| Arete Quarterly Q212 |
Welcome
There are so many issues and options to consider when it comes to investing, it can overwhelm even the most diligent of souls. We believe we have a fairly decent understanding of the multitude of challenges facing investors partly because we study them: We attend conferences, read surveys and research, and listen to investors. Perhaps the most pervasive feeling we have heard expressed is that of what investors don’t want — which is more of the same.
Indeed, a recent Gallup poll showed that stockbrokers (the professional group listed most closely related to investing) ranked near the bottom regarding perceptions of ethics and integrity. Only 12% of participants ranked the ethics of brokers as “very high” while 40% ranked them as “very low”. Brokers ranked on a par with telemarketers, car salespeople and lobbyists. The highest rank went to nurses and the lowest rank went to members of Congress.
Arete was created to provide an antidote to “more of the same.” We do this first and foremost by putting the interests of our clients first. As a result, we tend to talk in terms of solving problems and satisfying needs rather than increasing assets under management or adding distribution platforms. While it is important to grow the business, we want to do it in a way that retains its intense focus on serving investors.
In our efforts to help solve what we broadly label the “investment challenge” for people, many of the unique characteristics of Arete become clearer. For example, many people are surprised to hear that as an active manager, we recommend the use of passive investment vehicles in many situations. We also discuss basic criteria for evaluating money managers in our Arete Insights newsletter.
We do this partly because we believe it is important to share some of our knowledge of the industry with investors whether they decide to become clients or not. Ultimately, there is far greater collective good (and less waste!) if everyone ends up with the investments and services that are best suited to them so as to solve their specific investment challenges.
We also do this partly because it serves Arete’s interest. Arete’s proposition (really that of every investment service) works best when clients fully understand and appreciate the strategy and its implications. Because Arete provides a niche service — active management of mid cap stocks — it is only appropriate for certain types of investment situations. We don’t want to dilute the value proposition for exisiting clients by chasing assets and clients who don’t fit well. Eliminating confusion allows us to focus on what we do best.
We also believe that providing investor education regarding manager selection serves our interest in that better informed investors will have a much greater appreciation for all of the great things Arete does. When addressing the investment challenge, there are so many factors to consider and so many half-truths proffered that it is easy to get distracted or to give up altogether. Well-informed investors can better help themselves, and are also good for Arete.
In the end, a big part of what distinguishes Arete is that we aren’t trying to build a really big firm. Historically size has been a much more common priority largely because it makes people richer. We are much more interested in building a firm of outstanding quality — and that changes almost everything.
There are so many issues and options to consider when it comes to investing, it can overwhelm even the most diligent of souls. We believe we have a fairly decent understanding of the multitude of challenges facing investors partly because we study them: We attend conferences, read surveys and research, and listen to investors. Perhaps the most pervasive feeling we have heard expressed is that of what investors don’t want — which is more of the same.
Indeed, a recent Gallup poll showed that stockbrokers (the professional group listed most closely related to investing) ranked near the bottom regarding perceptions of ethics and integrity. Only 12% of participants ranked the ethics of brokers as “very high” while 40% ranked them as “very low”. Brokers ranked on a par with telemarketers, car salespeople and lobbyists. The highest rank went to nurses and the lowest rank went to members of Congress.
Arete was created to provide an antidote to “more of the same.” We do this first and foremost by putting the interests of our clients first. As a result, we tend to talk in terms of solving problems and satisfying needs rather than increasing assets under management or adding distribution platforms. While it is important to grow the business, we want to do it in a way that retains its intense focus on serving investors.
In our efforts to help solve what we broadly label the “investment challenge” for people, many of the unique characteristics of Arete become clearer. For example, many people are surprised to hear that as an active manager, we recommend the use of passive investment vehicles in many situations. We also discuss basic criteria for evaluating money managers in our Arete Insights newsletter.
We do this partly because we believe it is important to share some of our knowledge of the industry with investors whether they decide to become clients or not. Ultimately, there is far greater collective good (and less waste!) if everyone ends up with the investments and services that are best suited to them so as to solve their specific investment challenges.
We also do this partly because it serves Arete’s interest. Arete’s proposition (really that of every investment service) works best when clients fully understand and appreciate the strategy and its implications. Because Arete provides a niche service — active management of mid cap stocks — it is only appropriate for certain types of investment situations. We don’t want to dilute the value proposition for exisiting clients by chasing assets and clients who don’t fit well. Eliminating confusion allows us to focus on what we do best.
We also believe that providing investor education regarding manager selection serves our interest in that better informed investors will have a much greater appreciation for all of the great things Arete does. When addressing the investment challenge, there are so many factors to consider and so many half-truths proffered that it is easy to get distracted or to give up altogether. Well-informed investors can better help themselves, and are also good for Arete.
