3rd Quarter 2018

September 2018 marked the 10^th anniversary of the Lehman Brothers collapse, one of the defining moments of the financial crisis or the Great Recession. In addition to the Lehman bankruptcy, Fannie Mae and Freddie Mac were placed under federal conservatorship, and several other government-orchestrated bank tie-ups and bailouts occurred in a chaotic September 2008. For the full year 2008, the S&P 500 declined by 37%. It was an historic, turbulent and nerve-rattling period for investors. 

Paramount to long-term investment success is the ability to wed a prudent, well-designed investment plan with a disciplined and proven process to carrying out those investments.

What a difference a decade can make. We are in the 10^th year of one of the greatest bull markets in U.S. history. During September 2018, the S&P 500 set a new all-time high. According to Wilshire Associates, U.S. equity values have increased 337% (as of this writing) since the stock market’s low in March 2009. Today we are experiencing the opposite of where we stood 10 years ago. The focus now should be on where we go from here and how best to guard against emotional triggers, overconfidence and complacency that can lead to both poor decisions and results.

Market cycles, or the ups and downs of the stock market, can be hard to navigate and even harder to predict. Even in the midst of a great bull market, successfully managing through the constantly shifting financial markets is a challenge for investors due to the inability to accurately time market changes as well as our emotions that often overtake reason. This challenge is greater in periods of turbulence and market declines. We know from history that market cycles are an inevitability, but timing the beginning and end of these cycles has proven to be an unsuccessful endeavor for individuals and professionals alike. Investors must guard against biases and emotions that can cause us to make impulsive investment decisions that may derail our long-term goals.   

In a recent Wall Street Journal joint commentary, the CEO of JP Morgan Chase, Jamie Dimon, and legendary value investor, Warren Buffet, declared that quarterly earnings guidance “often leads to an unhealthy focus on short-term profits at the expense of long-term strategy, growth and sustainability.” They argue that companies frequently cut back investment in hiring, technology upgrades, and research and development to meet quarterly earnings guidance. 

The challenge and stress of meeting short-term earnings guidance has likely contributed to the decline in the number of public companies over the past two decades. The universe of publicly traded companies has been steadily shrinking in the U.S. New businesses have been going public at less than half the rate of the 1980's and 1990's. About 3,600 firms were listed on U.S. stock exchanges at the end of last year, down more than half from 1997.  

Good returns come from the decisions that sometime run counter to market sentiment and depend on whether the investor has the fortitude to maintain the necessary  discipline.

Another marker for a short-term emphasis by management is the increasing use of pro-forma reporting and earnings. Some critics argue that pro-forma earnings are simply an effort by management to cast a company’s earnings in a more positive light or to gloss over poor financial results in an effort to improve stock performance. “Pro-forma earnings in current usage” means that many items are excluded from the calculation of net income at the discretion of management. Expense categories often excluded from pro-forma earnings include restructuring charges, one-time charges, non-cash charges and gains / losses from one-time sale of assets. There is no regulatory guidance or consistency in the reporting or calculation of pro-forma earnings, making comparisons difficult. 

As a corollary to some companies’ short-term focus, individual and institutional investors can likewise be fixated on short-term results. Missing or beating quarterly earnings guidance can lead to an overreaction, both on the upside and the downside. How much emphasis should one actually place on a company beating a number that its management sets? Investors who react to one quarter’s results may buy or sell just when the reverse action is needed, based on the long-term intrinsic value of the company. Ironically, it is these overreactions on the downside that create new investment opportunities.

Stock market indexes provide a convenient way of capturing the general mood of the financial markets and are widely quoted and followed. Current and recent values of the key averages and indexes are quoted daily on financial websites, in the financial news, in most local newspapers and on many radio and television news programs. They are used as performance benchmarks for actively managed accounts and funds. They also take the form of investments through index funds and Exchange Traded Funds (ETFs) which attempt to replicate their performance. 

The notion that increased passive investing may lead to heightened correlations in prices raises the importance of diversification beyond passive investment products.

One of the most profound developments in the stock market in the last two decades has been the growth of indexed based investments and the increasing prevalence of passive fund management. Though the assets of traditional mutual funds have increased three-fold in the last 17 years, the assets of ETFs, funds that are typically indexed, have grown 130-fold.

