| Arete Quarterly Q411 |
Welcome
The new year is starting off with all the promise and freshness typical of new years. The foreboding presence of an economy functioning less than perfectly continues, however. As a result, many people are seeking explanations. History provides a useful context, and Arete is trying to provide some of the answers.
Questions regarding the robustness of the capitalistic economic model arise from the unfortunate truth that a lot of people are getting a raw deal. Income and opportunity inequality have broached dangerously high levels and many people have lost all realistic hope of realizing the American Dream. Too many others are perched dangerously on the precipice of economic disaster. Much of this is unrelated to effort or intent. On a human level it represents unnecessary suffering. On an economic level it represents hugely underutilized resources. How did we get here?
Interestingly, when Adam Smith wrote about capitalism in the 1700s, he lauded the system for promoting public interest more effectively than other systems. He argued that public interest does not result from any particular design, but is rather the result of each person’s desire to deploy his or her capital to greatest effect (and in his or her own self-interest). Such efforts lead to an extremely efficient allocation of resources which benefits a national economy. The serendipitious effect occurs as if directed by an “invisible hand.”
Even though these insights were valid, and remain so today, flaws in the capitalistic system appeared early. Edmund Burke, for example, criticized the unruly behavior of British East India Company agents. He concluded that, “Commercial society may depend upon inherited institutions that restrain people and make them decent,” (“Thinking about Capitalism,” by Jerry Z. Muller, The Great Courses, The Teaching Company). In other words, capitalism works fairly well, but it importantly depends on cultural and social institutions to keep people in line.
In an economic system driven by self-interest, it shouldn’t be any wonder that external forces may be necessary to keep people “decent”. This inherent weakness with capitalism was amplified by the proliferation of limited liability companies. With this development, the control of capital was bestowed upon managers by owners of capital. As a result, not only were there incentives to not be “decent”, but often incentives were lacking for managers to deploy capital to greatest effect. They were playing with other people’s money.
The condition of trying to receive something of value that exceeds a person’s interest and/or capacity to give something of comparable value in return, is called rent-seeking by economists. Rent-seeking is defined as, “The expenditure of resources attempting to enrich oneself by increasing one’s share of a fixed amount of wealth rather than trying to create wealth” (Wikipedia).
Such activities are unfair to other individuals because value is being taken, not exchanged. Rent-seeking also harms society as a whole: “Since resources are expended but no new wealth is created, the net effect of rent-seeking is to reduce the sum of social wealth.”
Unfortunately for investors, the investment business is especially vulnerable to rent-seeking behavior. This happens because investment services are often hard to evaluate and of dubious value. As a result, it is extremely difficult for owners of capital to judge with certainty as to whether their capital is being deployed effectively or simply being reallocated to their advisor.
A recent Financial Times article by Pauline Skypala highlights the dilemma: “The basic problem [of the savings and investment industry] is blatant disregard for customers’ or society’s interest. Go to any conference and there is little if any discussion of how to serve customers better, but lots on how to make more money out of them.”
Interestingly, Skypala differentiates between employees and organizations: “The individuals running money no doubt believe they are doing the best they can for their customers, but the machine they work within means however well they do, most of the rewards will accrue to the industry rather than the people it purports to serve.”
One answer to the shortcomings of capitalism, then, is fleshed out by the criticisms: Change the “machine”. That is exactly what Arete is trying to do in our world of investing. We work hard deploying our expertise and we charge very reasonable fees to do it. We try to get the biggest bang for our clients’ investment bucks so they will be better off. We have no delusions that we will siginficantly improve capitalism or the economy on our own, but we will give a number of investors the choice of getting a much better deal than they have had.
The new year is starting off with all the promise and freshness typical of new years. The foreboding presence of an economy functioning less than perfectly continues, however. As a result, many people are seeking explanations. History provides a useful context, and Arete is trying to provide some of the answers.
Questions regarding the robustness of the capitalistic economic model arise from the unfortunate truth that a lot of people are getting a raw deal. Income and opportunity inequality have broached dangerously high levels and many people have lost all realistic hope of realizing the American Dream. Too many others are perched dangerously on the precipice of economic disaster. Much of this is unrelated to effort or intent. On a human level it represents unnecessary suffering. On an economic level it represents hugely underutilized resources. How did we get here?
