An Important Time
This review has double significance. One wants, of course, to review the past year: how we are invested and what the next 12 months might bring. However, this is also a moment in the longer sweep of time when investors are well advised to take pause and be particularly thoughtful about how their long-term financial assets are positioned. Because the financial markets now have all of the earmarks of a serious change in valuation – not a good one. First we’ll briefly cover the factors that brought the stock market to this juncture, what stock valuations really look like, what can happen if our concerns are borne out, and what might make it happen. Then, how we are adjusting our investment posture, some examples of what we continue to own and why, and of what else we might wish to own when the time is right – because we think those opportunities will be extraordinary. Also: opportunities in non-traditional income producing securities, because it’s starting to become that time again.
Horizon Kinetics - Why Do We Write So Much?
Well, there’s so much to say. On the other hand, it ultimately boils down to a few simple observations, just as might one day appear in some paragraphs of a history textbook. Over the last few years, we’ve traced the massive shift of investment capital away from individual stocks and active management into baskets of securities: over $1 trillion into ETFs and indexed mutual funds while a half-trillion dollars left equity mutual funds. There was a natural instinct behind this flight from risk after the 2008/2009 financial crisis, and there is a legitimate foundation for indexed-based investing: passive participation in the long-term results of basic asset classes like equities, real estate, and bonds. But activity in financial markets does not occur in a vacuum.
First and foremost, in any marketplace, whether for 1-bedroom apartments in mid-town Manhattan or for rock concert tickets, enough demand relative to supply will alter the pricing. Enough demand to alter pricing will attract middlemen: real estate brokers, ticket brokers. That’s reality. And Wall Street attracts some of the best and brightest – or, at least, some of the most motivated. And their motivation is to collect fees, which are maximized by gathering more of the assets on which fees are earned.
Second, the behavior of the middlemen themselves affects the market: in response to the obvious demand, an enormous industry was created to promote ETF investing. At a certain point in the competition for assets, some providers began to reduce fees for mainstream products such as the S&P 500 and Russell 2000 ETFs. Lower fees, though, equal lower profits. To counterbalance fee compression, there began a wild proliferation of more exotic sub-categories of ETFs for which higher fees could be charged.
But so much money poured in that the ETFs themselves forced securities prices upward, and with that a deceptive reduction in volatility. This was a critical transition because it means that for some time the indexes have lost their legitimacy: how can they be relied upon to measure the results of an asset class, judge a manager, or provide passive participation if they are in fact responsible for changing the prices of the securities in the index? The terminology is the same, but indexation has become something else – the opposite of what it originally was.
Two of our previous colorful examples, from among the exotic ETFs: Russian Federation 15-year bonds, in the iShares Emerging Markets High Yield ETF, trading at 3.7%, the same borrowing cost as IBM; or the iShares MSCI Frontier 100 ETF having a beta 1/3 lower than the S&P 500, meaning that a combination predominantly of Kuwait, Nigeria and Pakistan is much less risky by Wall Street statistical measures than the U.S. Those were easy examples to propose, without counterargument, as evidence of excessive, even bubble-level fund flows and valuations. Not so easy, though, to find acceptance of that warning about the familiar S&P 500 or Russell 2000.
But the time for that has come, too. It was helped along by the latest round of ETF exotica: the momentum funds. These have gathered billions of dollars of assets, using various formulas to purchase more of that which has already outperformed; some also sell short securities that have under-performed. Ergo, the accompanying large-font table, featuring Netflix, Inc., about which we’ll say no more.
So Where Are We Now?
One of the outcomes of this process has been that money has flowed into ever fewer securities. In the early years, in order to be able to accept more assets, ETF providers required stocks with ample trading liquidity. This separated the market into stocks on the right side of the ETF divide, which receive automatic bids whenever new money is received, versus those not in the ETF sphere of influence. An ever-widening valuation differential was created. Recently, with intensified marketing focus on risk statistics like Beta, and via robo-advisers as well, and with the rise of momentum indexes, the market has become extraordinarily narrow.
This is how narrow: in 2015, the S&P return was 1.4%, but the best-performing 10 stocks – 2% of the names in the index — and which account for less than 10% of the value of the S&P, had an average return (weighted by index position size) of 44%. Without those ten stocks, the S&P 500 return was negative (2.7%), not positive. Incidentally, the average revenue growth of these companies was only 10% in 2015. So if someone asks how the market has done, it’s kind of important to ask which market? The Netflix market, which has a P/E of 100x or 50x the earnings it might have in 5 or 10 years? Or the rest of it? Unfortunately, much of the rest has the same issues; they’re simply not screaming as loudly. Even Hormel Foods, a prosaic producer of luncheon meats, gelatin products, sugar substitutes and the like, a business with certain obvious limitations on its growth and profitability, albeit, with a creditable 10-year revenue growth rate of 5.5%, is trading at 27x estimated 2016 earnings. Would you – should you – pay 27 years’ worth of earnings for such a business? Let’s see.
