“Over the past 100 years the returns from smaller companies have exceeded those of larger companies. It is also true that stocks with low valuations (i.e. lower prices relative to earnings and book values) have generated better returns than those with high valuations. What is less certain is whether these tendencies will continue in the future…”

–Burton G. Malkiel, criticizing investors like Buffett who have captured factor premia for decades

To be fair, Malkiel goes on to list other reasons to be skeptical of smart beta, but number one is that it might not work in the future. Malkiel’s comment is almost akin to a health policy expert telling us, “Sure, Jonas Salk’s polio vaccine has worked for 62 years, but let’s give it a little more time before we declare victory.” I guess we will never know whether the polio vaccine will become ineffective, but that doesn’t mean we shouldn’t exploit its use today. But, Malkiel would condemn investors into accepting market risk in order to receive reduced fee invoices. What if you didn’t want market risk? Or, what if you wanted more risk than the market provided (as PAR did in 1Q09 when it used some leverage to become fully invested)?

Factor premia have existed for more than 100 years. The premia exist either because of sub-optimal investor behavior (mostly my view) or because factor investors are being compensated for risk (mostly the view of EMH proponents). Either way, factor premia are not likely to disappear for the long-term investor, so we might as well exploit factor premia for the long-term portion of our portfolios.

https://blog.wealthfront.com/smart-beta/

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Hire advisors who understand risk and know how to manage it well.

The Market from the Top Down, the Federal Reserve, and the Economy

PAR’s pessimism is due to a dearth of bottom-up bargains. (Few businesses can be purchased at prices that deliver a margin of safety.)

A top-down analysis reveals a significantly overvalued market, which merely confirms the dearth of bargains. Shiller’s CAPE, Buffett’s PE, Tobin’s Q, and profit margins are at or near all-time highs (other than during the dotcom bubble) while interest rates are near historic lows.

Shiller’s CAPE

As of July 3, the CAPE was 26.6, which would require a 31% drop to reach its post-war average of 18.4 (including the dotcom bubble in that average).

Shiller’s CAPE (S&P 500 Index /10-Year Average Earnings)

Source: Multipl.com and www.econ.yale.edu/~Shiller/data.htm

I have been writing about the CAPE for a while in letters and on my blog. Although it has been above its long-term average since early 2009 (and for most of the time since 1990), it is not a good indicator for short-term market timing.

At these CAPE levels, stocks are unlikely to deliver much more than low single-digit returns per year over the next decade and the market is vulnerable to large corrections. Since 1881, with the exception of the dotcom bubble, every time that the CAPE reached 24 (April 1901, November 1928, and January 1966) inflation-adjusted losses of 29% or more followed within 4.5 years and peak-to-trough losses were much higher. In this cycle, the CAPE first reached 24 in November 2013. But the market has also severely corrected when the CAPE was lower than 24.

William Poundstone wrote the following in his latest book, Rock Breaks Scissors:

“Today’s investors have every right to feel cursed. They have had few opportunities to buy at average (CAPE levels) much less low ones…The average return at (a CAPE of 23) is something like 2 percent over the coming 20 years. Never has the twenty-year stock market returned as much as 3 percent annually (after inflation) when the (CAPE) was 23 or higher.”

Largely because of the CAPE level, as of May 31, 2014, GMO thinks that US large-cap and small-cap stock real returns will average -1.5% and -4.5%, respectively, each year for the next seven years.

Market Cap-to-GDP (AKA Buffett’s PE) 

Buffett’s favorite measure of market price-to-earnings is the ratio depicted in the chart below, which indicates that the market is about 45% overvalued.

Source Listed in Chart

GMO believes that whenever a measure of market prices (relative to market fundamentals) is two standard deviations from its long-term average, then that market is in a bubble. According to GMO’s definition, Buffett’s PE indicates the market is currently in a bubble. However, Grantham prefers the CAPE (along with other measures) over Buffett’s PE and he believes the S&P 500 will not enter bubble territory until it reaches about 2,250. As of July 4, it’s only 13% away from that mark. 

Tobin’s Q

Tobin’s Q Ratio is a measure of the market’s price-to-book ratio. It equals market value relative to the cost to replace the assets of the businesses in the market. The numerator is the same as the one in Buffett’s PE Ratio. The Q indicates that the market is about 41% overvalued.

Source Listed in Chart 

Profit Margins

Corporate profit margins are at all-time highs. Because high profit margins attract competition in free markets, Jeremy Grantham of GMO calls margins the most mean-reverting statistic in finance and economics. If margins decline, EPS will decline, leading to a decline in stock prices. 

