Cyclical Opinions – Secular Approaches

Two complementary approaches to structuring large equity portfolios

November 10, 2016 | François Sicart
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Technological progress makes the world evolve and change. As it does, Sicart Associates believe that the secret to success is to occasionally adapt opinions to changed circumstances while staying true to our long-term contrarian value investment principles.

 The obsolescence of Ben Graham’s simple value formula

The first time I personally had to reassess previously acquired “certainties” about investing was in the early 1980s.

The pope of value investing — the discipline in which I was educated and mentored — was Benjamin Graham. In the aftermath of the Great Depression, he had pointed out that many companies could be bought for less than their immediate liquidating value, or “net working capital”, a figure that Graham defined very conservatively as current assets (cash, inventories and receivables) less all liabilities.           

If the relevant companies’ accounting methods were honest and conservative, there was no need to make assumptions about future sales, earnings or management quality: you were buying the company for the net value of its readily saleable assets and got everything else (property, machinery, patents, and future growth) for free. What’s more, in markets where information circulated less efficiently and cheaply than today, such undervalued shares were not rare.

However, in the early 1980s all this changed irreversibly. With the advent of cheap computing power and the development of massive databases of corporate financial data, it became possible to screen thousands of companies and, in minutes, to come up with those selling at or below Graham’s definition of net working capital.

Efficient markets responded quickly to this technological breakthrough. In short order the only companies selling below their published net working capital were ones with blemishes or problems that could only be uncovered in the footnotes to the annual reports. Value investors had to resort to other criteria, which often involved making assumptions about the future (growth of sales and earnings, appreciation or obsolescence of assets, etc.).

The (seemingly) inexorable rise of indexing

Today, another technological development may require us to abandon some of our preconceived ideas about portfolio construction – at least cyclically.

The world’s first index mutual fund was created as early as 1975 by John Bogle, the outspoken founder of The Vanguard Group. His idea was that low-cost funds that merely mimicked a benchmark index’s performance over the long run would still outperform many mutual funds simply because of their lower fees. That argument was reinforced by empirical evidence that, over long time frames, very few “active” investment managers had bested or even matched the performance of the leading stock market indexes.

All the same, index investing was slow to gain acceptance and I, too, was highly skeptical at first. Not only was I convinced of the superiority of the value investing discipline on both theoretical and logical grounds, but some of the most successful long-term investors had vindicated that discipline by outperforming the indexes over their full careers.

The problem with indexing, or passive investing, is that it is a form of momentum investing: buying more of what has been going up. This not only disregards valuation, which I believe is key to investment performance, but it could even be considered an anti-value discipline.

Indexing can be beneficial in the early stages of a rising market, when the large companies making up the indexes often outperform the broader markets. But indexing offers no protection in falling markets. In fact it may literally become a bubble factory where yesterday’s stars quickly become tomorrow’s duds. This dynamic is illustrated by the recent extreme example of bond market ETFs (or exchange-traded funds):

Most bond indexes are weighted according to how much debt a company or country has issued. Thus, the more indebted an issuer becomes, the bigger share it will occupy in the index, and the more of its debt passive (or index) funds will be required to buy. This is how many funds loaded up on Argentine debt just before the country’s 2012 default crisis.

Nevertheless, during the 1990s, improved computing and networking technologies allowed large institutions to build portfolios that mimicked major market indexes easily and very cheaply. Since then, such passively managed funds, including exchange-traded funds and index funds, have become increasingly popular: in just the six years to 2015, for example, they grew 73% in size to represent 19% of global assets under management.

The situation for equities alone is similar: most stock indexes are weighted according to market capitalization, so that the more expensive a company’s stock price becomes relative to the market, the more index-trackers will be required to buy of it, regardless of valuation.

Closet indexers: If you can’t beat them, imitate them

Today, U.S. equity index funds alone are estimated to total $4 trillion. But the actual amount of money influenced by the major indexes may actually be much higher: some studies have shown closet indexers to represent as much as 60% of active funds. (S&P Global, September 2016 and Philosophical EconomicsMay 1, 2016)

A growing number of investment managers who still claim to exercise their judgment in the selection process are in fact jumping on the indexing bandwagon by including in their portfolios the most influential stocks from their benchmark index. They are commonly referred to ascloset indexers.

