way we combine our portfolio construction with our marketing strategy. Our portfolio construction is based on creating a relatively diversified, but relatively concentrated portfolio of best ideas. The result is that there can be times when the portfolio does not keep up with the market. Because these are often the times of greatest market inefficiency, and therefore greatest opportunity for future performance, it is critical that our clients understand and embrace these dynamics. Without such an understanding, we would face the risk of losing clients, and clients would risk locking in losses, at exactly the wrong times.
As anyone knows though, having great ingredients and a great recipe still don’t ensure having a great meal. Even good recipes require the skill and care of someone who can bring everything together in way that makes for a special experience for the diner.
So it is with money management. We believe that exercising a standard of care is critical to ensure the delivery of superior performance to investors as well as delivery of a superior overall experience. Arete was founded on the basis of serving investors’ needs — specifically, to make their lives better and to help ensure they have adequate funds for retirement. When firms fail to focus on this ultimate purpose, the other components don’t mean nearly as much.
Of course it is easier to pursue the end of serving investors’ needs when you enjoy it. We, for example, consider ourselves incredibly fortunate to do what we love to do — reading, researching, and analyzing stocks. As a result, we only ask that we get a fair return for our effort. Several other managers, in contrast, believe that with so many skills and so much effort required to manage money well, that they need extraordinary compensation for their “extraordinary” effort. Needless to say, this type of thinking detracts from investment returns.
In summary, we absolutely agree that competitive advantage is an extremely important concept for business. Regarding the money management business however, compeitive advantage is neither simple nor one-dimensional. Instead, it requires the quality ingredients of distinctive competencies, a good recipe that combines strategic and operational elements in a useful way, and the care and skill to prepare and assemble everything into something special. We believe we have done this with Arete and hope you enjoy the results.
Bon Apppetit!
For years, the mark of an outstanding business has been a “sustainable competitive advantage.” Unfortunately, competitive advantages are often bandied about as cavalierly as if they were fashion accessories. “Where did you get that proprietary model? Really? Wow, it looks great on you!”
Needless to say, with our analytical bent, it is not unlike us to be skeptical, curmudgeonly, or even unfashionable. As such, we often find ourselves being quite skeptical of the nature, quantity and duration of competitve advantages in the real world.
We are arguably even more skeptical when we evaluate the money management business, and we don’t take it any easier on ourselves. Sure we do a lot of modeling and valuation work, for example, but we are not the only ones. Does this really consitute a competitive advantage?
A recent article in the McKinsey Quarterly frames the issues nicely. In Have you tested your strategy lately?, Chris Bradley, Martin Hirt, and Sven Smit describe competitive advantages, in one sense, as “distinctive competencies” which consist of things a company does especially well. The authors are careful to note that special capabilities must “be critical to a company’s profits and exist in abundance within [the firm] while . . . scarce outside.”
This helps create an important context for many of the things we do. For example, if the question is, “Is valuation and modeling something Arete does especially well, something that is critical to profits, and something that exists in abundance at the firm?”, then our answer is a resounding, “Yes — absolutely!” We have over twenty years of experience in learning, adapting, and refining our approach to valuation. In addition to being crucial to generating superior returns, our valuation work also helps us avoid permanent impairments of capital.
The final part of the test for distinctive competency is the degree to which it is scarce outside of the firm. But what is meant by scarce? Relative to Arete’s goal of fuctional excellence, we are the first to admit that there are clearly other examples of very high quality money management firms that do an excellent job of valuation. This, however, defines scarcity too narrowly to be useful.
The measure of a quality active manager is outperformance, after all, and more than one firm qualifies. These managers outperform because their skills are scarce relative to all other market participants. Indeed, regarding valuation work, progressively larger proportions of the market don’t even attempt to do it. Based on the standard of having skills that are scarce relative to all market participants, it is fair to say that our valuation expertise is extremely scarce, and that it qualifies as a distinctive competency.
Another issue regarding competitive advantage is that one distinctive competency is almost never enough to ensure success in money management. While we do absolutely consider our skills at valuation, fundamental analysis, and managing knowledge as being special advantages, we also view them as individual “ingredients” that alone, are insufficient to ensure Arete’s success. The cold, hard truth is that other firms have done the same thing in the past and failed to deliver superior performance or a successful business.