Corporate Profit Margins

Source Listed in Chart and dshort.com

John Hussman of Hussman Funds notes that investors who pay high prices for high profit margins are almost always disappointed in profit growth later.

Source: Hussman Funds

Interest Rates

Interest rates are important because declining rates translate into a higher present value of cash flow, which translates into higher asset prices. It is hard to imagine rates falling much more from here after the 33-year bull market in bonds, but it is easy to imagine rates rising, which will cause present values (and markets) to decline, all other things being equal. 

Source Listed in Chart

The Federal Reserve

“This goes down right now as the mother of all reflation strategies by the Federal Reserve…The cycle starts off with asset inflation, followed by credit inflation, followed by price inflation, and then by wage inflation.” –David Rosenberg, on CNBC’s Squawk on the Street 6/24/14

It appears that a major reason for the market’s rise since 2010 has been the extraordinary measures used by the Federal Reserve to offset the effects of the financial crisis. Quantitative Easing 1, 2, and 3 (QE) has created an environment for company stock buybacks and M&A activity largely by lowering the cost of corporate debt issuance to finance buybacks and M&A. 

In 2013, S&P 500 company buybacks totaled $477 Billion, the most since the 2007 peak. Fortuna Advisors estimates that since the 2009 lows, buybacks juiced cumulative returns from a natural 80% to a steroid-like 178% reached in the first quarter of 2014.

(http://www.washingtonpost.com/business/corporations-cant-stop-gobbling-up-their-own-stock/2014/05/09/83c8ddb0-d6e6-11e3-aae8-c2d44bd79778_story.html)

Of course, it is what happens at the margin—the last trade—that determines your portfolio value. The stock of corporate buybacks over the last three years will be of little consolation in a declining market unless you have already sold into buybacks and are holding the proceeds in cash. 

Further evidence of a Fed-fueled market include: 1) margin debt used to purchase equities is as high as in the dotcom bubble; 2) the junk bond market has been raging again; and 3) IPOs—insiders who want to cash out before the punch bowl is pulled away—are as high as in the dotcom era. 

Correlation is not causation, but there is good reason to believe the Federal Reserve’s extraordinary balance sheet expansion since the crisis (depicted below) is responsible for much of the froth.

Source: ZeroHedge.com

A 2000 publication from the CFA Institute’s Research Foundation studied asset class returns during periods of expansionary and restrictive monetary policy. It should give pause.  

The study (http://www.cfapubs.org/doi/abs/10.2470/rf.v2000.n3.3912) covered the years 1960 through 1998. The average monthly nominal stock market return in expansionary periods was 1.64%. The average in restrictive periods was 0.38%. All eleven periods of expansionary monetary policy over those 38 years resulted in a positive monthly average real return, but five out of the ten (50%) restrictive periods resulted in negative average monthly real returns. Clearly, the maxim “Don’t fight the fed” has a lot of truth in it.

David Tepper

One investor who refused to fight the Fed was the highest earning hedge fund manager in 2013. On September 24, 2010, David Tepper presciently said the following on CNBC:

“Either the economy is going to get better by itself in the next three months…What assets are going to do well? Stocks are going to do well, bonds won’t do so well, gold won’t do as well…Or the economy is not going to pick up in the next three months and the Fed is going to come in with QE (and the stock market will rise because of that).” 

Tepper repeated that analysis several times into 2013. Today, we know he was right because the Fed came to the rescue with QE several times. 

So, it should be a concern that the Fed has already begun to pull back. QE is tapering and will likely end by October 2014, and three of the seventeen Federal Reserve officials responsible for setting the fed funds rate believe it will rise in 2014. Twelve think it will rise in 2015. Only two of the seventeen believe fed funds will not rise until 2016. Nine of the seventeen believe the fed funds target rate will rise from its current 0%-0.25% to at least 1% next year. Three believe it will rise to 3% or higher, which would be a striking change. 

(http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20130918.pdf).

But, make no mistake, whenever the fed funds rate rises, many investors will be surprised. According to the Research Foundation’s Fed study, the average equity return following a Fed interest rate policy increase was most pronounced in the month of the policy change, indicating that it wasn’t expected. The second-most pronounced effect of an increase came in the next month following the policy change. For the first month in a tightening period, stocks declined an average 2.05%.

So, what does Tepper think now? At the SALT Conference on May 14, 2014 he said:

“…there (are) times to make money and there (are) times not to lose money. This is probably (a time when) you’re supposed to think about preserving some of your money. If you’re 120 percent invested, it’s probably too much. You can still be long, but you probably should have some cash…I am nervous. I think it’s nervous time.” 

Tepper’s fund cut its net long exposure from 100% in December 2013 to 60% in May 2014.