Interestingly, when Adam Smith wrote about capitalism in the 1700s, he lauded the system for promoting public interest more effectively than other systems. He argued that public interest does not result from any particular design, but is rather the result of each person’s desire to deploy his or her capital to greatest effect (and in his or her own self-interest). Such efforts lead to an extremely efficient allocation of resources which benefits a national economy. The serendipitious effect occurs as if directed by an “invisible hand.”
Even though these insights were valid, and remain so today, flaws in the capitalistic system appeared early. Edmund Burke, for example, criticized the unruly behavior of British East India Company agents. He concluded that, “Commercial society may depend upon inherited institutions that restrain people and make them decent,” (“Thinking about Capitalism,” by Jerry Z. Muller, The Great Courses, The Teaching Company). In other words, capitalism works fairly well, but it importantly depends on cultural and social institutions to keep people in line.
In an economic system driven by self-interest, it shouldn’t be any wonder that external forces may be necessary to keep people “decent”. This inherent weakness with capitalism was amplified by the proliferation of limited liability companies. With this development, the control of capital was bestowed upon managers by owners of capital. As a result, not only were there incentives to not be “decent”, but often incentives were lacking for managers to deploy capital to greatest effect. They were playing with other people’s money.
The condition of trying to receive something of value that exceeds a person’s interest and/or capacity to give something of comparable value in return, is called rent-seeking by economists. Rent-seeking is defined as, “The expenditure of resources attempting to enrich oneself by increasing one’s share of a fixed amount of wealth rather than trying to create wealth” (Wikipedia).
Such activities are unfair to other individuals because value is being taken, not exchanged. Rent-seeking also harms society as a whole: “Since resources are expended but no new wealth is created, the net effect of rent-seeking is to reduce the sum of social wealth.”
Unfortunately for investors, the investment business is especially vulnerable to rent-seeking behavior. This happens because investment services are often hard to evaluate and of dubious value. As a result, it is extremely difficult for owners of capital to judge with certainty as to whether their capital is being deployed effectively or simply being reallocated to their advisor.
A recent Financial Times article by Pauline Skypala highlights the dilemma: “The basic problem [of the savings and investment industry] is blatant disregard for customers’ or society’s interest. Go to any conference and there is little if any discussion of how to serve customers better, but lots on how to make more money out of them.”
Interestingly, Skypala differentiates between employees and organizations: “The individuals running money no doubt believe they are doing the best they can for their customers, but the machine they work within means however well they do, most of the rewards will accrue to the industry rather than the people it purports to serve.”
One answer to the shortcomings of capitalism, then, is fleshed out by the criticisms: Change the “machine”. That is exactly what Arete is trying to do in our world of investing. We work hard deploying our expertise and we charge very reasonable fees to do it. We try to get the biggest bang for our clients’ investment bucks so they will be better off. We have no delusions that we will siginficantly improve capitalism or the economy on our own, but we will give a number of investors the choice of getting a much better deal than they have had.
Business Update
The end of the year is often a time for reflection for me and all the more so with Arete’s fourth anniversary. A lot of things have changed since Arete was founded so I have been revisiting the marketing plan and re-examining conditions and assumptions.
Clearly, the seminal event since Arete’s inception was the financial crisis of 2008 .2009. While I was certainly aware of the potential for a market decline at the time (periodic declines are inherent to the business), I was especially surprised by the reactions of others.
Most notably, I was surprised by what can only be described as panic by many investment “professionals.” Panic, and its subsequent trauma, caused some institutions to withdraw from the markets by reducing equity exposure, and caused others to increase risk by seeking hedge funds, alternative investments, and emerging markets exposure. In both cases, interest moved away from core U.S. equity strategies where Arete currently focuses. Despite substantial empirical evidence favoring the performance of smaller managers, institutional interest was further diverted by a heightened perception of risk.