In the end, a big part of what distinguishes Arete is that we aren’t trying to build a really big firm. Historically size has been a much more common priority largely because it makes people richer. We are much more interested in building a firm of outstanding quality — and that changes almost everything.
Business Update
When I founded Arete, one of the aspects of running a business that surprised me a bit was just how many decisions there were to make. Virtually each decision involves a tradeoff of competing pros and cons, opportunities and risks. The magnitude of these tradeoffs was far greater than anything I had ever experienced before. Indeed one of the bigger challenges I face now is figuring out how to best apply thoughtful and well-intended advice that sometimes does not fully incorporate the multiplicity of tradeoffs I face as a business owner.
One huge tradeoff I made occurred when I founded Arete. It involved what I call the “classic conundrum” of money management: Which comes first, the money or the business? After all, you need a fair amount of money under management to pay the bills for several years while establishing a track record. But how do you get the money before the business?
Since I didn’t have access to a big chunk of money, I took the somewhat unusual and risky path of founding Arete first and building the business from scratch. I did this partly because I was convinced, based on my skills and historical experience, that I would be able to continue generating good (and perhaps very good) performance and that would be allow me to build a sustainable business. I just needed a chance to show my stuff.
I also felt strongly that there was an opportunity to completely rethink the cost structure of a serious research effort and to reset it lower. By seriously scrutinizing the value of many services, remaining frugal with existing services, leveraging technology, and simply passing on many of the substantial reductions in operating costs that have occurred over the past twenty years, I thought I could keep expenses low enough to buy me the time to grow. It also helps that I am uniquely capable of doing nearly every job myself and don’t pay for many outside services.
The good news is that much of this has worked. Technology has reduced baseline operating costs and vastly increased the opportunities to manage knowledge well and cheaply. The less good news is that it is still very difficult to grow a money management business from scratch. Investors still often equate size with quality and security despite much evidence to the contrary.
As a result, the evidence still favors the path that one must have money in order to start a money management firm. It is interesting, though, that this path creates an enormous barrier to entry for firms that want to challenge the status quo. In a time of growing dissatisfaction with transaction-based business models, conflicts of interest, excess compensation, and insufficient security, how long can this last?
Arete offers an antidote to the status quo, but it comes with a tradeoff. I have created an investment service that combines a robust investment philosophy and process with many of the best features and safeguards in the business and all for a very fair price. The only tradeoff is that all of this comes in the package of a small firm. If you or someone you know is looking for something different, please let me know.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
When I founded Arete, one of the aspects of running a business that surprised me a bit was just how many decisions there were to make. Virtually each decision involves a tradeoff of competing pros and cons, opportunities and risks. The magnitude of these tradeoffs was far greater than anything I had ever experienced before. Indeed one of the bigger challenges I face now is figuring out how to best apply thoughtful and well-intended advice that sometimes does not fully incorporate the multiplicity of tradeoffs I face as a business owner.
One huge tradeoff I made occurred when I founded Arete. It involved what I call the “classic conundrum” of money management: Which comes first, the money or the business? After all, you need a fair amount of money under management to pay the bills for several years while establishing a track record. But how do you get the money before the business?
Since I didn’t have access to a big chunk of money, I took the somewhat unusual and risky path of founding Arete first and building the business from scratch. I did this partly because I was convinced, based on my skills and historical experience, that I would be able to continue generating good (and perhaps very good) performance and that would be allow me to build a sustainable business. I just needed a chance to show my stuff.
I also felt strongly that there was an opportunity to completely rethink the cost structure of a serious research effort and to reset it lower. By seriously scrutinizing the value of many services, remaining frugal with existing services, leveraging technology, and simply passing on many of the substantial reductions in operating costs that have occurred over the past twenty years, I thought I could keep expenses low enough to buy me the time to grow. It also helps that I am uniquely capable of doing nearly every job myself and don’t pay for many outside services.
The good news is that much of this has worked. Technology has reduced baseline operating costs and vastly increased the opportunities to manage knowledge well and cheaply. The less good news is that it is still very difficult to grow a money management business from scratch. Investors still often equate size with quality and security despite much evidence to the contrary.
As a result, the evidence still favors the path that one must have money in order to start a money management firm. It is interesting, though, that this path creates an enormous barrier to entry for firms that want to challenge the status quo. In a time of growing dissatisfaction with transaction-based business models, conflicts of interest, excess compensation, and insufficient security, how long can this last?
Arete offers an antidote to the status quo, but it comes with a tradeoff. I have created an investment service that combines a robust investment philosophy and process with many of the best features and safeguards in the business and all for a very fair price. The only tradeoff is that all of this comes in the package of a small firm. If you or someone you know is looking for something different, please let me know.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
Market Overview
Over the second quarter, we have seen the continuation of relatively low market volatility (as measured by VIX), relatively high market valuations, and the confluence of several significant risk factors. The simultaneous presence of these conditions speaks to just how bizarre the current market environment is.