(http://www.cnbc.com/id/101674055) 

Employment

While the market rose 144% since January 1, 2009, the underlying fundamentals of the economy have been weak, which is further evidence that the market has been largely driven by the Fed. GDP declined in the first quarter by a whopping 2.9%. Bad weather cannot explain the long-term weakness in the ratio of Employment-to-Population (E/Pop), which has barely budged from the nadir (58.2%) since the crisis abated. The chart of this ratio does not look like an economy that can justify a 144% rise in the S&P 500 Total Return Index since January 1, 2009 or 178% since the nadir. 

Ratio of Employment-to-Population (January 2006 through May 2014)

Source: BLS

Unlike the unemployment rate and the Labor Force Participation Rate, the E/Pop ratio implicitly assumes that every unemployed person of working age is looking for work. It may be the best indicator of economic robustness. The E/Pop has not been this low since the effects of the “malaise” of the 1970s, yet the S&P 500 Index has hit all-time highs dozens of times already this year. (http://www.bls.gov/opub/mlr/1981/02/art4full.pdf) 

We probably should not anchor on the post-war high E/Pop of 64.7% in April 2000, or even the post-dotcom bust of 63.3% last reached in March 2007, but the 58.2% read in October 2013 is a post-1983 low. The latest figure is from June 2014. It is just 59%.

The Other Side of the Inflated-Market Argument

To help combat confirmation bias, I now present the other side to the top-down view that markets are inflated and approaching a bubble. Most of the counter-argument centers on four ideas: 1) there are flaws in each of the metrics outlined above; 2) after six years of anemic economic growth, the economy is due to break out; 3) forward PE ratios (today’s price relative to analysts’ earnings per share estimates for 2015) are not extraordinarily high; and 4) it’s different this time, so the Federal Reserve will not be able to tighten because the economy will not be strong enough. (Note to blog readers: the argument that stocks are the best alternative is not addressed  here because the letter makes clear that PAR believes all markets–stocks, bonds, housing, etc.–are inflated beyond levels that are justified by fundamentals.)

Point four contradicts the other points. For example, if it is different this time and the economy is not strong enough for the Fed to tighten, then it is hard to argue that forward earnings will be good or that the other metrics would point to better conditions if they weren’t so flawed. At least in the pessimistic case, all compasses point in the same direction. 

I think I understand all of the identified flaws in each metric above (e.g.  flaw: “the CAPE in 2012 was distorted by two recessions, which is unlikely to be repeated”) even if I disagree with the rationales for why they are flaws (e.g. Shiller used a ten-year horizon to capture long cycles). Also, the various flaws have always been in the measures, which make trends important. It is the trends that are troubling. 

I do not know where the economy is headed and I don’t know where earnings will be next year. But, I do agree with Steven Levitt and Stephen Dubner, who wrote the following in their latest book, Think Like a Freak:

“It has long been said that the three hardest words to say in the English language are ‘I Love You.’ We heartily disagree! For most people, it is much harder to say ‘I don’t know.’”

David Dreman demonstrated that analyst EPS estimates have been far off the mark for a long time. But, analysts have to keep on guessing because their institutional clients demand it and they cannot tell their clients the truth: that they just don’t know what forward EPS will be and that they could deliver more value to clients if clients would let them focus instead on what can be known about a business. Given analysts’ abysmal records in forecasting EPS, how can anyone find comfort in forward PE estimates? 

I hope the economy surprises to the upside and justifies today’s high stock market prices. All PAR can do is stick with its Separate Account Value Investing (SAVI)* discipline and buy stocks only when PAR finds a margin of safety, and “buy” call options that never expire on every company in the market (i.e. hold cash) when margins of safety do not exist. Those call options will be valuable one day.

Discipline is the key.

* SAVI is a separate account platform with Charles Schwab in which PAR invests client funds using PAR’s value investing processes. Clients have complete transparency into PAR’s activity in their account and clients control their separate account. Client funds are not commingled in the SAVI platform, so clients receive asset management tailored to their needs.

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At this month’s CFA Institute Annual Conference in Seattle, Sharpe said that Smart Beta made him sick because it implied that index investors had to be “dumb beta.” Sharpe believes the so-called dumb beta investors would eventually gravitate to Smart Beta strategies because no one is that dumb for long, and then the advantages of Smart Beta would simply melt away into average beta.

As regular readers know, Fama and French (F&F), and later Lakonishok et al. (LSV)  (See F&F and LSV tab above) demonstrated as early as 1992 that two factors consistently resulted in outperformance in the long run: Value and Small Cap. It is largely these two factors that put the “smart” in “Smart Beta.” F&F and LSV were not the first academics to publish papers on the value and small-cap factors, but they certainly popularized the factors in academia. Before these academics came along, we had research from practitioners Ben Graham from the 1930s through the 1970s; Warren Buffett from the 1950s to today; and Seth Klarman from the 1980s to today; that demonstrated that value strategies consistently outperform the market in the long run.