I still feel very strongly that Arete’s investment philosophy and strategy are well-suited to many institutions, but the reality is I have limited resources and this is not the best group for me to focus my energy on right now. As a result, I have been shifting relatively more of Arete’s business development efforts to individual investors.
This incremental shift to individuals has been extremely easy because the original value proposition started with me. I knew once I graduated from college that I would need to not only work hard but also to invest well in order to improve my station in life. I knew it would be important to take risks in order to get ahead, but I also knew they had to be smart risks because I couldn’t afford to lose much. These ideas form the foundation of Arete’s value proposition.
Interestingly, while the investment industry has been very good in providing me a forum to develop and refine my craft, it has been substantially bereft of investment products or services that meet my own demands for functional excellence. I believe the single biggest reason for this deficiency is that today’s investment industry was built on the coattails of booming markets. Adapting to that environment, the most successful firms actively pursued asset growth at the expense of investment quality and cost control. Because investors were also making a lot of money, there was little pushback on inefficient and ineffective practices.
Eventually, my skills grew great enough that I thought I could offer a better value to investors (including myself!) than could most competitors by starting Arete on my own. The formula is simple: I focus on the aspects that matter most for long-term investment success and make concessions on other aspects. For example, I focus on investment philosophy and process, and I actively manage costs, but I restrict marketing efforts to only the most cost-effective ways to convey information.
I have no delusions that Arete’s proposition is perfect; it is not. For certain, it requires a certain amount of effort on the part of investors to meet me halfway in learning about our services by reviewing our website, our newsletters, and our Form ADV which describes many important aspects of the business. Those willing to make that effort, however, receive an investment service that punches way above its weight regarding analytical output and investor value.
Further, I think it is also important to note the Arete represents far more than just my conception of terrific investment value. I believe it also represents a great business opportunity.
This notion was strongly reinforced recently when I attended a conference for high net worth investing in Philadelphia. In her keynote presentation, Lisa Shalett, Chief Investment Officer for Merrill Lynch Global Wealth Management, described 2008 as far more than just a market correction, but a “global inflection point” for the investment industry.
She continued, “Out” are the days of gathering assets, adjusting risk exposure, and selling products. “In” are managing capacity at investment firms, managing and mitigating risk, and providing services that increase well-being. When I asked Lisa in the Q&A session how many incumbent firms she thought could make the transition, she answered, “Maybe a handful of firms can change their stripes and not be paralyzed by incumbency costs.”
This suggests that now is a great time for investors to start thinking which investment firms really are best placed to adapt to changing market conditions. If all but a “handful” of existing firms are unlikely to make the transition, there will be a very different playing field ten years hence; many existing firms won’t make it. While Arete is not perfect, it is designed for the new landscape and it will keep getting better with time. I like Arete’s chances!
On a separate note, I will also be increasing my efforts to find creative ways to leverage Arete’s strengths this year. From a business standpoint, it is clear to me that the best way to leverage Arete’s many strengths is to focus on them. The way to make that happen is to get help in other areas.
Importantly, I have always felt that working with others is more powerful and rewarding than working alone. Working with smart, interesting, insightful people is one of the many great pleasures of this business for me.
While I decided to start Arete alone, this was a sacrifice, not a preference. Now If you know of anyone who may have an interest in partnering with Arete in some capacity, please let me know! I would love to discuss the possibilities.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
The end of the year is often a time for reflection for me and all the more so with Arete’s fourth anniversary. A lot of things have changed since Arete was founded so I have been revisiting the marketing plan and re-examining conditions and assumptions.
Clearly, the seminal event since Arete’s inception was the financial crisis of 2008 .2009. While I was certainly aware of the potential for a market decline at the time (periodic declines are inherent to the business), I was especially surprised by the reactions of others.
Most notably, I was surprised by what can only be described as panic by many investment “professionals.” Panic, and its subsequent trauma, caused some institutions to withdraw from the markets by reducing equity exposure, and caused others to increase risk by seeking hedge funds, alternative investments, and emerging markets exposure. In both cases, interest moved away from core U.S. equity strategies where Arete currently focuses. Despite substantial empirical evidence favoring the performance of smaller managers, institutional interest was further diverted by a heightened perception of risk.
