One could almost hear the collective “sigh” of relief as the market finally rebounded strongly in the second quarter after getting beaten up for two consecutive quarters. While the rebound has allowed us all to breathe a little easier, it now poses some very important questions.
These questions are deep and wide-ranging. For some, the role of equities in a diversified portfolio is being questioned now that their risk is all too apparent. Others are challenging the business processes that failed to identify numerous fraudsters and are asking what can be done to protect against such malfeasance. In short, these and many other questions suggest we are in the midst of the most thorough and fundamental re-evaluation of the whole investment business in at least twenty years.
As a result, we believe the industry is likely to undergo some significant changes over the next several years. One of those changes will be an ever-growing demand for transparency from money managers. In our effort to promote transparency, and to facilitate your evaluation of us, we publish and distribute the Arete Quarterly at the end of each quarter.
This newsletter serves as a compendium of “vital statistics” of Arete’s Mid Cap Core (AMCC) product including portfolio characteristics and performance. In addition, it provides important information and updates about the company and how we go about the process of managing portfolios. If you are interested, you can also find a great deal more information about us on our website at www.areteam.com.
As always, we appreciate your comments and suggestions regarding any aspect of the business which might make our services more useful to you. We hope you find our proposition compelling and always look forward to talking with you!
It has now been one year since Arete’s first portfolio was funded and what a year it has been! Not surprisingly, the timing of Arete’s inception often begs the question of whether the market turmoil has helped or hurt the business. This question also serves as an appropriate segue into an evaluation of the business environment over the past year and my expectations going forward.
First and foremost, the market turmoil and volatility has lengthened the sales cycle. All else equal, this obviously forestalls business development and pushes back the timing of the break-even point. The good news is that the actual marketing environment is falling well within the variety of scenarios considered in the startup business plan. In addition, the business has been built on the premise of tightly managing costs so the business is especially resilient to delays in revenue growth.
Perhaps the greatest effect of the turmoil has been on Arete’s competitive position relative to the rest of the industry. In this regard, I see several elements of the business environment that bode extremely well for the company.
First, while the market downturn has hurt revenue growth, it is important to note that it has also hurt everyone else in the business as well. Institutional Investor just reported that the top 300 money management firms had assets fall by over 23% last year. In fact, one industry veteran reported recently in the Economist that “as many as half the world’s asset managers are breaking even at best.”
The important issues, I believe, are who manages better through the downturn and who improves their competitive position? Regarding these issues, I firmly believe that Arete has a lower and more flexible cost structure than the vast majority of its peers. I also believe that advantage will be virtually impossible for most competitors to replicate. Some of these advantages are due to starting with a clean slate, some are due to establishing a clean and simple business model, and some are due to aggressively scrutinizing services for value. All of these advantages begin with the goal of saving money for investors and thereby creating an outstanding value proposition for them.
In addition to having an advantage with costs, Arete is also benefitting from weaker demand for talent across the industry. Many larger competitors, in order to better manage costs, are letting some of their people go. This is widespread across the industry. It also means that at exactly the same time when Arete is trying grow its business, a plethora of highly qualified analysts and internship candidates are available. I could hardly conceive a better environment for adding analytical personnel.
Finally, and I would argue most importantly, the way the market turmoil is helping the business is because it is spawning an almost universal re-evaluation of existing managers and the business as a whole. In times of low volatility and high returns, there is very little incentive to change things. Now however, investors are challenging incumbents and demanding value. There could hardly be a better environment to contrast the work ethic, fiduciary principles, transparency and passion for the business that exemplify Arete with the rampant conflicts of interest and excessive fees endemic to so many competitors.
I always enjoy talking about stocks, the business, and the market so if you are going to be in Baltimore, please stop by. I’d love to get together and talk about what Arete can do for you.
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
As we reflect back on the quarter, we saw two key causes for the market rebound. The most important, and the initial catalyst, was the improvement in financial institutions and markets. So much of the economic downturn was caused by the freeze in credit and collapse of confidence that it is not surprising improvements in the financial industry were an important precondition for recovery. As capital began flowing again, we also witnessed sprouting signs of economic recovery which further improved expectations, and therefore facilitated market recovery.
As we look at it, the defining moment of improvement occurred with the disclosure of the bank stress tests. The most important element of the bank stress tests was that they relieved the worst fears of massive insolvency and financial collapse, and therefore stanched the impending sense of panic. We believe the process of thoroughly reviewing the banks fundamentally changed attitudes towards the markets by providing legitimate assurance that the financial system was not going to break.