Since F&F and LSV published their research in the 1990s, there has been an overwhelming amount of academic research that demonstrates that value strategies outperform. Most of that research proves that value outperforms for reasons that are not related to risk, therefore value has consistently delivered alpha in the long run.

Most Smart Beta strategies are nothing more than systematic ways for managers to capture some of the factors that are known to deliver this alpha in the long run. The adoption of this approach in a more systematic and passive way somewhat proves Sharpe’s theory that no one stays that dumb for long. However, value and small-cap strategies outperform over long periods not necessarily because value and small-cap investors are smarter than everyone else, but because behavioral flaws and institutional constraints do not permit EVERYONE to FULLY capture the alpha in value and small cap. I remind you that it did take over 150 years for Smart Beta to be born.

Only small investors with contrarian streaks (see my future post on Investor DNA) can fully exploit these factors. Even Smart Beta strategies will fail to fully exploit these factors because of the amount of capital that Smart Beta will need to invest. Much of that capital will have to be allocated to large cap firms, but most of the alpha in these factors is found in relatively unknown and un-followed small-cap firms.

So, my answer to Sharpe’s queasiness is this: Smart Beta is just a label. Would he have taken less umbrage if that label were “Behavioral Beta” or “Factor-Focused Beta?”

http://advisorperspectives.com/newsletters14/Bill_Sharpe-Smart_beta_makes_me_sick.php

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1. He’s super-smart;

Yet, as Buffett himself has said, if you have more than 130 IQ points you should sell the excess because you won’t need it to be a great investor. In fact, that extra IQ may be detrimental if it leads to behavioral flaws such as overconfidence or lack of discipline.

2. He’s guided by an overarching philosophy;

That philosophy is value investing, which can be executed in several forms.

3. He’s mentally flexible;

It may seem as if Buffett had a change in philosophy when he transitioned from Ben Graham’s “Net Net” and “Cigar Butt” approaches to investing to Charlie Munger’s “wide-moat” approach. However, all three approaches are guided by the value-investing tenet that requires a Margin of Safety.

Graham’s margin of safety was found in businesses trading at less than the net value of their assets. Munger’s approach of investing in under-appreciated companies with wide moats found a margin of safety in well-run business with pricing power and even growth. The key is in the qualifier “under-appreciated.”  Value investors love growth, but tend to be more skeptical of growth projections than glamour investors, and are usually better at maintaining discipline when pricing growth, and rightly so.

Hence, value investors usually buy fast-growing, wide-moat companies only when the market does not fully appreciate their wide moats as much as it should. One example: Buffett paid $1.02 billion for shares of Coca Cola by the end of 1989 after the 1987 crash had damaged Coke’s shares. By 1999, that investment was worth $11.6 billion according to Hagstrom.

4. He’s unemotional;

Marks: “Many of the obstacles to investment success relate to human emotion…perhaps worst of all, (most investors) have a tendency to judge how they’re doing based on how others are doing, and to let envy of others’ success force them to take additional risk… (Warren) doesn’t care whether others think he’s right or whether his investment decisions promptly (my emphasis) make him look right.”

My Take: Warren is disciplined, which can make a person appear unemotional. I would be willing to bet that on more than one occasion in his career he lost sleep over a decision, but that his discipline allowed logic to triumph.

5. He’s contrarian and iconoclastic;

As Charlie Munger likes to say, I have nothing more to add.

6. He’s counter-cyclical;

Marks: “Many of the best investors accept that they can’t predict what the macro future holds in terms of economic developments, interest rates and market fluctuations…the greatest bargains are accessed by buying when the economy and companies are suffering…how many acted as boldly (as Buffett) when fear of financial collapse was rampant (in 2009)?”

7. He has a long-term focus and is unconcerned with volatility;

One should only invest in the equity or long-term debt of businesses to cover long term liabilities such as college tuition that is due in twenty years, retirement liabilities, and bequests, so volatility is the friend of the long-term value investor. Volatility gives the long-term value investor the chance to buy low and eventually sell high, in contrast to what most investors do; that is, buying when rising prices make them feel good and selling when plummeting prices are too painful to bear.

This is where a good wealth advisor comes in for an individual investor or family office. He or she will help such investors identify their goals and estimate when the invoices for those goals need to be paid. Then, a good advisor will allocate assets to broad asset categories that “immunize” those liabilities and help make the euphoria of rising prices and pain of plummeting ones easier to ignore and bear because short-term goals are covered in cash or high-quality short-term debt, and opportunities to cover long-term goals will arise over a multi-decade run.