I still feel very strongly that Arete’s investment philosophy and strategy are well-suited to many institutions, but the reality is I have limited resources and this is not the best group for me to focus my energy on right now. As a result, I have been shifting relatively more of Arete’s business development efforts to individual investors.
This incremental shift to individuals has been extremely easy because the original value proposition started with me. I knew once I graduated from college that I would need to not only work hard but also to invest well in order to improve my station in life. I knew it would be important to take risks in order to get ahead, but I also knew they had to be smart risks because I couldn’t afford to lose much. These ideas form the foundation of Arete’s value proposition.
Interestingly, while the investment industry has been very good in providing me a forum to develop and refine my craft, it has been substantially bereft of investment products or services that meet my own demands for functional excellence. I believe the single biggest reason for this deficiency is that today’s investment industry was built on the coattails of booming markets. Adapting to that environment, the most successful firms actively pursued asset growth at the expense of investment quality and cost control. Because investors were also making a lot of money, there was little pushback on inefficient and ineffective practices.
Eventually, my skills grew great enough that I thought I could offer a better value to investors (including myself!) than could most competitors by starting Arete on my own. The formula is simple: I focus on the aspects that matter most for long-term investment success and make concessions on other aspects. For example, I focus on investment philosophy and process, and I actively manage costs, but I restrict marketing efforts to only the most cost-effective ways to convey information.
I have no delusions that Arete’s proposition is perfect; it is not. For certain, it requires a certain amount of effort on the part of investors to meet me halfway in learning about our services by reviewing our website, our newsletters, and our Form ADV which describes many important aspects of the business. Those willing to make that effort, however, receive an investment service that punches way above its weight regarding analytical output and investor value.
Further, I think it is also important to note the Arete represents far more than just my conception of terrific investment value. I believe it also represents a great business opportunity.
This notion was strongly reinforced recently when I attended a conference for high net worth investing in Philadelphia. In her keynote presentation, Lisa Shalett, Chief Investment Officer for Merrill Lynch Global Wealth Management, described 2008 as far more than just a market correction, but a “global inflection point” for the investment industry.
She continued, “Out” are the days of gathering assets, adjusting risk exposure, and selling products. “In” are managing capacity at investment firms, managing and mitigating risk, and providing services that increase well-being. When I asked Lisa in the Q&A session how many incumbent firms she thought could make the transition, she answered, “Maybe a handful of firms can change their stripes and not be paralyzed by incumbency costs.”
This suggests that now is a great time for investors to start thinking which investment firms really are best placed to adapt to changing market conditions. If all but a “handful” of existing firms are unlikely to make the transition, there will be a very different playing field ten years hence; many existing firms won’t make it. While Arete is not perfect, it is designed for the new landscape and it will keep getting better with time. I like Arete’s chances!
On a separate note, I will also be increasing my efforts to find creative ways to leverage Arete’s strengths this year. From a business standpoint, it is clear to me that the best way to leverage Arete’s many strengths is to focus on them. The way to make that happen is to get help in other areas.
Importantly, I have always felt that working with others is more powerful and rewarding than working alone. Working with smart, interesting, insightful people is one of the many great pleasures of this business for me.
While I decided to start Arete alone, this was a sacrifice, not a preference. Now If you know of anyone who may have an interest in partnering with Arete in some capacity, please let me know! I would love to discuss the possibilities.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
Market Overview
Most of our market observations from the past quarter remained very similar to those of the past two years. We saw extreme volatility in the markets and even more so in individual stocks. Most of this was related to the continuation of swings in “risk on” and “risk off” activity by market participants.
One manifestation of risk bifurcation has been record high correlations across stocks and asset classes. The perception seems to be that an asset either has risk or it doesn’t. Those perceived as risky, whether through being in a cyclical downturn, having a questionable balance sheet, or suffering short-term setbacks, have been punished disproportionately. It has often seemed as if these stocks get caught in the gravitational field of a black hole, never to return.
Conversely, stocks perceived as safe, such as those paying dividends, the larger companies with more diverse revenue streams, and those in defensive industries, seem to be given every benefit of the doubt. These stocks seem to continue to float effortlessly upward.