So what is missing? We believe the success of a money management operation is contingent upon demonstrating several dimensions of quality and competitive advantage. Having good “ingredients” is important, but so is having a good “recipe” to combine them in just the right proportions.
An important example of this at Arete is the way we combine our portfolio construction with our marketing strategy. Our portfolio construction is based on creating a relatively diversified, but relatively concentrated portfolio of best ideas. The result is that there can be times when the portfolio does not keep up with the market. Because these are often the times of greatest market inefficiency, and therefore greatest opportunity for future performance, it is critical that our clients understand and embrace these dynamics. Without such an understanding, we would face the risk of losing clients, and clients would risk locking in losses, at exactly the wrong times.
As anyone knows though, having great ingredients and a great recipe still don’t ensure having a great meal. Even good recipes require the skill and care of someone who can bring everything together in way that makes for a special experience for the diner.
So it is with money management. We believe that exercising a standard of care is critical to ensure the delivery of superior performance to investors as well as delivery of a superior overall experience. Arete was founded on the basis of serving investors’ needs — specifically, to make their lives better and to help ensure they have adequate funds for retirement. When firms fail to focus on this ultimate purpose, the other components don’t mean nearly as much.
Of course it is easier to pursue the end of serving investors’ needs when you enjoy it. We, for example, consider ourselves incredibly fortunate to do what we love to do — reading, researching, and analyzing stocks. As a result, we only ask that we get a fair return for our effort. Several other managers, in contrast, believe that with so many skills and so much effort required to manage money well, that they need extraordinary compensation for their “extraordinary” effort. Needless to say, this type of thinking detracts from investment returns.
In summary, we absolutely agree that competitive advantage is an extremely important concept for business. Regarding the money management business however, compeitive advantage is neither simple nor one-dimensional. Instead, it requires the quality ingredients of distinctive competencies, a good recipe that combines strategic and operational elements in a useful way, and the care and skill to prepare and assemble everything into something special. We believe we have done this with Arete and hope you enjoy the results.
Bon Apppetit!
Business Update
In the course of talking to people at various events and gatherings, I often get asked the question of what it’s like to run my own business. I can honestly say that the first word that always pops into my mind is “liberating.”
This is not to say that running Arete does not take enormous amounts of my time. And there is no doubt that I spend a lot of time doing things like reconciling accounts and typing up contact notes that in and of themselves are not the highest and best use of my time.
However, the vast majority of the decisions people make involve tradeoffs. The way in which we lean when we make these tradeoffs is what is important. My freedom to lean towards doing what I believe to be right and towards doing what is right for clients is the key aspect of my “liberation.”
I’ve been in the money management business long enough now to be aware of most of these dynamics and to have thoughtfully considered the implications of each. It is fair to say that Arete arose from my conclusion that I could improve upon almost every single aspect of the business relative to standard industry practice and to what I saw many firms doing.
I think the most important benefit I have at Arete is the luxury of being able to focus on portfolio decisions solely for their investment merits. This sounds like such and obvious situation, but it just isn’t. I have worked where we got a call every day asking for an explanation of relative performance for that day. Anyone who has studied the markets knows that performance on such a short time frame is essentially random. Nonetheless, our jobs were on the line to come up with answers.
I have also heard institutional investors reject investments on the basis of short-term bonuses rather than long-term investment merits. If a manager’s bonus is paid quarterly, and his/her performance.to-date merits a substantial bonus, there is often a disincentive to buy a poor-performing stock, regardless of long-term potential.
The unfortunate truth is that there are myriad practices in the business that force transactions up and holding periods down. Ultimately, it makes Arete’s pure focus on investment merits feel like quite a luxury. While I keep plenty busy, it doesn’t feel like work when I don’t have to worry about all of the extracurricular activities that pervade the business at the expense of improving end results to clients.
Another extremely important feature I enjoy about Arete is that the marketing strategy is wholly integrated with the portfolio strategy. I began the exercise of founding Arete by asking what investors want and need. This was fairly easy since I am an investor too and need to manage my own investments. As a professional investor, I want the best possible investment performance at the lowest possible price. I figured this investment value would also appeal to a great many other savvy investors.