Corroborating our assessment, the headline, “Yield record in Treasury sale” was recently emblazoned across an article in the Financial Times, giving further indication of the massive demand for “risk.free” investments. At the same time, the S&P 500, although down modestly in the last few months, is still within clear sight of the record peak of 2007. The evidence that record risk aversion can occur simultaneously with near-record risk-seeking speaks to these unusual times.
What does all this mean? For one, we believe it signals the degree of excesses in virtually all markets now. Ten year Treasury yields don’t even cover current inflation expectations, let alone the distinct possibility inflation could be much higher in ten years. It’s not hard to conclude there are excesses in the bond markets.
The stock market has its own version of excesses. It is currently bifurcated into two distinct groups. One is a group of cyclicals and companies which have missed earnings estimates. Many of these are selling at or below the levels of the liquidity crunch of the financial crisis. Many are at fractions of book value. In aggregate, most of these are quite viable long-term businesses that are excessively cheap right now.
The other group includes larger companies, more defensive businesses, and high dividend payers. These are perfectly reasonable investments for a weak economy, but only at reasonable prices. Many of these stocks are selling at record highs, despite valuations that imply ever-increasing growth and profitability.
We believe this unusual landscape can be explained in a couple of ways. We know that one of the really big economic problems is too much debt. Longer term, the only reasonable outcome is for debt (relative to income and assets) to be reduced significantly.
The Fed recognizes this problem and is trying to ease the pain of retrenchment through monetary easing. This provides a short-term boost to certain asset prices at the expense of future appreciation. As such, it also provides an opportunity for traders and managers to take the Fed’s bait and buy stocks in the face of significant risks. In doing so, they are accepting a short-term game of guessing incremental monetary policy and chasing performance. Longer term, economics and fair valuation will prevail.
Another possible explanation for the unusual landscape is that investors are responding to various risks by buying insurance. Due to escalating concerns about disparate risks, more and higher-priced insurance is being purchased. Some market participants may be buying stocks near record highs as protection against further monetary easing and future inflation. Treasuries are purchased to protect against the imminent threat of deflation as the economy appears to be cooling again.
While the idea of buying insurance makes sense in many situations, the idea of paying ever-higher prices for it defeats the broader goal of protection by eroding capital through premium payments. We believe this partly explains the rush for gold and commodities as well. We also believe investors pursuing this strategy will pay for their excesses.
What might cause this unusual environment to change? Judging by current practices of managing to short-term conditions irrespective of long-term consequences, one distinct possibility is that it will end with a significant market dislocation not dissimilar to Lehman Brothers, a “Thelma and Louise moment,” if you will. This would be really bad for people chasing performance in the stock market and without any spare cash. It would also likely to be painful for index investors who will have no protection and no chance to react.
It is also certainly possible (and preferable) for a more orderly transition to take place, but some important things would have to change. Primarily, the pricing mechanism of the markets would have to improve and that will only really happen when long-term capital is attracted to the opportunities.
This can happen in a variety of ways. It could happen in the form of earnings and cash flows coming in better than the absolutely dismal expectations priced into cyclical and other value stocks. This may give long-term investors enough incremental confidence in the cash flow streams they are purchasing. Of course any constructive dialogue regarding the country’s debt and deficit issues would be enormously beneficial as well. The good news is that plenty of cash is available when the conditions are right.
How long might it take for these changes to emerge? An optimistic view is that value has underperformed for years now and the pendulum is due to swing back, perhaps as soon as with this quarter’s earnings reports. Even short of a broad swing, there are pockets of valuation succeeding that can be captured in a concentrated portfolio.
A particularly pessimistic view is expressed by Jamil Baz, the chief investment strategist at GLG Partners. He wrote recently in the Financial Times, “[Since] deleveraging has not even started yet, the crisis of the world economy has not begun either.” He continues, “It [the investment situation] is hopeless in that virtue is not likely to be rewarded for a generation.” We’re not this pessimistic, but we are well aware that this dour assessment is distinctly possible.
Either way, it is clear that these market conditions warrant a great deal of caution and diligence. It will be extremely important to be patient and wait for attractive opportunities. As tempting as it may be to just wait things out by holding cash, this strategy bears the potential cost of lost opportunity. It will also be important to continuously gauge the tradeoff in risks between action and inaction.
It will also be important to differentiate between the market indexes and active strategies. Passive funds have benefitted from Fed policy actions, high correlations, and strong inflows. The structural bias of most indexes to overweight overpriced stocks further exacerbates these trends. When any of these factors change, active funds will be far better placed to exploit stock-specific opportunities.