The 2015 market is reminiscent of the era of the Nifty Fifty. These were 50 growth companies that in the early 1970s were considered so assured of virtually permanent rapid earnings growth that traditional valuation measures were felt to be irrelevant. Some of those names are still familiar, some less so: Disney traded at 82x earnings, Polaroid at 91x, and McDonalds at a P/E of 86x. At year-end 1972, the Nifty Fifty traded at 42x earnings, even as the P/E of the S&P was less than 18x. In the market decline of 1973-1974, the Nifty Fifty declined by 62%. Disney fell by 91% from its high to its 1974 low, Polaroid fell by 91% and McDonalds by 64%.
Here is how 2016’s high-P/E companies differ from those in 1972: today’s high-P/E stocks will not enjoy the same decades of fiscal stimulus, since governments are now overindebted, and unlike the Nifty Fifty, have already accomplished their international expan-sion. Here’s how they are similar: the 10-year Treasury rate rose from 5.9% at the beginning of 1972 to over 14% by the end of 19813; and the price of the S&P 500 rose a cumulative 3.8% over those 9 years; substantially all of the return came from dividends. Today’s interest rates, a policy-engineered anomaly, are the lowest they have ever been and can only go up.
Horizon Kinetics - The Temporary Loss of the Value Investor
There is another ‘market’, though. Investable funds are a somewhat finite quantity. When money flows excessively to one sector, ultimately it must come from somewhere else; great excess in one portion of a market suggests a great deficit in another. One of those somewhere elses has been stocks outside the major indexes and ETFs, those that might appear attractive to active managers and value managers: managers who might be indifferent to share price statistics like Beta or whether a stock trades in large volumes, but who are specifically interested in financial statement information that might suggest the presence of a hidden asset like a large tax shield or undeveloped land that is being prepared for sale.
To get a handle on this other ‘market’, take a look at a partial list of the most successful and renowned active and value investors of recent decades: Mario Gabelli (Trades, Portfolio), a 2000 inductee into Barron’s All-Century Team of most influential mutual fund managers; Bill Gross, who co-founded PIMCO and managed the largest and most successful bond fund in the world; Bruce Berkowitz (Trades, Portfolio) of Fairholme Fund (Trades, Portfolio), named Manager of the Decade in 2010 by Morningstar; Warren Buffett (Trades, Portfolio), whose Berkshire Hathaway has the best long-term track record of a public company; Carl Icahn (Trades, Portfolio), whose multi-decade returns in Icahn Enterprises well exceed those of the market and even of Berkshire Hathaway; Bill Ackman (Trades, Portfolio) of Pershing Square; David Einhorn (Trades, Portfolio) of Greenlight Capital and Greenlight Reinsurance. Unusually for an insurer, the Greenlight Reinsurance investments are managed as a long/short portfolio, with a substantial short position. All them underperformed the market by 10% to 20% in 2015.
By itself, this data does not lead to conclusions. It only leads to questions. Let’s just list the questions.
- First, how can so many famous, and even brilliant, investors underperform the S&P 500 by this magnitude, all at the same time?
- Second, how did this occur when, for the most part, they actually correctly gauged the most important sector decisions, which were to dramatically underweight oil in particular and commodities in general?
- Third, why would Berkshire Hathaway shares decline by double-digit percent if its shareholders’ equity rose over the prior year? Was it overvalued one year ago? If it was overvalued, how is this possible, given the prominence of its $300 billion market capitalization, its extensive financial disclosure, and the fact that every move the company makes is closely scrutinized? Why shouldn’t a stock like that be fairly priced?
- Fourth, a) what could these investors have done differently in order to outperform? This is the one question for which the answer is knowable. They would have needed to purchase the momentum stocks like Amazon, Facebook, Netflix, Google, etc.
- Fourth, b), though, what would have made anyone imagine on December 31, 2014, that Netflix was more than 150% undervalued? This is especially true since the insiders have been heavy sellers of the stock.
This brings us to, if not conclusions, then a statement of contrast. The earlier example of Netflix was a partial demonstration of a preposterous phenomenon, preposterous because even if the analysts’ maniacally optimistic earnings projections are actually realized (the 35 analysts who cover Netflix anticipate a 5-year earnings growth rate of 24%) and even extend that to 6 years, the application of a 30x P/E ratio in 2021 would result in a loss of 80%. The ETF buy decisions may be contrasted with those of a disciplined value investor, who would never under-take such an investment. However, since value investors have been underperforming so consistently and egre-giously as this environment has taken over, they are being dismissed. And in its dismissal, the market has lost an important valuation sensibility that was historically visible among the other sets of participants.
That brings us to the next question: where do we go from here?