This is known in High Net-Worth Investor (HNWI) Wealth Management circles as Goals-Based Investing (GBI).  The underlying assumption is that all investors would be happy to simply meet their goals and avoid their nightmares so that they can focus on their careers and the things that make them happy.

In GBI, capital for near-term goals is held mostly in cash and short-term bills, and capital for long-term goals is invested in less liquid or more volatile (in the short run) investments such as equities, long-term debt, real estate, and alternatives in order to exploit the return premiums that are available there.

Within asset categories a good advisor will help clients find investment managers who understand each asset’s risks and who can manage those risks well. He will also find managers who can exploit specific premiums in those asset classes such as the value premium in equity investments.

8. He’s unafraid to bet big on his best ideas;

So many active investors have capital spread thinly, and almost all of it is allocated to S&P 500 companies. They have low “active share,” so they are essentially closet indexers who charge higher fees than indexers.

9. He’s willing to be inactive;

According to a speech that Seth Klarman delivered at a Grant’s conference in the fall of 2013, Baupost Group has about 50% in cash. Klarman is fearful of returning cash to his investors because he believes that they may go out and invest it with a hot-hand manager and will suffer during an inevitable shakeout.

PAR views cash as an investment in an option on every asset, an option that has no expiration date. That option is worth quite a lot right now.

10. Finally, he’s not worried about losing his job;

Professional portfolio managers who work for large firms lose their jobs if they underperform. That is why many make the rational decision to become closet indexers in order to hug their benchmark and avoid underperformance.

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“…around 50% of our assets are in cash, and that’s a very high absolute number, now around $14 billion and rising…”–Seth Klarman

I recently came across this quote from Seth Klarman of the Baupost Group, which he said during a speech that he gave at James Grant’s Investment Conference in October 2013 (http://www.grantspub.com/mygrants/viewarticle.cfm?aid=4995).

If anything, Seth has less capital employed now than he did then.

If I had to pick one investor with whom I felt closest philosophically (and operationally), it would be Seth. PAR is currently sitting on cash equal to 55% of client capital because our bottom-up process has revealed few bargains and PAR has just about enough invested in the bargains PAR has uncovered.

As readers of PAR’s holiday card may have noted, I now view cash the way Buffett’s biographer believes Buffett views it: Cash is an option on thousands of companies and each option has no strike price, no expiration date, and no premium cost other than the lost purchasing power due to inflation. At current inflation rates, the premium is low.

This is the strongest argument to the oft-asked question: Why should I pay [Investment Manager] to hold cash? The answer, of course, is that they are paying [Investment Manager] to have the discipline to buy perpetual options on companies that will one day provide a margin of safety. [Investment Manager] “finds” these perpetual options by selling positions that become fully valued in inflated markets. It takes discipline to sell at or near full value when markets have been rising. Clients who believe that they could do the same as [Investment Manager] need to be introspective and seriously question (and answer honestly) whether they held significant amounts of cash in 2007 and employed it fully in 2009.

Coming into 2014, the market in general was overvalued as evidenced by the CAPE, Tobin’s Q, profit margins, etc., but patient investors will get their opportunities. Those with dry powder, who have been sitting on a perpetual option on every company–i.e. sitting on cash–will be the ones who exploit those opportunities.

My friend Chris Cannon attended Grant’s conference last fall and took some notes from Klarman’s speech that day that I have condensed. Enjoy:

“Seth is a great worrier.  He worries top down but invests bottom up.  He says top down analysis is a lot like sports talk radio – lots of talk and opinions…

Most investors/portfolio managers feel a gun to their head to get fully invested.  This is a weakness…

…if (Baupost) thought the world was going to collapse tomorrow then they wouldn’t return the cash. So he can’t figure out the timing.  But if it does collapse he will ask his investors for more cash…

His biggest concern is that his investors take the cash he returns them and place it with a manager putting up big numbers over the past few years, especially the last two. “This is a recipe for disaster.”  He’s encouraging them to protect it…

Nobody in the White House or the Fed has any practical business experience and handing the reigns to another academic seems totally nuts to him…

He thinks big cap companies (like Jeremy Grantham’s high quality) aren’t mispriced enough for him to do anything interesting with them…

(Because of LBO recaps and refinancings, Y)ou don’t need an economic downturn for a crack up (in high yield), just slightly higher yields… So a crackup in high yield is very, very, likely…

It’s embarrassing that after a crisis that nobody saw, government policy continues pouring on more gas to fuel more speculation to get things (stocks, real estate, debt) back to the same place we were, or maybe even worse now…

It took him at least 15 years of repeating his ideas so clients can see them really work and then they sink in.”