Perhaps the index most widely used by consultants for both portfolio indexing and as a performance benchmark is the Standard &Poor’s 500 index. However, out of the 500 mostly US companies in the index, the largest 50 account for nearly half the index’s total value. Just 100 companies make up almost two-thirds of that total. The stock prices of the other 400 companies have far less influence on the index, even though the smallest one has a market capitalization in excess of $2 billion.

Thus it is fairly easy for closet indexers to nearly mimic the performance of the S&P 500 index with a portfolio of only 50-100 stocks. There is growing evidence that this is what many portfolio managers have been doing, consciously or not, under pressure from marketing departments and statistical consultants.

Currently, the exodus from active towards passive management is still gaining momentum. Only 9.5 percent of actively managed large-cap domestic equity funds beat the S&P 500 Index in the five years ended Aug. 31. That’s the worst five-year performance since 1999, according to Morningstar Inc. As a result, about 3,000 actively run funds saw redemptions of $422 billion over five years, while passive vehicles attracted $480 billion.

In a vicious circle, these flows boost the prices of the stocks included in the indexes and tend to depress those that are not, making it difficult for active managers to outperform the indexes – at least until the indexing bubble bursts.

The Lehman epiphany: Macro counts

In my judgment, through the major cycles punctuating my investment career, the contrarian value discipline has performed satisfactorily. The timing is never perfect. Value investors tend not to participate fully in the most ebullient bull markets, when clients wish for more performance, though they also tend to give back less when markets correct significantly. Overall, though, one can argue that the value discipline outperformed other disciplines over the long term.

But the bear market of 2007-2009 changed this. Two main realizations were shared by some of the most thoughtful value investors.

One was that the modern financial system had become so closely layered into the “real” economy that major financial earthquakes (such as the bursting of the sub-prime lending bubble and the Lehman Brothers’ failure) had the potential to trigger deep and durable domino effects. Deservedly or not, practically every type of share was sucked down in the 2007-2009 whirlpool, including so-called “value stocks.” As a Morningstar Hall of Fame mutual fund manager told me in the aftermath: “Maybe we did not pay enough attention to the macro side of things.”

The other realization was that the old adage “Don’t fight the Fed,” which had in the past applied mostly to short-term traders, was now worth heeding by serious fundamental investors as well. This was the result of policies initiated by the Greenspan Federal Reserve, later emulated and reinforced by the Bernanke and Yellen Federal Reserves and more recently adopted by other major central banks. The new policy idea is that because of the increased interdependence between finance and the real economies, it is prudent to give monetary policy a stimulating bias as soon as the behavior of the stock markets give an early, ominous signal.

Unfortunately, pumping money into the economy does not guarantee that the banking system will lend it – or that consumers and businesses, made prudent by the previous recession, will want to borrow. Before newly-released central bank money finds its way to investment in new equipment or even consumer durables,  the money tends to be parked in the financial markets, boosting bond and stock prices.

Since the still-fragile global economies have responded only hesitantly since the Great Recession to the stimulus from central banks, newly “printed” money has continued to flow to the bond and stock markets in the last few years. It has artificially prolonged the bull markets started in 2009, and created the apparent paradox of lukewarm economies and booming stock markets. The result? Investor complacency.

Charles Mackay observed in his 1841 classic Extraordinary Popular Delusions and the Madness of Crowds:

“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their sense slowly, and one by one.”

There is little doubt in my mind that passive investing, despite all its obvious mechanical advantages, exaggerates the natural tendencies of crowd behavior. Keeping this in mind, our challenge is to reconcile

  • our medium-term opinions about the recent trend toward indexing, the role of central banks and the desirability to allocate among at least a few major foreign markets and cash reserves.
  • our long-term principle that the contrarian value approach is more likely to be successful when applied to companies less prominent than the large “usual suspects” followed by a majority of analysts and managers. These less-popular companies are where markets are less efficient and where mispricing thus is more likely to occur, creating investment opportunities for value investors.