Over the second quarter, we have seen the continuation of relatively low market volatility (as measured by VIX), relatively high market valuations, and the confluence of several significant risk factors. The simultaneous presence of these conditions speaks to just how bizarre the current market environment is.
Corroborating our assessment, the headline, “Yield record in Treasury sale” was recently emblazoned across an article in the Financial Times, giving further indication of the massive demand for “risk.free” investments. At the same time, the S&P 500, although down modestly in the last few months, is still within clear sight of the record peak of 2007. The evidence that record risk aversion can occur simultaneously with near-record risk-seeking speaks to these unusual times.
What does all this mean? For one, we believe it signals the degree of excesses in virtually all markets now. Ten year Treasury yields don’t even cover current inflation expectations, let alone the distinct possibility inflation could be much higher in ten years. It’s not hard to conclude there are excesses in the bond markets.
The stock market has its own version of excesses. It is currently bifurcated into two distinct groups. One is a group of cyclicals and companies which have missed earnings estimates. Many of these are selling at or below the levels of the liquidity crunch of the financial crisis. Many are at fractions of book value. In aggregate, most of these are quite viable long-term businesses that are excessively cheap right now.
The other group includes larger companies, more defensive businesses, and high dividend payers. These are perfectly reasonable investments for a weak economy, but only at reasonable prices. Many of these stocks are selling at record highs, despite valuations that imply ever-increasing growth and profitability.
We believe this unusual landscape can be explained in a couple of ways. We know that one of the really big economic problems is too much debt. Longer term, the only reasonable outcome is for debt (relative to income and assets) to be reduced significantly.
The Fed recognizes this problem and is trying to ease the pain of retrenchment through monetary easing. This provides a short-term boost to certain asset prices at the expense of future appreciation. As such, it also provides an opportunity for traders and managers to take the Fed’s bait and buy stocks in the face of significant risks. In doing so, they are accepting a short-term game of guessing incremental monetary policy and chasing performance. Longer term, economics and fair valuation will prevail.
Another possible explanation for the unusual landscape is that investors are responding to various risks by buying insurance. Due to escalating concerns about disparate risks, more and higher-priced insurance is being purchased. Some market participants may be buying stocks near record highs as protection against further monetary easing and future inflation. Treasuries are purchased to protect against the imminent threat of deflation as the economy appears to be cooling again.
While the idea of buying insurance makes sense in many situations, the idea of paying ever-higher prices for it defeats the broader goal of protection by eroding capital through premium payments. We believe this partly explains the rush for gold and commodities as well. We also believe investors pursuing this strategy will pay for their excesses.
What might cause this unusual environment to change? Judging by current practices of managing to short-term conditions irrespective of long-term consequences, one distinct possibility is that it will end with a significant market dislocation not dissimilar to Lehman Brothers, a “Thelma and Louise moment,” if you will. This would be really bad for people chasing performance in the stock market and without any spare cash. It would also likely to be painful for index investors who will have no protection and no chance to react.
It is also certainly possible (and preferable) for a more orderly transition to take place, but some important things would have to change. Primarily, the pricing mechanism of the markets would have to improve and that will only really happen when long-term capital is attracted to the opportunities.
This can happen in a variety of ways. It could happen in the form of earnings and cash flows coming in better than the absolutely dismal expectations priced into cyclical and other value stocks. This may give long-term investors enough incremental confidence in the cash flow streams they are purchasing. Of course any constructive dialogue regarding the country’s debt and deficit issues would be enormously beneficial as well. The good news is that plenty of cash is available when the conditions are right.
How long might it take for these changes to emerge? An optimistic view is that value has underperformed for years now and the pendulum is due to swing back, perhaps as soon as with this quarter’s earnings reports. Even short of a broad swing, there are pockets of valuation succeeding that can be captured in a concentrated portfolio.
A particularly pessimistic view is expressed by Jamil Baz, the chief investment strategist at GLG Partners. He wrote recently in the Financial Times, “[Since] deleveraging has not even started yet, the crisis of the world economy has not begun either.” He continues, “It [the investment situation] is hopeless in that virtue is not likely to be rewarded for a generation.” We’re not this pessimistic, but we are well aware that this dour assessment is distinctly possible.
Either way, it is clear that these market conditions warrant a great deal of caution and diligence. It will be extremely important to be patient and wait for attractive opportunities. As tempting as it may be to just wait things out by holding cash, this strategy bears the potential cost of lost opportunity. It will also be important to continuously gauge the tradeoff in risks between action and inaction.
It will also be important to differentiate between the market indexes and active strategies. Passive funds have benefitted from Fed policy actions, high correlations, and strong inflows. The structural bias of most indexes to overweight overpriced stocks further exacerbates these trends. When any of these factors change, active funds will be far better placed to exploit stock-specific opportunities.
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