“The only way a man can remain consistent amid changing circumstances is to change with them while preserving the same dominating purpose.” Winston S. Churchill, “Consistency in Politics,” Nash’s Pall Mall, July 1927, reprinted in Churchill’s Thoughts and Adventures (1932)

Where’s the Risk?

Horizon Kinetics, in its Q3 Commentary, again did a superb job of raising issues that investors should be thinking about, given a wide range of potential outcomes for Gross Domestic Product, as well as inflation and deflation. Now I am fully aware that both David Snowball and I have been banging the drum about the dangers of extreme overvaluation in the marketplace, and the possibilities of a major market decline. For those “Game of Thrones” fans I will say it differently, “Winter is coming.”

We are at a point where there are things taking place that we have not seen before, all happening concurrently. On the one hand, we have rapidly growing companies, the Amazons and Mastercards, trading at price to earnings ratios often in excess of 30. (Forward p/e’s of 54 and 31, respectively, as of 11/01/2019.) Or rather, they are trading at 30 years’ worth of earnings. They represent (and I am showing my age here), the new Nifty Fifty like the growth stocks of old, the Polaroids, Data Generals, and Digital Equipments.

At the same time, we have very mature companies that are often showing minimal or negative growth, that are trading in a range around 24X earnings. In this category you can find a 3M (19X earnings) or a Kellogg (29X earnings). For these companies to survive, you are dependent on a continued environment of low (or suppressed) interest rates.

Don’t like being in the stock market, especially if you are near retirement or in retirement? What’s your alternative? An eighteen-month certificate of deposit at 1.75% or a ten-year U.S. Treasury at roughly the same return, 1.7%? Try living on that, Dividend yield on the S&P 500 is closer to 2%. There has been a migration to stocks by people who really don’t want to be invested in them, but who have not a lot of alternative choices.

Finally, we have the issue of non-diversification. You think if you own a couple of ETF’s or index products that you have become broadly diversified? I recently had to point out to a young widow that she, although owning three or four of the most popular equity index mutual fund products out there, was in reality under-diversified and over-concentrated. Because if you look carefully, you will find in the portfolios that the same stocks, depending on the product category of the fund, are presented as a Value stock, a Growth stock, a High Yield stock, or some other category, all at once.

Why is this happening? It is now a question of money flows into funds and products, and trading liquidity. One of my former colleagues, after some of the early trading and liquidity debacles in 2001-2002, pre-ETF availability, started limiting the position sizes of equity positions in his fund to a number of days trading volume to enter or exit a position. Concomitant with that, he no longer was interested in mid-cap stocks, where he had achieved a successful performance record. Rather, he style-drifted upwards to large cap and mega-cap issues. This worked for a while. Now, because of the amounts of money that have gone into these newer ETF vehicles and indexation, his ability to earn a positive alpha in his fund due to his own skill set has been arbitraged away because everyone owns the same stuff. Differentiation is not easy (which explains more money spent on marketing than research).

A similar explanation seems to fit as to why hedge funds have also lost their ability to thrive and outperform, where individual manager stock-picking by hedge fund managers has lost both its cache and its edge. In that vein, I commend an article in the Wall Street Journal this week concerning Highfields Capital in Boston, as well as an explanation as to how the endowment at Harvard University shot itself in the foot. (“Twilight of the Stock Pickers: Hedge Fund Kings Face a Reckoning,” 10/27/2019)

Which brings me to what should be the most concerning fact of all. And, it raises again the liquidity issue. In June of 2019, Morningstar issued a report that indicated that there were now more assets in indexed vehicles (passive management) than were placed with active managers. This of course is driven primarily by asset allocation strategies, often set by consultants. Should individuals or institutions one day wake up and decide to reallocate their assets to different strategies or allocations, especially to cash, the markets lack the ability to buy those equities and provide liquidity. The allocations are effectively hung assets. The active managers lack cash, which they would have to raise, in effect driving clearing prices in the markets lower. The resulting permanent capital losses would end up causing other serious effects.

What’s to be done? I again would argue that investors need to review their allocations and comfort zones with those allocations, especially as to their ability to replenish their assets in the event of a permanent capital loss. Things that were five or ten years ago are often no longer what they seem. Just ask anyone who owns coastal property which is now in an area reclassified as a flood plain due to rising sea levels.

First, don’t be afraid to hold more cash than you usually would. Secondly, if you are going to be invested in equities, try and make sure that they and your other assets are as uncorrelated to the general markets as possible. Look for things that are unloved. Avoid asset classes that are laden with debt, especially where the cash flows may not be sustainable to pay the debts in the event that rates rise. And try to protect yourself from asset managers who are talking their own book.

Many years ago, I would run to get the Barron’s Roundtable write-ups, to see what good new ideas were out there. Imagine my surprise when I learned some time after the fact, having discovered 13-F filings, that often the issues being recommended were being sold out of the recommending firm’s portfolios. There was a need to stimulate interest (and liquidity) in some of the issues.

Reformulation Redux

I have previously touched on reformulation as it pertains to consumer brands, and to a certain extent pertains as well to money management firms. There, as in many businesses tied to individuals, the intellectual capital assets go down the elevator at the end of the day. And they may or may not come back, depending on any number of other factors.

We have seen an impact at Artisan International Value Fund and Artisan Global Value where, in October 2018, one organization basically split into two, with different personnel and locations (San Francisco and greater Chicago). You of course don’t need to have a tag day for the lead portfolio managers of each fund, as each one received more than $100M in stock when Artisan Partners went public. But how have the fund investors fared since then?

Similar questions need to be raised at other firms where the culture and personnel begin to shift for a variety of reasons.  If the research and portfolio brand management equity of a firm has been built upon the synergies of having everyone sited in one place (like a Dodge and Cox), changes need to be commented upon when they become noticeable.  Such synergies may be as de minimis as the intellectual exchanges that take place daily in the lunchroom, especially when you have marketed them as such.  Alternatively, if your lead portfolio managers of funds begin telecommuting from distant locations or states, it should raise questions as to whether there is a pre-retirement transition going on at that firm.  And existing and future clients would want to be made aware of those transitions.  Obviously, modern technology such as “Go to Meeting” software makes on-line commuting much easier.  But where your brand equity has been built upon the synergies of having your intellectual capital in one place?  For example, Wellington Management has announced that the portfolio manager of Vanguard’s Wellington Balanced Fund will be retiring in 2020, and that the succession planning is under way.   What is happening is in effect a reformulation of the brand which should be and has been disclosed to the clients.  The clients have a right to not be surprised with something different than what they thought they signed up for.  Another example of fair disclosure would be that of Bob Rodriguez, the retired First Pacific Advisors managing partner and portfolio manager, who when I saw him in 2009 in Chicago, a few years before he retired,  told me quite clearly that if I wanted to come visit with him, it would be to his office in Las Vegas, California where he lived and had an office, not Los Angeles where the firm’s offices were located.  Clearly with Bob, this was not an example of retiring in place, in absentia.

P.S. I do commend to those of you with the time and interest, the entire transcript or replay of the Q3 Commentary. They go into a discussion at length of dealing with the different scenarios of inflation or deflation that we may face. And they approach things with a degree of honesty and integrity that I find refreshing in a world full of asset gatherers with no interest in the yachts of the investors.