Tell us something we don’t know
February 10, 2015
Market Summary – 4th Quarter, 2014
“Never make predictions, especially about the future.”
– Casey Stengel (legendary baseball manager)
It’s that time of year when we customarily hear from various prognosticators about what to expect in the year ahead. These would-be fortune-tellers attract a lot of attention from fortune-seekers who hope to glean some insight that might give a hint about how to gain an edge in the markets for the year to come. But history has shown that listeners should be cautious. Predictions, whether about the economy or a slate of NFL games, are little more than a form of entertainment.
Byron Wien of Blackstone, Douglas Kass of Seabreeze Partners, and a roster of popular pundits that participate in the annual Barron’s Roundtable (to name just a few) are tripping over one another in a contest to one-up each other with their oftentimes shocking predictions. But here is something that you may not know: none of these forecasts matter when it comes to successful investing.
No matter how confident a market forecaster may be, NOBODY knows what events will define 2015. For example, last year all 67 economists surveyed by Bloomberg predicted that the yield on the 10-year U.S. Treasury bond would rise in 2014. Instead, it dropped from 3% to 2.17%. Likewise nobody predicted many of the 2014 headlines, such as Russia/Ukraine, the emergence of ISIS, and the Ebola outbreak, to say nothing of the collapse in crude oil prices that would cripple one of the most powerful cartels (OPEC) of the modern era. With this as a reminder of how “off” the forecasters can be, we’re happy to be quite possibly the only year-end newsletter that is devoid of any grandiose predictions.
Good investors don’t ignore the world around them, but they also don’t rely on “knowing” all that the future will bring to dictate specific moves within a portfolio. Trying to make money by following macroeconomic trends, without regard to individual stock valuations, ultimately leads to disappointing investment outcomes. Events or trends on a grand scale can provide an indication of specific investment opportunities, but the key issue is value – the price that one pays to obtain an ownership position in a specific business. Price is what protects investors from systematic shocks and macroeconomic upheaval that cannot be anticipated. Even if the economic environment creates negative surprises, investments bought at the right price carry a material margin of safety. A portfolio built using a value approach is protection against not only the failings of forecasters, but also (and more importantly) the inevitable surprises that will arise.
This isn’t to say macroeconomic events are irrelevant. Smart investing seeks to capitalize on developing trends and themes. Within that context, the key to building and protecting wealth is to pay the right price for a business. At MPMG, we look at the world around us, determine where opportunities exist and then invest in great businesses at inexpensive prices that are well positioned to take advantage of these developments.
Ignoring that which is often interestingly unimportant and focusing on value-based investment principles is the secret to successful, long-term investing. As the great Peter Lynch once said, “Your ultimate success or failure will depend on your ability to ignore the worries of the world long enough to allow your investments to succeed. It isn’t the head but the stomach that determines the fate of the stock picker.”
Here is something else that you may not know
The market volatility that is keeping many investors awake at night is primarily caused by (1) high frequency trading firms (HFTs) and (2) investors using passive index funds and exchange traded funds (ETFs). Together they account for the majority of trading volume in the market today and serve as the primary culprit for the market’s dramatic up-and-down movements with no discernible justification. Meanwhile, real money (non-ETFs and non-HFTs) has seen its share of trading volume fall to a level where its constituents are temporarily along for the ride. The influence of HFTs and passive investing has resulted in a disjointed market where significant disparity between price and value of many businesses exists. As we have seen this cycle play out many times before, investors with patience and the courage to own what is currently unpopular will once again be handsomely rewarded. Those who choose to chase the popular assets du jour, confusing short term success with long term excellence, will be taught a painful and expensive lesson.
So what is an investor to do?
As we enter the seventh year of a bull market, many investors are carelessly chasing returns without consideration of the risks that they are taking. In a market with significant dislocations between price and value, the imperative to know what you own in order to define your risk is more important than ever.
We continue to implore investors to ignore the noise generated by the hapless market experts and capitalize on the incredibly disjointed nature of the current market. High frequency traders and their computer codes focus exclusively on short-term profits. Meanwhile the growing cadre of passive money continues to exacerbate the inefficiencies of the market by chasing the market’s momentum with little regard to valuation or risk. It is as if nobody in the market is valuing businesses anymore.
