In the dawn, although I know

It will grow dark again,

How I hate the coming day.

                        Fujiwara No Michinobu

Buffett’s irreproducible edge

First, some addenda to last month’s comments, as there were a number of readers interested in private equity. One reader, whom I happened to agree with, identified Berkshire Hathaway as a private equity proxy, given that (a) Buffett is dealing with permanent capital with a true long-term time horizon, and (b) he has been clearly disciplined and dedicated to going where opportunities surface that others are inclined or required to ignore. It has actually been quite instructive to watch him complement his major holdings in Berkshire’s insurance businesses as well as the equity investments that he owned pieces of, such as American Express and Coca Cola, with the wholesale acquisition of an entire portfolio of what would have been smaller capitalization businesses, both public and private. His modus operandi was to acquire the entire company at a fair price of what he considered good businesses, leaving the managements in place. He was prepared to supply them with capital when appropriate. This was followed by his acquisition of entire large companies, such as Burlington Northern or Pacificorp when the opportunity was presented at a price that would meet a target hurdle rate on invested capital over time, and were in basically oligopoly situations.

I remember this well as a number of the smaller companies were ideas that had been put forward or owned as appropriate investments for some of the domestic funds we were running that were rejected or sold because they “did not move the needle.” This was the curse, even fifteen years ago, of sustained asset inflows, which made it difficult to purchase and own something like Dairy Queen, which was public at the time. This now plays out as style drift, as “small capitalization” now encompasses ideas up to $2B in market capitalization. “Mid-cap” arguably subsumes ideas all the way up to $12B in market capitalization. We note that few value funds other than Longleaf Partners own Scripps Network International but almost all large cap value funds have positions in Alphabet, Bank America, or Wells Fargo. In many instances there is a commonality of ownership, not just among them, but with some of the larger growth players as well (or GARP – Growth at a Reasonable Price players).

Now the larger fund managers cannot duplicate Buffett, as he has permanent capital to invest and they do not. And the counter-argument to investing in Berkshire at this point is that Buffett is in his eighties, so how much longer can things move as they have. There are however other private equity like businesses that are doing the same thing, albeit not quite yet with the history. They are all insurance holding companies such as Alleghany and Markel, who have the same luxury of permanent capital to invest, the float from their investment portfolios that they hold as a backstop to the claims-paying requirements of their businesses. And while they do not have Warren Buffett doing the investing, they have been managing to generate eight to ten per cent average compounded returns on tangible equity (book value) over time.

I will leave you in this section with these thoughts. Yes, there is only one Warren Buffett. And there are a number of mutual funds out there that have claimed to invest similarly (the Buffett clones) over the years. They use a method of deconstruction and reverse engineering, although it would appear they don’t invest the same way that he does. They are always a step or two behind in the evolution of the thought process. They also do not have a partner like Charlie Munger. Those who doubt his impact or acumen over the years should go dig out the annual reports and returns from The New America Fund, a closed-end fund run by Munger years ago. (Here’s a taste of what you’ll find.) Alternatively, they can read the annual reports from WESCO, before Berkshire bought it all in. A close friend who is a long-time observer of Mr. Buffett pointed out to me that it was a huge statement on his part when he spent the time at this year’s meeting that he did talking about Jeff Bezos and Amazon. That he would admit that he made a major mistake in not investing in Amazon is a major admission. So the evolution continues.

Drawdowns Ahoy?

Two cautionary pieces were published recently. The first was Advisor Perspectives an interview with Bob Rodriguez, in a piece entitled “We are witnessing the development of a perfect storm” (6/27/2017). Mr. Rodriguez retired from First Pacific Advisors at the end of 2016. He makes a compelling case that the actions of the Federal Reserve in keeping interest rates close to zero for so long have disrupted the normal functioning of the capital markets. Those markets have been distorted to the point that the only hope an active manager has of outperforming is by being invested in absolutely the right areas. If you were an absolute value manager, you would hold greater cash levels as the things you could or would invest in became fewer and fewer. Performance would lag and you would either be fired by your clients or retire.

Rodriguez further makes the point that active managers have not really added value to the process over the last twenty years. In the dot-com craze of 2000, active growth managers piled into the same names until they imploded, regardless of how speculative those investments were. Likewise, prior to the 2007-2009 financial crisis, many value-oriented managers held the same financial services investments such as large banks (Washington Mutual and their ilk) which would be destroyed as a result of the excesses in the credit markets. Both styles, putting short-term job security in front of their investors, did not cover themselves in glory. Major amounts of investor capital were destroyed. The unintended consequence was that lower-fee index funds and exchange-traded vehicles started to catch on, since the active managers did not identify the dangers while charging higher fees.

What is new says Rodriguez, is that those index funds and exchange-traded products will be destabilizing influences when the equity markets stop going up. Those products generally hold little in the way of cash reserves, and when the turn comes, they will have to sell to meet redemptions. The only question becomes, “Sell to whom?” I won’t give away the rest of the interview, which you can find on line. However Rodriguez says that he is carrying close to 65% liquidity in his personal investments, mostly in Treasury-like securities, with nothing beyond a three-year maturity.