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I have found the story of Allan Mecham to be fairly typical. You have probably never heard of Mecham because his fund is structured as a hedge fund, and so SEC rules prevent him from advertising and state that he must limit the number of his investors to a few hundred who must be wealthy.

The companies he buys trade at a discount to their intrinsic value because the “smart money” will not buy them, usually (but not always) because the company is too small to attract the attention of large investors. If the smart money does buy them, they usually do not stay with the investment for very long; the typical non-index mutual fund turnover rate is over 100%. In many ways the story of investment in these companies parallels the predicament of Mecham’s fund. The smart money that will not invest in the companies that Mecham buys shares a philosophy with the smart money that will not invest in small, concentrated, contrarian funds.

The following are the typical characteristics of the philosophy and processes used by small, value investors such as Mecham. They:

• Make investment decisions alone because groupthink generally leads to poor investing results. As Mohnish Pabrai once said, it is doubtful that Warren Buffett would have made one of the most successful investments of his career–taking a stake in American Express that amounted to 40% of his fund’s assets–if he had to answer to an investment committee or justify the investment to a pension fund consultant;
• Are usually somewhat quirky and do not have the pedigree or use processes that Wall Street understands, at least not before they have $1 billion in assets under management (AUM). After a billion dollars in AUM, Wall Street understands even gibberish. To Wall Street, Buffett was just some quirky guy in Omaha before he had a few billion in AUM. And, by Wall Street, I mean every potential investor in Meacham’s fund–seeders, incubators, funds of funds, pension funds, family offices, and other high net worth investors. At a recent family office (FO) conference that I attended, every speaker said that FOs–once the mainstay investor in small, quirky, value-investing startups–have gone the way of big institutions seeking to invest only in large, well known managers who have the infrastructure to gather assets;
• Because of the “institutionalization” since 2000 of the processes used by FOs and other high net worth investors, it is nearly impossible to find funds like Arlington that launched after 2000. We now know of the huge success stories such as Arlington, Klarman’s Baupost; Einhorn’s Greenlight; Pabrai’s Pabrai Funds; and Tilson’s T2 partners. These once-tiny value funds all launched before 2000–almost all with less than $1 million AUM–and grew through word of mouth. Can you name one that launched after 2000? Those that launched after 2000 have had little chance to raise capital in the new institutional environment;
• Are contrarian–buying when others sell, and selling when others buy
• Are structured as hedge funds because 1. SEC rules severely restrict the way mutual fund managers operate (e.g. SEC rules force diversification–”di-Worsification” as Peter Lynch liked to say–limit the ability to manage risk by hedging and selling short; and limit the ability to use leverage to exploit extraordinary contrarian opportunities and special situations); 2. mutual funds must be able to meet redemptions every day and so are not conducive to long-term thinking; and 3. mutual funds have higher startup costs;
• Do not try to predict where the market is heading but hedge market risks when the costs of hedges are cheap such as when everyone thinks the market can only go higher. In fact, they usually do not make explicit predictions for the companies in which they invest because they know that those predictions are rarely accurate (See the evidence for this in any of about one hundred sources such as Dreman’s Contrarian Strategies (Just added the latest edition to the bookstore above))
• Do not take in a lot of money because they know that true value opportunities are few and that sitting on a lot of unused cash would only hurt their investors’ returns. Even if the smart money suddenly realized that funds like Mecham’s were safe investments that delivered excellent long-term results, Mecham would not likely take in much more than he is managing now;
• Know that senior managers rise to the top of their organizations because of their inordinate salesmanship abilities and so meetings with companies are likely to lead to biased analyses. Meetings with management should therefore be avoided, or kept short and limited to extracting a vital piece of information that could not be obtained any other way;

I have a personal story. I write this blog anonymously because I do not want to run afoul of SEC rules regarding solicitation. A high net worth investor–a doctor from North Carolina–managed to track me down because he liked what he read here and wanted more information in order to invest in my fund. My law firm said he had to fill out a questionnaire before I sent him any information.

The doctor filled out the paperwork, but I could only send him the PPM after I received his information and determined that the fund was a suitable investment for him. The PPM is boilerplate but I told him that I could not take any investment from him until he had taken a little over a month to digest it. He still has not seen the results that the fund delivered, but he did ask general questions about the fund, which I launched in 2010. The information I gave him demonstrated that my fund started with ten times the assets and ten times the number of partners as Mecham’s fund, and from what I gathered in the article, twice the number of fund employees as Mecham.