For most investment products, however, marketing costs constitute a huge portion of total costs. Advertising, marketing, and distribution can cost a lot of money, but what do these functions really do to help investors? Distribution, for example, can make purchase more convenient. But how much should one pay for convenience in regards to a long-term investment?
We take our cue from other industries that have vastly reduced marketing expenses in order to provide a greater value to consumers. Amazon is a well-known example of such a business model. With large, centralized warehouses and automated fulfillment systems, Amazon has leveraged technology to makes books, and lots of other things, available to consumers at prices that are much lower than those found in stores. As much as I like bookstores, buying a book there is like buying a mutual fund from a broker. You get it right away, but you pay a lot more than buying direct.
As part of my mission to provide investment value at Arete, I want to provide the same types of advantages to investors. I provide interested investors with a great deal of information on Arete’s website and through our newsletters which are delivered by email. In this way, people can learn a great deal about Arete for free which means we don’t have to charge expensive marketing fees like many mutual funds do.
In addition to investment focus and marketing strategy, I also hugely appreciate Arete’s unique focus on avoiding conflicts of interest. When I began my career as an analyst, I thought there were so many market inefficiencies because there were a lot of dumb people in the market. Since then, I have grown to appreciate the powerful influence that organizational structure has on individual decisions.
Perhaps no person has been more thoughtful or had more influence describing the context surrounding organizations as Peter Drucker. In a November 2009 article for the Harvard Business Review entitled, “What Would Peter Say?” Rosabeth Moss Kanter describes, “Drucker rarely named or blamed individuals; he saw root causes in the design of organizations — in their structures, processes, norms, and routines. He would remind us that it is the responsibility of executives to challenge that design while being mindful of their companies’ ultimate purpose.”
So we ask, if the ultimate purpose of a money manager is to serve its investors, why would it grow funds so large as to impede performance? Why would it create conflicts of interest between advisory and broker-dealer operations? Why would executives pay themselves 30 - 50% more than they would make in any other industry? I think the answer is that the design of these organizations has not been adequately challenged to ensure investors are well served.
Drucker also said that, “Knowledge workers cannot be controlled; they must be motivated.” And so it is with me at Arete. Because of Arete’s ability to focus on investment merits, the vision of its marketing strategy, and its structural aversion to conflicts of interest, I am proud to be part of this effort and am happy to dedicate myself to it. If I didn’t enjoy the work and if I didn’t truly believe in Arete’s mission, it probably would be too hard for me to run Arete. But then, I guess that’s why so many businesses fail.
In the meantime, if you have any suggestions for how Arete can more effectively serve you or other investors, please let me know — that’s how it keeps getting better.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
In the course of talking to people at various events and gatherings, I often get asked the question of what it’s like to run my own business. I can honestly say that the first word that always pops into my mind is “liberating.”
This is not to say that running Arete does not take enormous amounts of my time. And there is no doubt that I spend a lot of time doing things like reconciling accounts and typing up contact notes that in and of themselves are not the highest and best use of my time.
However, the vast majority of the decisions people make involve tradeoffs. The way in which we lean when we make these tradeoffs is what is important. My freedom to lean towards doing what I believe to be right and towards doing what is right for clients is the key aspect of my “liberation.”
I’ve been in the money management business long enough now to be aware of most of these dynamics and to have thoughtfully considered the implications of each. It is fair to say that Arete arose from my conclusion that I could improve upon almost every single aspect of the business relative to standard industry practice and to what I saw many firms doing.
I think the most important benefit I have at Arete is the luxury of being able to focus on portfolio decisions solely for their investment merits. This sounds like such and obvious situation, but it just isn’t. I have worked where we got a call every day asking for an explanation of relative performance for that day. Anyone who has studied the markets knows that performance on such a short time frame is essentially random. Nonetheless, our jobs were on the line to come up with answers.
I have also heard institutional investors reject investments on the basis of short-term bonuses rather than long-term investment merits. If a manager’s bonus is paid quarterly, and his/her performance.to-date merits a substantial bonus, there is often a disincentive to buy a poor-performing stock, regardless of long-term potential.