The other piece in a similar vein but considerably longer, is from Howard Marks of Oaktree Capital, published on 7/26/2017 and entitled “There They Go Again …. Again.” Marks says that the reason not to invest now, the negative catalyst, is for most investors not clear. What could cause the markets to crater? Given low returns on cash, people are more worried about missing out low but highly risky returns than they are worried about the permanent loss of capital. There is a willingness to compromise disciplines and not ask questions – “Everyone is doing it, so it must be okay” that would not pass the sniff test if investors were prodding more.

Among the signals that Marks points to are an S&P 500 selling at 25 times trailing-twelve month earnings versus the long-term median of 15; the Shiller Cyclically Adjusted PE Ratio at 30 against a historic median of 16; earnings inflated by cost-cutting and share repurchase, among other things, making the already high valuations understated relative to norms; and the “Buffett Yardstick” of total stock market capitalization as a percentage of GDP at an all-time high in June of 145.

Marks then spends a lot of time anecdotally fleshing out his concerns, pointing out (as did Rodriguez) the importance of investors having a knowledge and awareness of history. He offers a checklist for knowing where we are in a market cycle. His premise here is that investors make the greatest and safest returns on their investment when they are prepared to do what others do not want to do. He posits a situation, analogous to what we see today, where too much money with too little fear is chasing risky investments since the alternative is unappealing (and will not sound good at the cocktail party).

Do As I Say, Not …..

One of my summer projects has been looking at the Statements of Additional Information filed by fund companies, which most have posted on their websites. Among other things, you get to see how much money fund managers have invested in the funds they are managing. Or as is more often the case than not, how much money they have not invested in the funds they are running. Given the profitability of the mutual fund business it should not be that difficult for a fund manager to have a seven figure investment in his or her fund. Unfortunately, that is the highest cutoff the SEC has allowed for, so you don’t get to see how much more than a million they have invested. Now I recognize that for most investors in funds, a million dollars starts to be real money. Unfortunately, over the last ten years that has proven in many instances to not be the case in the fund business.

Posit an international fund manager who is running some $40B of assets. Annual compensation has been in excess of $30M a year for more than ten years and that $30M number is typical of the shell game that is often played. Fund trustees will be told that the manager’s annual compensation is actually only $2M a year, and that the other moneys reflect payment for the manager’s ownership interest in the organization. But if the organization was sold to a publicly-traded asset gatherer, either domestic or international, how does that work? Are there really any checks and balances in place, or is it like the basketball team where one player is the franchise?

I noted that in the case of Vanguard, many of its international managers, from firms based in London, often had no moneys invested in the product they were managing. When I raised that question with a friend in Edinburgh, he said that in the UK, many of the managers would invest their own funds in the similar strategy product in the UK, recognizing that different tax regimes often made cross-border investing difficult in commingled products. So if you are wondering why the Baillie Gifford managers of Vanguard International Growth Fund (VWIGX, the fund has 30.8% total return year to date and charges 46 basis point expense ratio) no moneys invested in that product, take a look at the similar strategy product run by them in the UK, the Scottish Mortgage Investment Trust (a UK closed-end fund), where they have millions of pounds sterling invested. As an aside, a Morningstar review of Scottish Mortgage will allow you to pull up the annual and semi-annual reports for that investment trust. I commend them to you for a discussion of the strategy, its implementation, and the results obtained. Although I disagree with the investment style, I commend the efforts at communication with shareholders.

Which brings me to a final thought here – we need to modify the rules for reflecting manager ownership. Another band of investment ranges needs to be added to the SAI, either $1M-$5M or $1M- $10M. I say that because I am aware of a number of individuals who could easily meet that higher level of disclosure but instead choose to diversify away from their own organization. Alternatively, the Longleaf Partners rule of allowing no other investments outside of the group’s own funds would go quite far in aligning interests.

I recently asked a senior individual at an investment firm how much time he ascribed, being in his forties, to the longevity of the golden goose, namely his firm’s mutual fund business before fees collapsed and expenses were reined in wholesale. My guess was three years. His was on the order of perhaps ten. The truth is most likely in between. He then made two telling comments which I think fit in with both the Marks and Rodriguez cautionary tales. With his personal moneys beyond the required investments in firm products, he was deploying funds into uncorrelated, non-equity or fixed-income assets that would produce income and tax advantages. Namely, he was following what would have been the old immigrant strategy of buying a brownstone two or three flat in a changing neighborhood, fixing it up, renting out the units, and getting both capital appreciation and sheltered income. His other comment was more telling – he felt sorry for the young men and women in their thirties and early forties who had come into the business. They had been lured into the investment business out of business school expecting the path to fame and fortune, or at least fortune, to be a relatively certain one. Sadly, they are perhaps like that last group of fifty-odd thousand troops at Dunkirk, hoping the shrinking defense perimeter will hold and that another boat will come for them.