Long-term investors need to disregard the indiscriminate flow of funds that move the market in the short-term and rely on the fundamental principle of investing: buying a good business at the right price. Undiscerned buying (such as index investing), is not an effective way to capitalize on the market’s inefficiencies. Remember that the S&P 500 (the most popular index for passive investors) is weighted by market capitalization. At the end of 2014, just 2% of the stocks in the index represented 17.5% of its value1. Passive investors continue to see a large portion of their money directed toward the most popular stocks. But as is so often the case, that which is currently popular is also dangerously overpriced. These passive investors by definition will be unable to protect themselves from the current market excesses that their indiscriminate buying has created.
The case of the maligned stock picker
If one were to “Google” the term “active investment manager,” headlines such as “Is Active Management Dying?” and “Can Anything Save Active Management?” would be listed at the top of one’s search results. Such skepticism is not uncommon during a bull market when investors start to reach for returns and overlook risk.
Passive investing worked while the Federal Reserve was artificially stimulating the economy through quantitative easing. One of the consequences of quantitative easing was a high degree of correlation amongst stocks, as the stocks of both good and bad businesses with often disparate valuations tended to move in a similar direction (mostly higher).
But this index investing craze has also skewed returns in favor of the companies with the largest market capitalizations. Today’s most popular index (S&P 500) is a capitalization-weighted index and the few companies with the largest market capitalization bear a disproportionate influence on the index. Consider that in 2014 five stocks (Apple, Berkshire Hathaway, Johnson & Johnson, Microsoft and Intel) accounted for 20% of the gains generated by the S&P 500 Index. Failure to include these five stocks as top holdings in your portfolio made it nearly impossible to outperform the S&P 500 Index.
The market suffered a severe case of “bad breadth” in 2014, as only 30% of the stocks in the S&P 1500 Index posted gains that exceeded the index itself. Not since 1999 have we seen a year where 70% of stocks in this benchmark index underperformed the index itself. Combined with the disproportionate influence of the five mega-cap stocks listed above, active managers suffered through one of their worst years on record in 2014. According to Lipper, 85% of all active stock managers were trailing their benchmarks through November. In a typical year, nearly twice as many managers outperform their benchmarks. This made 2014 the worst year for active managers relative to the market in three decades.
With quantitative easing seemingly at or near its end, the Federal Reserve’s tidal wave of liquidity that has lifted all boats should subside. The dislocation between (1) the currently popular and overvalued companies and (2) the overlooked and undervalued businesses will ultimately return to reason.
And if this belief fails to materialize in 2015, MPMG investors can rest assured knowing that our value approach is still protecting them while also offering compelling growth opportunities. Value investing doesn’t work every second of every day; markets are not efficient. But over time the markets will recognize undervalued businesses and reward them with a fair (and oftentimes excessive) price. Valuation is to markets as gravity is to physics.
A confluence of favorable developments
While MPMG’s value-oriented approach does not require positive economic tailwinds to succeed, there appears to be a confluence of favorable developments that should promote continued economic growth.
The decline of oil prices
The price for a barrel of crude oil has fallen by more than half since July 2014. Part of the selloff experienced on certain trading days by the markets (and index funds) can be attributed to the negative impact falling oil prices have on energy companies. Some of the major indices include giant oil companies as major components. The bigger story is that lower oil prices are good for the economy and many individual businesses. Over the past six months, U.S. gasoline expenditures fell by $170 billion or about 1% of the nation’s GDP. It is a windfall for consumers, equivalent to a tax cut, leaving more money to spend in other parts of the economy. The sudden relief from high oil prices may be the potential catalyst toward more rapid growth we’ve been looking for in our economy. The dawn of the regime of lower oil prices has the potential to keep the U.S. economy growing.
Accelerating economic growth
The U.S. economy in the third quarter grew by 5%, its fastest rate since 2003. This is on the heels of a strong second quarter that saw growth of 4.6%. Job growth also picked up substantially in the second half of the year. If that trend continues, it is likely to carry over into an improved housing market, the most notable laggard in the U.S. economy in 2014. It already seems to have helped the auto industry close out 2014 on a high note.
