AIM13 Commentary - 2017 Q1

“Where all think alike, no one thinks very much.”
- Walter Lippman

May 25, 2017

Dear Investor,

The two most prominent sentiments we are feeling right now are humility and puzzlement. Humility comes from the trust and confidence our investors have placed in us over the years to steward their capital alongside ours, navigating some of the highest highs and lowest lows equity markets have seen in the last hundred years. Our letters may often seem light and topical, at times irreverent, but readers should know that we never speak out of hubris. We work hard to know what we know, but more importantly work even harder to know what we do not know, and we are grateful to the many smart people in our lives to whom we look for guidance and thought leadership.

With humility then above all else, we must say, however, we are puzzled by the current dynamic between managers and investors. Sam Walton famously said, “Focus on something the customer wants, and then deliver it.” And deliver he did, building one of the greatest commercial franchises of all time. His success embodied Harry Selfridge’s famous original edict, “The customer is always right.” When it comes to investing, managers seem to be taking the same approach – giving the customer what he or she wants. Unfortunately, in that regard, we feel out of sync with the current moment; hence our befuddlement when we look around. Indeed, we feel a lot less like Sam Walton and Harry Selfridge and more like Enzo Ferrari, who quipped, “The client is not always right…

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“Nothing to see here… Please disperse.”

- Leslie Nielsen as Frank Drebin in The Naked Gun: From the Files of Police Squad! (1988)

It has been our belief for a long time that the current positive market sentiment masks substantial underlying problems. Investors seem to be following the advice of Frank Drebin, carrying on as usual as if nothing is going on in the background that should cause serious concerns. Nicholas Colas, Chief Market Strategist at ConvergEx captured it well when he wrote in early May that “There is an overwhelming market narrative that equates to, ‘Don’t worry, be happy.’”  

At one level, there is a lot to be complacent about. The S&P 500 has more than tripled (gaining over 250%) since bottoming at 666 on March 6, 2009, and the bull market is now in its ninth year, the second longest run since World War II. During the first quarter, one of the longest streaks without a 1% decline in the S&P 500 came to an end. Prior to the modest pullback on March 21st (due to the fracas over the healthcare bill), there had been 110 days without such a decline, which amounted to the seventh longest such streak in the history of the S&P 500.  Indeed, you would need to go back to 1993 to find a stretch longer than the one that ended this quarter, and then 1966 for one longer before that one. Such long runs of steady returns are very rare. Viewed another way, according to research published by Schaeffer’s Investment Research, as of May 17th, in 2017 there have been only three out of 93 trading days where the S&P 500 has moved up or down by at least 1%. Since 1929, only five years have had fewer 1% days at the 93-day marker. Smooth sailing indeed. 

The benign environment for stocks is illustrated by the VIX (which many use to measure volatility) which in May reached its lowest level since December 1993, according to CNN Money:

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We are aware of the constructive signals in the market that support this “all is good” sentiment. Leaving aside the “Trump trade” – or the optimism the new presidency brought with regard to tax policy, financial services deregulation, and pro-business legislation – other indicators are fueling the euphoria. Unemployment is down to 4.5%, interest rates remain very low, and generally leading economic indicators point to stronger economic results to come. However, as we point out below, there are reasons to believe that all is not so well and the markets may turn quickly. While not as visible as such things as unemployment and the prospect for lower taxes, they exist nonetheless.

In the face of all of this good news, the balance of power between investors and investment managers has decidedly shifted in recent years in favor of investors. Emboldened investors, who now think investing is “easy,” are either switching to passive strategies or demanding more and more from their active managers. At our firm, however, rather than embracing a “the customer is always right” mentality, we feel quite the opposite; indeed, our mantra for most investors today is caveat emptor – buyer beware!