It is not unusual for such starkly delineated activity in markets to occur, but it is unusual for it to persist for so long. A recent paper entitled, “A Network Value Theory of a Market, and Puzzles,” by Robert Snigaroff and David Wroblewski, in the Financial Analysts Journal, goes a long way toward explaining this activity.
The authors begin by acknowledging the usefulness of discounting dividends to value shares. Their contribution is to demonstrate that including a component for network value to discounted dividends substantially increases the capacity to explain share prices. By using share turnover as a proxy for network value, they show the explanatory power of a combined model is more than twice as great as a dividend discount model alone.
The implications of this network value theory are significant. First and foremost, it goes a long way toward explaining the observation of some significant declines in individual stock prices, despite negligible changes in fundamental values. This phenomenon can occur when network value erodes, even though fundamental value does not. For example, fears regarding a stock’s economic exposure, liquidity, etc., may significantly reduce the number of potential buyers in the market. While the value of the network increases exponentially with incremental buyers and sellers, so too does it decline in a nonlinear fashion.
Insofar as network value theory is correct, it gives a strong indication of how dysfunctional markets are right now. As the number and diversity of market participants has dried up, it has had a disproportionately negative effect on the subset of under-appreciated stocks that, by definition, have fewer network connections. This has flown largely under the radar of major market indexes which are biased by market cap weighting.
As a result, we believe a number of extreme expectation disparities exist at the individual stock level. Indexes are dominated by large components with average performance and excessive valuations in many cases. While unsustainable, this quite possibly will not change until better alternatives become clear. On the other hand, several “at risk” stocks are excessively cheap, but will require increased buying interest from some source or sources.
Most of our market observations from the past quarter remained very similar to those of the past two years. We saw extreme volatility in the markets and even more so in individual stocks. Most of this was related to the continuation of swings in “risk on” and “risk off” activity by market participants.
One manifestation of risk bifurcation has been record high correlations across stocks and asset classes. The perception seems to be that an asset either has risk or it doesn’t. Those perceived as risky, whether through being in a cyclical downturn, having a questionable balance sheet, or suffering short-term setbacks, have been punished disproportionately. It has often seemed as if these stocks get caught in the gravitational field of a black hole, never to return.
Conversely, stocks perceived as safe, such as those paying dividends, the larger companies with more diverse revenue streams, and those in defensive industries, seem to be given every benefit of the doubt. These stocks seem to continue to float effortlessly upward.
It is not unusual for such starkly delineated activity in markets to occur, but it is unusual for it to persist for so long. A recent paper entitled, “A Network Value Theory of a Market, and Puzzles,” by Robert Snigaroff and David Wroblewski, in the Financial Analysts Journal, goes a long way toward explaining this activity.
The authors begin by acknowledging the usefulness of discounting dividends to value shares. Their contribution is to demonstrate that including a component for network value to discounted dividends substantially increases the capacity to explain share prices. By using share turnover as a proxy for network value, they show the explanatory power of a combined model is more than twice as great as a dividend discount model alone.
The implications of this network value theory are significant. First and foremost, it goes a long way toward explaining the observation of some significant declines in individual stock prices, despite negligible changes in fundamental values. This phenomenon can occur when network value erodes, even though fundamental value does not. For example, fears regarding a stock’s economic exposure, liquidity, etc., may significantly reduce the number of potential buyers in the market. While the value of the network increases exponentially with incremental buyers and sellers, so too does it decline in a nonlinear fashion.
Insofar as network value theory is correct, it gives a strong indication of how dysfunctional markets are right now. As the number and diversity of market participants has dried up, it has had a disproportionately negative effect on the subset of under-appreciated stocks that, by definition, have fewer network connections. This has flown largely under the radar of major market indexes which are biased by market cap weighting.
As a result, we believe a number of extreme expectation disparities exist at the individual stock level. Indexes are dominated by large components with average performance and excessive valuations in many cases. While unsustainable, this quite possibly will not change until better alternatives become clear. On the other hand, several “at risk” stocks are excessively cheap, but will require increased buying interest from some source or sources.
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