The unfortunate truth is that there are myriad practices in the business that force transactions up and holding periods down. Ultimately, it makes Arete’s pure focus on investment merits feel like quite a luxury. While I keep plenty busy, it doesn’t feel like work when I don’t have to worry about all of the extracurricular activities that pervade the business at the expense of improving end results to clients.
Another extremely important feature I enjoy about Arete is that the marketing strategy is wholly integrated with the portfolio strategy. I began the exercise of founding Arete by asking what investors want and need. This was fairly easy since I am an investor too and need to manage my own investments. As a professional investor, I want the best possible investment performance at the lowest possible price. I figured this investment value would also appeal to a great many other savvy investors.
For most investment products, however, marketing costs constitute a huge portion of total costs. Advertising, marketing, and distribution can cost a lot of money, but what do these functions really do to help investors? Distribution, for example, can make purchase more convenient. But how much should one pay for convenience in regards to a long-term investment?
We take our cue from other industries that have vastly reduced marketing expenses in order to provide a greater value to consumers. Amazon is a well-known example of such a business model. With large, centralized warehouses and automated fulfillment systems, Amazon has leveraged technology to makes books, and lots of other things, available to consumers at prices that are much lower than those found in stores. As much as I like bookstores, buying a book there is like buying a mutual fund from a broker. You get it right away, but you pay a lot more than buying direct.
As part of my mission to provide investment value at Arete, I want to provide the same types of advantages to investors. I provide interested investors with a great deal of information on Arete’s website and through our newsletters which are delivered by email. In this way, people can learn a great deal about Arete for free which means we don’t have to charge expensive marketing fees like many mutual funds do.
In addition to investment focus and marketing strategy, I also hugely appreciate Arete’s unique focus on avoiding conflicts of interest. When I began my career as an analyst, I thought there were so many market inefficiencies because there were a lot of dumb people in the market. Since then, I have grown to appreciate the powerful influence that organizational structure has on individual decisions.
Perhaps no person has been more thoughtful or had more influence describing the context surrounding organizations as Peter Drucker. In a November 2009 article for the Harvard Business Review entitled, “What Would Peter Say?” Rosabeth Moss Kanter describes, “Drucker rarely named or blamed individuals; he saw root causes in the design of organizations — in their structures, processes, norms, and routines. He would remind us that it is the responsibility of executives to challenge that design while being mindful of their companies’ ultimate purpose.”
So we ask, if the ultimate purpose of a money manager is to serve its investors, why would it grow funds so large as to impede performance? Why would it create conflicts of interest between advisory and broker-dealer operations? Why would executives pay themselves 30 - 50% more than they would make in any other industry? I think the answer is that the design of these organizations has not been adequately challenged to ensure investors are well served.
Drucker also said that, “Knowledge workers cannot be controlled; they must be motivated.” And so it is with me at Arete. Because of Arete’s ability to focus on investment merits, the vision of its marketing strategy, and its structural aversion to conflicts of interest, I am proud to be part of this effort and am happy to dedicate myself to it. If I didn’t enjoy the work and if I didn’t truly believe in Arete’s mission, it probably would be too hard for me to run Arete. But then, I guess that’s why so many businesses fail.
In the meantime, if you have any suggestions for how Arete can more effectively serve you or other investors, please let me know — that’s how it keeps getting better.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
Market Overview
The “narratives” that we talked about the last two quarters continued to play out through the fourth quarter. Perhaps the only difference was the increase in breadth and magnitude of the rally that began with Fed chairman Bernanke’s speech in August about quantitative easing. For the last several months it has felt like we were judiciously pacing ourselves for a marathon, but were getting outrun by many stocks making a mad sprint to the finish line of calendar year 2010.
There were some notable characteristics of the rally. First, we had déjà vu all over again as technology stocks, especially internet-related stocks, outperformed almost regardless of what happened. Salesforce.com, a poster child for the phenomenon, posts a trailing PE of 256x and a price/sales ratio greater than 12x. Unlike many internet darlings of the late 1990s, Salesforce is a real business.
However, very much like in the past, these are the types of valuations that are rarely sustainable.