Although credit is still not easy to secure, nor available to all-comers, a number of improvements have been witnessed. For one, the TALF program restarted credit availability through securitizations. We witnessed this when CarMax was one of the first to participate in TALF with a securitization backed by auto loans in April. Improvement was also evident as many of the better firms were able to refinance tranches of debt on reasonably attractive terms. Many of the larger banks were even able to access to equity markets to raise capital.
The other element of market recovery was based on improving fundamentals in the underlying economy. As spring progressed, we gathered increasing evidence that the economy was no longer in free fall, and there were also a number of glimpses of things getting better. Improving credit markets provided more attractive mortgage rates which allowed for improvement in home sales in some areas as well as some refinancing activity. Consumer confidence responded in kind by leaping up from its nadir in the first quarter. Many companies, after aggressively managing inventories through the downturn, halted de-stocking when they saw hints of renewed, albeit moderate, revenue growth in a number of industries.
Where does this leave our opinion of market opportunities going forward? Our short-term outlook is that we still see a lot of attractive (and attractively priced) stocks, and therefore are reasonably optimistic about stock selection opportunities. While some semblance of normalcy has returned to the credit markets, in many cases the equity markets still seem to be discounting significant chances of default for some high quality companies. In addition, the market seems to be very cautious about discounting improving competitive positions at a number of companies. Finally, there is still about $3.7 trillion in money market funds that sooner or later will migrate to investments that generate higher returns.
Our positive short-term outlook is moderated by a number of risks though. First, it is no secret any more that consumers need to reduce their debt and that is likely to take several years to accomplish. Despite this arithmetic necessity, the market still seems surprised when retailers and other consumer spending beneficiaries fall short of revenue estimates. This is not a good sign that the market has fully digested and discounted the weakened financial state of the U.S. consumer.
This raises a couple of other concerns. One is that many business leaders and politicians are managing to levels of growth that we are unlikely to attain. Companies that aim break-even levels too high are unlikely to find forgiving creditors when proven wrong. Second, the very idea of a weak consumer is a different paradigm for thinking about U.S. economic growth. How will consumer spending habits change? Who or what will replace the consumer as the growth engine of the economy? Nobody knows the answers to these questions yet. Until sources of incremental growth emerge, we will be faced with a level of uncertainty we haven’t known in the markets for quite some time. Not trivially, lower growth rates during the interim will increase the premium on managing risks well, because there will be far fewer opportunities to recover losses.
Longer-term, we are still extremely bullish on U.S. Mid Cap stocks. Regarding attractiveness of U.S. markets, we remain strong believers in the quality and nature of U.S. government, institutions, and entrepreneurial culture. Short-term glitches aside, property rights, the rule of law, and capitalism function as well or better here than anywhere else in the world. These characteristics bode extremely well for the economy’s efficiency and resilience, and are critical for long-term success. In addition, mid caps now, as much as ever, seem to be in the sweet spot of being at the forefront of very attractive markets and growth opportunities, but large and experienced enough to manage through difficulties in professional and effective manner.
Our strong belief in U.S. stocks deserves mention especially relative to much popular opinion that emerging markets deserve a significantly higher allocation in a diversified portfolio. We believe this conventional view understates two important points. The first point is that U.S. stocks are not uniformly exposed to the U.S. economy and therefore not equally vulnerable to expectations of weaker consumer spending. The conventional view of emerging market exposure hugely understates the vast and diverse businesses many U.S. companies have abroad which represent very real economic exposures to emerging economies.
We believe the conventional view of emerging market exposure also significantly understates the risks associated with immature markets in developing countries. Absent robust governments, strong laws and enforcement, and cultural respect for efficiency, markets simply don’t work as well. Immature markets can be subject to a whole host of risks including liquidity constraints, arbitrary rule-setting, and nationalization. In short, emerging markets are generally (still) far riskier than U.S. markets.
We provide such a lengthy overview for a couple of reasons. Certainly we want investors and prospects to understand how we view market opportunities so we can be evaluated for appropriateness. Due to the significant changes we see in the market, however, we believe it is also extremely important to fully appreciate that the markets of the future may look quite a bit different than what most of us are familiar with. Therefore, while we remain optimistic about short-term opportunities and the long-term future, the path between the two may be a lot different, and sometimes less enjoyable, than what we have become accustomed to.