The Customer Is Not Always Right

At the risk of sounding anything but humble, we would like to call out some of the things we see among investors these days that suggest to us that, when it comes to investing, the customer is not always right:

  • Investors think more liquidity is always better. Many investors believe they can make better short-term decisions regarding where their money should be invested and are demanding more frequent liquidity options from their managers. More often than not, this proves counter-productive. Countless studies have shown that investors more frequently time the market to their detriment, rather than to their benefit. Managers, for their part, need time to allow their best ideas to develop. Knowing that their investors can pull money at any time causes managers to think short term. Inevitably, during times of turmoil, managers are more worried about assets running out the door than finding great underpriced opportunities.
     
  • Investors focus on headline fees and not on net returns. CalPERS made headlines recently when it reduced its private equity allocation after disclosing it was paying higher fees to those managers relative to their public equity, real estate, and fixed income managers. Ironically, even taking into account the higher fees, private equity had been the best performing asset class on a net return basis. However, the move was applauded as a way to reduce outside manager fees. The result is lower returns for their plan participants.  This makes no sense to us. We are the first ones to object to alternative investments structured only as vehicles designed to transfer wealth from the LPs to the GPs. However, we do hope our managers make a lot of money on performance fees because that means they are delivering superior returns.
     
  • Investors think bigger is better when it comes to hedge funds. Studies have shown that since the financial crisis, “a vast majority of hedge fund net asset flows have gone to a small minority of hedge funds with the strongest brands,” according to a report published by ValueWalk in May 2017. Funds with $5 billion or more now control about 69% of all hedge fund assets. Asset gathering, however, is almost always at odds with superior investment returns. In fact, in our experience, it is the managers who return capital, rather than the ones that do anything to attract it, who deliver the best returns over time.
     
  • Investors think more frequent performance reporting is always better. We are always puzzled to see hedge fund managers issue performance updates more frequently than on a monthly basis. Some managers even publish daily returns. Similar to the liquidity demands, managers that publish short term results necessarily will think more short term. Given that most managers only offer quarterly, semiannual, or annual redemption rights, the result is paradoxical: investors end up with the worst of both worlds, an illiquid investment managed on a short term basis.
     
  • Investors fire last year’s underperformers and hire last year’s outperformers. Too many investors use a rear view mirror to pick managers. In a study published in November 2016 entitled, “Do investors chase performance or skill?,” Jon Fulkerson and Timothy Riley demonstrated that “investors tend to buy the funds with the best past performance, not the funds whose managers have demonstrated the most skill.” The authors went on to show that, as we have always felt, investment skill is a better predictor of future performance than prior performance. Most investors, unfortunately, focus on the wrong thing. 

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“The man who complains about the way the ball bounces is likely the one who dropped it.”

- Lou Holtz

As University of Michigan Wolverines fans, we have a hard time giving ink to someone most people associate as the former head football coach of the University of Notre Dame. However, we are impartial when it comes to pithy aphorisms, and what Lou Holtz says here is apropos: investors (especially in hedge funds and private equity) have only themselves to blame when they complain about investment performance in this “group think” world we live in. Whether it be investors in hedge funds who are “whipsawed” by short term performance swings, like we saw in the first quarter of 2016, or pension beneficiaries finding their benefits reduced because pensions are shunning private equity over fees, the result is the same: When it comes to investing, the customer is not always right! 

In the past twelve months, we have seen striking examples of how prevailing forward-looking sentiment was on the wrong side of a particular event.  Whether it was Brexit or Donald Trump’s election, if recent events taught us anything it is to be wary of statistics and commonly-held opinions. Even the Super Bowl showed us that what is widely believed to be the likely outcome does not always play out. As the chart below shows, according to ESPN, the Atlanta Falcons had a 99.7% probability of winning over the New England Patriots at the six-minute mark in the third quarter. Yet they still lost:  

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The point is that accepted wisdom is not always wisdom and should not always be accepted. When we look at managers and think about where best to invest our capital and yours alongside us, we think about the following things that are not priorities for most “customers” these days:

  • Long term horizon: Our best returns have been earned during times of turmoil when we remained invested.
  • Partnering with like-minded LP’s: We spend a lot of time understanding who is invested alongside us.
  • Managers focused on returns, not asset gathering: LP’s never did better just because AUM increased.
  • Terms that are designed to help the manager be a better investor, not necessarily attract assets.