Wealth creation is a long-term process

I have examined the performance of various portfolios over several decades and observed that, as the number of investments and of managers or sub-managers increased over the years, the portfolio performances tended to become increasingly similar to those of the leading stock market indexes.

Typically, early performance — when portfolios presumably were smaller and more concentrated, and the markets less efficient — tended to be a little better, whereas in later years, when indexing and closet indexing became major influences on the markets, portfolio performances tended to marginally trail the indexes.

This reminds us of the importance of the long term in wealth creation, as well as of the force of compounding. It also points to the cost of underperforming, even by a small margin, over long periods.

To take an un-spectacular example: If a $10 million portfolio earns, on average, 5% per annum, it will grow to $26.5 million in 20 years and to $70.4 million in 40 years. If the same portfolio grows at 5.5% per annum (only half of one percent faster), it will become $29.2 million in 20 years ($2.6 million better) and $85.1 million in 40 years ($14.7 million better).

To be better, one must be different. We believe the dual strategy outlined below may satisfy both our medium-term and our long-term requirements. Combining macro and micro approaches should allow a large portfolio to outperform most competing portfolios without diverging excessively from the behavior of the overall market.

Approach one: contrarian macro

In a February 2015, white paper (“Is Skill Dead?”), Neil Constable and Matt Kadnar of GMO showed that active large-cap managers who outperform the S&P 500 (at least for a while) tend to owe their performance to holdings, not of broadly-owned, familiar stocks, but of foreign equities, small-caps, and cash.

There is a logic behind this observation. As a group, S&P 500 companies included in a portfolio tend to perform similarly to a S&P 500 index fund, and the same can be inferred for portfolios that hold only the largest companies in the index.

Indexers and closet indexers can thus hope to modestly outperform their overall benchmark during periods when the purchasing associated with indexing boosts the prices of these 50-100 companies. However, over the longer term, indexing will do exactly what its name promises – produce not much less than the index, but no more.

Since our cyclical view is that indexing has become too popular to fit our preferred contrarian approach, we suggest a complementary discipline:

The selection of a few indexed, regional portfolios that would have reasons to be uncorrelated with each other (if only because of currencies) and a very few portfolios of industries where companies have reasonably homogenous behavior, especially if unweighted indexes can be utilized (agricultural and industrial commodities, biotech, etc.).

Such a “macro portfolio” would be rebalanced only rarely, when it is determined that some sectors have benefitted excessively from irrational exuberance or, on the contrary, have been unduly punished by the emotional investor consensus. Significant cash reserves would also be included in that portion of one’s investments for prudential/liquidity reasons as well as to facilitate the occasional rebalancing.

If the new realities of the market and the makeup of its familiar benchmark indexes make it difficult for a large, diversified portfolio to materially outperform “the market,” a macro portfolio of indexed funds with a contrarian bias, which would be re-balanced only rarely, seems sensible. At the very least, that portion of the overall portfolio should incur lower costs than the actively managed part.

Approach two: To win over the long term, pick your battle ground

As indexing becomes more prevalent and tends to shape the behavior of the investment crowd, a manager wishing to outperform over the longer term must look beyond the largest companies populating the leading indexes.

Commercial logic dictates that fewer brokerage analysts follow smaller or more distant companies than follow larger domestic ones with liquid and actively traded shares. The consequence is that markets for less institutionally-popular companies are also less “efficient.” Thus mispriced, undervalued shares are easier to find within that segment of the investment universe, opening up the potential for superior gains. In my view, a significant portion of a large portfolio should thus also be devoted to stock-picking within this more fertile universe.

Our potential advantage in that quest is our chosen time horizon. Most analysts, again for commercial reasons, have a horizon of at most two years. In contrast Sicart Associates focuses on companies’ prospects over three years or more.

Investments selected with that approach typically will not behave in sync with the cycles of the overall market. But this is as it should be when a portfolio results from individual, bottom-up choices, and it should not matter much to investors seeking wealth creation over the long term.

François Sicart – November 3, 2016

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