Growing infrastructure demands
Engineering and construction companies, along with firms that specialize in infrastructure, have been mercilessly punished in the market over the past six months. These are prime examples of stocks that have experienced significant price dislocation. Yet infrastructure needs are a clear issue to be addressed domestically and around the globe. Lower energy costs may help tip the scales toward greater infrastructure investment. This could ultimately facilitate growth both in developed markets and in emerging markets. Along with infrastructure improvements, the ability to transport goods worldwide will be enhanced by lower energy costs.
The underlying environment for equity markets remains quite positive. Solid economic growth, low interest rates and low inflation have historically been favorable for stocks. If these conditions remain, we expect the positive tailwind for stocks to persist.
What we said – a look back at 2014
Throughout 2014, our newsletters emphasized the importance of paying attention to price, overcoming the tactics of high-speed traders and embracing the volatility that is inherently part of the investing process.
• In our first quarter letter (“If You Want To Play the Game, You Had Better Know The Rules”), we noted that the disadvantage of smaller investors in today’s high-speed, computer-driven market is not a new development. Small traders have always been at a technological disadvantage compared to professional traders. Yet we affirmed our belief that individual investors can still succeed by taking advantage of selective opportunities to build wealth over time. This topic was the catalyst for MPMG to invite Michael Lewis, the New York Times bestselling author of Flash Boys and an expert on the subject of high frequency trading, to serve as the featured speaker at the 2014 MPMG Speaker Series event.
• In the second quarter (“Man In The Mirror”), we identified the troubling disparity in returns between the average stock fund and the average individual fund investor. We attributed the shortcomings of individual investors to decisions that are too often based on emotions (jumping in and out of the market based on recent market performance). We noted that a disciplined, patient, unemotional approach to investing is critical to long-term success, even though it is often not rewarded over shorter spans of time. Investors need to stomach volatility and remain invested in stocks that offer real value in order to generate returns that keep pace or outperform the market.
• Our third quarter letter (“Walking on Thin Ice”) explained that temporary price stability and conformity should never be mistaken for safety. We pointed out that many investors have the misconception that the S&P 500 Index is reflective of the market. Most notable was the trend of assets flowing away from active managers and towards passively managed vehicles such as index funds. We suggested that investors relying on the performance of the index were, in reality, hitching their star to a select group of mega-cap stocks that dominated the S&P 500 Index. By doing so, they sacrificed any sense of paying an appropriate price for a stock, which, as we pointed out earlier, is an important defense against the market’s unpredictability.
We also sent out a special letter to investors in the fourth quarter (“All I Really Need To Know I Learned in Kindergarten”) re-emphasizing that the S&P 500 truly did not represent “the market” in 2014. Look beyond this index, weighted heavily toward the largest of the big-cap stocks, and we see that the S&P 500 was a true outlier.
Keeping an eye on what matters
In today’s world data is a commodity, while wisdom remains priceless. There is no shortage of perceived experts distracting investors with that which is interestingly unimportant. What they don’t tell you and what many do not know is this:
Successful investing requires having a balanced amount of fear and greed; too much of either leads to poor judgment. And consensus views on anything are often wrong. Building wealth in the markets requires a disciplined, and patient approach, as well as the courage to avoid the popular excesses of the day. Ultimately, those that focus on buying good businesses at the right price will be rewarded.
We are deeply honored that you have entrusted us to create what we are confident will be life-altering wealth for you and your family. We wish you and your loved ones great health and happiness in the year to come.
Although the information in this document has been carefully prepared and is believed to be accurate as of the date of publication, it has not been independently verified as to its accuracy or completeness. Information and data included in this document are subject to change based on market and other condition. All prices mentioned above are as of the close of business on the last day of the quarter unless otherwise noted. Market returns discussed in this letter are total returns (including reinvestment of dividends) unless otherwise noted.
The information in this document should not be considered a recommendation to purchase any particular security. There is no assurance that any of the securities noted will be in, or remain in, an account portfolio at the time you receive this document. It should not be assumed that any of the holdings discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable. The past performance of investments made by MPMG does not guarantee the success of MPMG’s future investments. As with any investment, there can be no assurance that MPMG’s investment objective will be achieved or that an investor will not lose a portion or all of its investment.