A related, but separate, phenomenon was massive outperformance by a number of the larger index contributors. Historically, we have seen this type of activity much later in a cyclical recovery. Given that the Fed felt the need to implement quantitative easing to nudge (or shove?) the economy back into recovery, it is hard to argue that lower risk and a declining cost of capital are the rationale for rising stock prices.
From a very high level, we see the market acting as a pendulum. Every few quarters it swings one way, and then it swings back. Insofar as this is the case, it does give short-term traders opportunities to jump on the swings. We suspect a fair amount of that is happening.
We also are very sensitive to global risks — they haven’t gone away. In our opinion, the many risks the market faces are far more severe than the market is discounting. Further, we also believe the risks have increased by virtue of the fact that none of the really serious problems have been dealt with. At home, we have a big housing problem that we have yet to work through. We are also facing structural employment problems and municipal debt is a problem like it never has been before.
Further abroad, but still extremely important, there are very severe sovereign debt problems. Europe’s banks have not been cleaned up and are getting more costly to do so by the day. The emerging market growth story is being challenged by inflation and exchange rates. It is unrealistic to expect emerging markets to continue fueling global growth when that growth comes at the expense of crippling their own economies.
Where does all of this leave us? Importantly, we do not see these risks as devastating or apocalyptic. We do see them as underappreciated and underpriced by the market right now. The primary caveat is investment horizon. For those with a shorter time horizon, we believe some caution is warranted. Returns are a function of original purchase price and there are clear indications that current prices for many stocks are not cheap.
Longer term, we are still extremely optimistic about US markets and about mid caps in particular. We remain fully invested and bullish about the prospects for our companies. Finally, due to our extensive financial analysis, we believe our stocks are largely protected against permanent impairments of capital should a market correction occur for some period during the interim.
The “narratives” that we talked about the last two quarters continued to play out through the fourth quarter. Perhaps the only difference was the increase in breadth and magnitude of the rally that began with Fed chairman Bernanke’s speech in August about quantitative easing. For the last several months it has felt like we were judiciously pacing ourselves for a marathon, but were getting outrun by many stocks making a mad sprint to the finish line of calendar year 2010.
There were some notable characteristics of the rally. First, we had déjà vu all over again as technology stocks, especially internet-related stocks, outperformed almost regardless of what happened. Salesforce.com, a poster child for the phenomenon, posts a trailing PE of 256x and a price/sales ratio greater than 12x. Unlike many internet darlings of the late 1990s, Salesforce is a real business.
However, very much like in the past, these are the types of valuations that are rarely sustainable.
A related, but separate, phenomenon was massive outperformance by a number of the larger index contributors. Historically, we have seen this type of activity much later in a cyclical recovery. Given that the Fed felt the need to implement quantitative easing to nudge (or shove?) the economy back into recovery, it is hard to argue that lower risk and a declining cost of capital are the rationale for rising stock prices.
From a very high level, we see the market acting as a pendulum. Every few quarters it swings one way, and then it swings back. Insofar as this is the case, it does give short-term traders opportunities to jump on the swings. We suspect a fair amount of that is happening.
We also are very sensitive to global risks — they haven’t gone away. In our opinion, the many risks the market faces are far more severe than the market is discounting. Further, we also believe the risks have increased by virtue of the fact that none of the really serious problems have been dealt with. At home, we have a big housing problem that we have yet to work through. We are also facing structural employment problems and municipal debt is a problem like it never has been before.
Further abroad, but still extremely important, there are very severe sovereign debt problems. Europe’s banks have not been cleaned up and are getting more costly to do so by the day. The emerging market growth story is being challenged by inflation and exchange rates. It is unrealistic to expect emerging markets to continue fueling global growth when that growth comes at the expense of crippling their own economies.
Where does all of this leave us? Importantly, we do not see these risks as devastating or apocalyptic. We do see them as underappreciated and underpriced by the market right now. The primary caveat is investment horizon. For those with a shorter time horizon, we believe some caution is warranted. Returns are a function of original purchase price and there are clear indications that current prices for many stocks are not cheap.
Longer term, we are still extremely optimistic about US markets and about mid caps in particular. We remain fully invested and bullish about the prospects for our companies. Finally, due to our extensive financial analysis, we believe our stocks are largely protected against permanent impairments of capital should a market correction occur for some period during the interim.
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