The oft-cited Standard & Poor's 500 Index has become the benchmark for estimating or calculating the “market return” and is comprised of 500 large companies (not necessarily the largest) weighted by the market value of each stock in the index. The problem with capitalization weighted indexes is that larger capitalization stocks can make the index vulnerable to concentration risk. As a company outperforms its index, its relative weight in the index will increase. Given the number of ETFs and index funds that are tied to the S&P 500, this becomes a circular and expanding problem. 

Many individuals focus on the everyday fluctuations of their investment portfolios, sometimes to such an extent that daily price quotes, rather than the long-term value of their investments, drive their sense of success or failure. It is this short-term emphasis which gives rise to the distinction between speculating versus investing. At first glance the difference between these two concepts can be a fine line. Both speculators and investors attempt to experience rewards by the upward movement of an asset (unless they are “shorting”); otherwise, they would not purchase the asset.

An excellent recent example of speculating is the bitcoin phenomenon. Bitcoin has been the best performing asset of the financial markets in 2017. Over the past weeks and months, speculators have flocked to bitcoin, a digital currency whose value has soared by about 2,000% (as of this writing) in the past year alone. This “speculation” example is not a critique of bitcoin as indeed the technology underlying it could fundamentally change the way money is used as a medium of exchange. Our purpose is to illustrate the distinction between valuing an asset based on short-term price momentum, versus pricing it based on its underlying sustainable economic value.

Time is one of the key elements, which favors the investor over the speculator.

Bitcoin was released in 2009 by an anonymous creator known as Satoshi Nakamoto. The software is open-sourced, meaning anyone could copy it and produce a refined version with any changes they want. It’s a digital form of money, except there is no government or central bank printing it or standing behind it. In other words, bitcoin has no identifiable intrinsic value. Quite literally, it is software. It’s a program that is run across an interlinked network of computers, which facilitates transactions between parties. At the heart of the software is an open ledger – called a blockchain – that is visible to the public. Every bitcoin transaction is recorded in this distributed ledger. 

“If you are more likely to purchase stocks during periods when the market is rising or tend to sell out of positions during periods of market pessimism, you are probably speculating excessively. The emotional urge to trade based upon the direction of the market has nothing to do with investing or attempting to ascertain the underlying value of a common stock.” - Benjamin Graham

One of the most significant developments in the investment markets in the last 20 years has been the growth of indexed-based investing and the move to passive fund management. Passive investing has grown in popularity among investors, and the recent rise in exchange-traded funds (ETFs) has accelerated the trend. Passive investments now account for 28.5% of assets under management in the U.S. Mutual funds, which track an index, have grown six-fold over the last 17 years while the assets of ETFs have grown 130-fold.   

The rapid growth of passive investing warrants greater study of its impact on financial markets, particularly in a downturn or bear market. A recurring argument against indexing is that aggregate or mass movement of funds in and out of the S&P 500, the most commonly followed index, could cause concentration risk, higher price correlation and reduced benefits of diversification. Equity indices weight the stocks they contain by market capitalization. As a result, a few larger companies (such as Alphabet, Amazon, Apple and Facebook) dominate and skew the performance of benchmarks. This weighting effect can be seen when comparing the S&P 500 Index with an equal-weighted S&P index, which removes the large capitalization bias. Year to date, the market cap weighted S&P 500 is up 11.3%, while the equal-weighted index is up 8.1% (as of 8/31/17).

In the pre-passive investing era, a sell-off would entail investors reducing their separate stock positions. Individual investors would own different portfolios of individual stocks and sell different stocks contained in their portfolios, depending on their particular investment parameters. Some stocks would sell off more than others. Conversely in a rising market, there would be uneven performers as some stocks performed better based on the preferences of individual investors. 

Contrast this behavior with the new phenomenon of a market with substantial passive investment exposure. A reasonable question is: What is the effect on the value of passive investment vehicles (index funds, ETFs) if a sizable percentage of the total U.S. market moved in lockstep during a rising or falling market? Substantial buying or selling of the same stocks at the same time could exert greater upward or downward pressure on prices, exacerbating highs and lows. 

Active management is not exclusively about finding opportunities that translate into outperformance; it is also about managing the downside risk during periods of higher market volatility.