Doctors like the one who contacted me were once the angels of startup funds like mine and they reaped the rewards; yet, it has been almost three months since I heard from him. As of today, I have nine investors in my fund made up of one family member, one former fund employee, six former colleagues from prior firms in which I worked, and one former client from a firm in which I last worked in 1997; no one that I have known for fewer than fifteen years.

The traditional investors who invested in funds like mine no longer invest in funds like mine. It is sad, and not just for entrepreneurial fund managers. Maybe it is the Madoff effect or severe risk-avoidance after two bubbles burst last decade, but it is especially sad for anyone who needs to fund a future liability–i.e. everyone. The story about Mecham opens with him in a conference room in New York City surrounded by potential investors who are peppering him with questions, trying to gauge his ”sophistication.” It would be funny, if it weren’t so sad.

http://www.smartmoney.com/invest/strategies/the-400-man-1328818316857/#tabs

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http://www.ft.com/intl/cms/s/0/77f0077c-c35a-11e0-9109-00144feabdc0.html#axzz1YtylE6lL

“…there is a simple, although not easy…alternative (to  benchmark-focused investing)…use a value approach across a wide range of assets. Buy when an asset is cheap, and sell when an asset gets expensive – buy low and sell high, a  sensible approach to both the preservation and growth of capital.

Valuation is the primary determinant of long-term returns, and the closest thing we have to a law of gravity in finance. For instance, buying assets when  they are expensive (high price/earnings ratios in the equity space and low  yields in the bond space) tends to result in low returns. In contrast, buying  cheap assets generally leads to high long-term returns. So moving your assets in  response to valuation signals makes sense.

Of course, there is a downside to this style of investing. In order to pursue  a value-driven approach you need two key traits – patience and a willingness to  be contrarian. Unfortunately these traits are in rare supply, and become almost  extinct when people act in groups (such as committees).

Let’s end as we began with a quotation from Sir John Templeton: “If you buy  the same securities as other people, you will have the same results as other  people. It is impossible to produce a superior performance unless you do  something different from the majority. To buy when others are despondently selling and to sell when others are greedily buying requires the greatest  fortitude and pays the greatest reward”.

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• Who is this guy? Why would Buffett pick an unknown manager/firm?
• How could someone be such a good investor and remain relatively unknown?
• Weschler has one investment employee working at his firm and one assistant. How could someone running a tiny office fill Buffett’s shoes?
• Why is Buffett once again tapping a hedge fund manager for a successor? Is he changing his approach to value investing?

I will address each question:

Why Would Buffett Pick an Unknown?

Of course Buffett has to pick an unknown investor from an unknown firm. Virtually all of the known investors at known firms are employees of great marketing firms–that’s how you know who they are–but they are usually not great investors. Virtually all of the known firms have business models that rely on well-oiled marketing machines to gather assets because they are paid on the size of the assets that they manage, not on their performance.

As asset gatherers, the known investors must ensure that they never fall too far behind the rest of the market and their competitors. The only way that they can ensure that they keep pace is by becoming a closet indexer–someone who pretends to spend a lot of effort on security selection but who, in reality, merely invests in each of the large companies in a large-company index, plus or minus minor adjustments for aesthetics. Of Course, Buffett, a value investor, does not invest that way even now.

How Could Someone be a Good Investor and Remain Relatively Unknown?

For almost their entire careers, most of the world’s best investors remained unknown by the overwhelming majority of the investing public. They generally have long periods when they are accessible to only a few savvy people/firms, and then they suddenly find themselves in the spotlight after reaching a tipping point. Welcome to Ted Weschler’s “moment.” Another example: Hardly any but a small number of savvy professionals heard of Peter Cundill before he died in January 2011. It took a posthumously published biography for many to know his record and style, and even now few have heard of him. Ironically, the lack of attention is what helps make value investors, great investors. By the way, it is no coincidence that most of the world’s best investment managers (by long-term performance) also happen to be value investors.

How Could Someone Running a Tiny Office Fill Buffett’s Shoes?

Are you kidding me? Most of the world’s best investors work alone; they avoid investment committees like the plague. Committees lead to group-think and group-thinking leads to bad investment decisions. They diligently read through financial statements, talk to a company’s customers, and meld dozens of pieces of information to form a unique view; they do not delegate that very important work.

The general attitude behind this third question is: “You aren’t structured like Fidelity or American Funds, you don’t have the resources that they do, and you don’t have a lot of experts on staff to which you can delegate work, so how can you be any good?” They fail to grasp that great investing does not take a lot of experts and IQ points, and that because of technology, a single investor has more resources at his fingertips than Fidelity did just ten years ago; it is how those resources are used that matter, not the number of them. As Buffett himself once said about what it takes to be a successful investor (I paraphrase), “Any IQ points over 125 are wasted.”