Furthermore, passive investment vehicles, such as index funds, do not consider valuation when buying or selling. With a large number of investment decisions on autopilot, more and more money will be invested with funds whose value is largely independent of factors that have traditionally guided investors, such as profitability, efficiency, competitive threats, management performance, growth potential and broader economic conditions. Passive investment products do not distinguish between the good and the bad. They invest in all of the stocks comprising the index, irrespective of any views about value or quality. 

There is a strongly held perception that Wall Street’s analysts tend to call a stock a “strong buy” when its price and earnings are high and to label it a “sell” after its price and earnings have fallen. Many investors also tend to follow the momentum of the market, wanting to invest when the market is rising and sell when the market is falling. Such investors and even some sophisticated stock analysts confuse the high earnings during favorable economic times with the average earnings power of the company. Investments purchased at peak earnings or at high multiples often do not offer an adequate margin of safety or long-term rate of return.

Value investing is conceptually easy to grasp but a difficult discipline to practice as it runs contrary to a herd mentality. 

Margin of safety is a fundamental principle of value investing, which states that an investor will purchase a stock if it is priced below its intrinsic value. Intrinsic value is the economic value of a company based on its long-term earnings power. The difference between the purchase price and the intrinsic value is the margin of safety. The greater the difference, the larger the margin of safety that provides an extra cushion in the event of future pressure on earnings from a myriad of factors (economic, market or company specific). Prices fluctuate more than intrinsic value, meaning opportunities exist to take advantage of irrational pricing and market psychology. 

The purpose of margin of safety is not just to preserve the initial capital investment, but to improve upon it. When a stock is purchased below its fair or intrinsic value, the expectation is that in some future time period the stock price will converge with its fair value in a rational market. If the growth expectations end up being correct, an investor who has bought at the discounted price will ultimately earn a superior rate of return.

Our First Quarter Letter noted that the current bull market celebrated its eighth anniversary on March 9, 2017. Value investing and margin of safety concepts are not so attractive in rising markets. The essence of value investing is finding a veritable bargain, which can be difficult in an aged bull market. As we’ve mentioned before, value investing is conceptually easy to grasp but difficult to practice as it runs contrary to a herd mentality. It entails researching investment options in depth, usually to discover the stock is fairly priced even though it shows some value attributes. It requires patience and a willingness not to participate in market momentum or a particular sector fad. It also requires fortitude to invest “in the foulest of weather.” Purchasing stocks in a declining market without knowing the bottom can be challenging. Stocks tend to trade at their greatest margin of safety during negative economic periods when investors are overly pessimistic.

The current bull market celebrated its eighth anniversary on March 9, 2017. Since it began in the aftermath of the “Great Recession,” the Standard & Poor’s 500 benchmark index has gained 249%. While there are some pundits who point to evidences of a bubble, particularly after the post-election rally, other signs point to a global economy that’s been picking up steam fueled by promises of corporate tax cuts and a fiscal spending boost.

How does this bull market compare to those of the past? As bull markets go, this one is neither the best performer nor the longest. The dot-com bull market of 1990 to 2000 is the longest on record and is also the best-performing with a 417% gain. In the area of valuation, the current bull market comes in second to the dot-com bubble, though it’s getting close. The S&P 500 was trading at a multiple of 30 times earnings when the dot-com bubble popped in 2000.

Long-term investing, however, puts the spotlight on what really matters – the growth of economic value and competitive advantages of a business.

Stock market rallies and declines are usually precipitated by a dramatic change in outlook for future profits. Before November 8, Wall Street seemed comfortable with the status quo represented by the anticipated election of Hillary Clinton. On election night, the Dow futures plunged 800 points when Donald Trump’s upset became apparent. The consensus was that the stock market would drop dramatically in the event of a Trump victory. However, it did not take long for the stock market to rapidly adjust to the reality of a Trump administration and economic policies, which were in some cases quite different from either party.

The post-election rally has been driven by a number of assessments (lower taxes, infrastructure spending and deregulation) on the economic front that was broadly interpreted as positive. This bellwether election represents the first time since Dwight Eisenhower was elected in 1952 that a Republican president will enter office with GOP majorities in both the House and the Senate. 

We feel there is greater value in focusing on individual companies and their economic merit as opposed to macro factors such as monetary and or fiscal policy, which are constantly in flux and give the stock market its overall random nature.