Also, contrarian value investors who run concentrated portfolios don’t need experts on staff as much as they need a strong constitution. Great investing is simple, but it is not easy. It is not difficult to read financial statements, have a view of a business’s competitive position, draw conclusions about the business’s prospects, and know whether its market price is low enough to offer a margin of safety. But, it is difficult to invest only when one has a margin of safety because for the price to be low enough to provide a margin of safety, nearly everyone else has to disagree with your view.

Contrarian, margin-of-safety investors must go against the herd. As Michael Mauboussin has explained about great investing: “A proper temperament beats a high IQ every time.” Finally, most of the Superinvestors that Buffett highlighted in his Superinvestors speech at Columbia University (see tab above) worked alone or with minimal staff. It is only the marketing machines that need a large staff and that consists mostly of marketing and legal professionals. Oh, and by the way, Buffett himself invests alone in a tiny office.

Why is Buffett Hiring Another Hedge Fund Manager to Succeed Him?

True value investors must use something like a hedge fund structure (or be an insurance company like Berkshire Hathaway with permanent capital) to improve the odds of generating alpha. Value investors must have a long-term view and hedge funds can be structured so that their investors cannot redeem for extended periods. Value investors must run concentrated portfolios and hedge funds allow the most freedom to do that. Value investors must be contrarian and hedge funds help insulate hedge fund managers from the daily scrutiny that would make contrarianism nearly impossible for the average person.

Finally, as I demonstrated in investor communications, Warren Buffett began his career as a hedge fund manager and remained one for ten years. Buffett contributed $700 of capital at the launch of his hedge fund in 1957 and his friends and family contributed another $100,000; most of today’s great investors started that way with small amounts of capital from friends and family.

Today, Buffett still behaves as a hedge fund manager but one with the ultimate luxury–permanent capital. I listed Buffett’s first business model as one that I  would emulate for my own fund. It should not be a surprise that many still relatively unknown, but extremely successful value investors also emulated Buffett’s hedge fund structure and philosophy. It should not be a surprise that virtually all of these great investors started small and stayed small for a long, long time thus enabling them to stay under the radar.

But don’t just take my word for it, read what Buffett wrote in a letter to his hedge fund partners on January 20, 1966:

“Last year in commenting on the inability of the overwhelming majority of investment managers to achieve performance superior to that of pure chance, I ascribed it primarily to the product of: “(1) group decisions – my perhaps jaundiced view is that it is close to impossible for outstanding investment management to come from a group of any size with all parties really participating in decisions; (2) a desire to conform to the policies and (to an extent) the portfolios of other large well-regarded organizations; (3) an institutional framework whereby average is “safe” and the personal rewards for independent action are in no way commensurate with the general risk attached to such action; (4) an adherence to certain diversification practices which are irrational; and finally and importantly, (5) inertia.”

In each of these ways, Ted Weschler is an ideal candidate to eventually replace Buffett.

For some of the media reaction, see:

http://online.wsj.com/article/SB10001424053111903532804576569142588655126.html?KEYWORDS=weschler

I’ll bet that Jason Zweig, a Ben Graham biographer, is as amused by the reaction as I am, but he keeps it together on the video in the story.

For an interesting take on Buffett’s transition from an obvious hedge fund manager to a less obvious one with permanent capital, see the Joe Taussig paper embedded in a link at the bottom of this blog post:

 http://www.santangelsreview.com/2011/09/05/dan-loeb-of-third-point-to-create-a-reinsurance-company/

Taussig Capital is a Zurich based consultant to hedge fund managers.

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Source: http://www.econ.yale.edu/~shiller/data.htm

In the sixteen-plus years from January 1966 to August 1982, the index value of the S&P 500 dropped 61.74% after adjusting for inflation. Real total returns would not have been as bad as that because investors would have collected dividends over that period, but the results are still dismal.

The CAPE has been a reliable indicator of long-run returns for the US stock market. It is impossible to say that a large market correction is imminent, but few could argue that the prospects for real returns in the US stock market are rosy especially when Tobin’s Q ratio, which measures market prices relative to corporate book value and is another reliable long-term indicator, is at an all-time high (excluding the dot com era but including the housing bubble).

When there are so many known economic pins bouncing around that could deflate this market quickly, and many more pins that our imagination is weak at identifying, what is driving it upward? That question is especially pertinent to those companies whose P/E, P/B, and P/S ratios are in the stratosphere such as OPEN and NFLX. The graveyards are full of companies that once flew high on growth prospects alone.

Last week’s 5.6% market pop on little news is a mystery. Unfortunately for the cautious among us, it looks like a mystery that may continue to play.

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