We often refer people to Byron Wien’s seminal article, “The Inherent Instability of Hedge Funds” (a copy of the article is included with this letter).  Writing over fifteen years ago, he observed that when a hedge fund gets bigger, “Suddenly, the hedge fund discovers that success is changing its style of investing.” We see that far too often. Things managers do to raise assets – such as creating fund structures and offering terms based on investor demand – are often antithetical to long term, superior risk-adjusted returns. Investors need to remember that when they see terms that are not designed to align interests between themselves and their managers for better long term results, they can still say, No, thanks!  Unfortunately, so long as managers prioritize pandering to investor preferences just to raise money, and LP’s do not push back, all we will be left with are disappointed investors and wealthy managers.

Market Observations

We noted above how there are many widely-reported things in the markets that indicate times are good for stocks. Now for two less covered developments that we have been monitoring that suggest otherwise:

  • Debt for the average consumer has returned to pre-2008 levels. Total household debt climbed to $12.73 trillion in the first three months of 2017, according to the Federal Reserve Bank of New York. This represents a $149 billion increase from the end of 2016. Today's debt level is higher than the $12.68 trillion peak hit in 2008, according to Federal Reserve research. The chart below, which isolates the steady growth in car loan and consumer credit for Americans, illustrates this troubling trend:
 Source: Federal Reserve, Federal Reserve Bank of New York 

Source: Federal Reserve, Federal Reserve Bank of New York 

Interestingly, the biggest increase in debt comes from student loans, which accounted for 10.6% of total consumer debt, more than triple the share of total debt that it was in 2003. Indeed, we believe the student loan industry is the latest “debt bubble” to watch. As of September 2015, more than 330,000 people, or 11% of borrowers, had gone at least a year without making a payment on a Parent Plus loan, according to the Government Accountability Office:

 Source:  The Wall Street Journal

Source:  The Wall Street Journal

This default rate exceeds the default rate on U.S. mortgages at the peak of the housing crisis, based on a report published in The Wall Street Journal. In fact, the GAO estimates taxpayers ultimately will forgive $108 billion on student loans made through the current fiscal year. By comparison, the savings-and-loan crisis of the 1980s cost the Federal government roughly $181 billion, in today’s dollars, according to the Federal Deposit Insurance Corp, as reported in The Wall Street Journal.

  • Stocks are not cheap. One of the more popular valuation tools, the Shiller PE Ratio, illustrates just how expensive stocks have become. At a current ratio of 29, the valuation of the S&P 500 is very high relative to historical levels. According to Forbes, the average since 1881 is 16.75, and the average since 1970 is 25.4. It now stands at close to 30:
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Even using more conventional trailing earnings, you see the same type of elevated PE levels: Average PE ratios based on trailing earnings for the S&P 500 dating back to the 1950s has been 16.5x; today it is 21.3x. Given current elevated valuations, return expectations should factor in the possibility of a correction or even a more substantial pullback. Notably, however, the S&P 500 was in the most expensive quartile this time last year and has since risen +19%, according to research published on SeeItMarket.com.

When it comes to recent valuations, there has been a lot written recently on how large Amazon has gotten (twice the size of Walmart by market capitalization) and the astounding returns its original investors enjoyed. Similar things can be said about Apple and Microsoft. We believe, however, the bigger story of the recent tech “boom” is that firms are finally making up prior losses. Indeed, it is worth remembering that only recently did many of these high flyers recoup the losses following the burst of the tech bubble in early 2000. In fact, on April 24, 2017, the Technology Sector ETF (XLK) hit an all-time new high – more than seventeen years after the previous peak in March 2000. In other words, assuming an investor maintained a position through that time period, seventeen years into it, he or she would have had earned no return. So while it is true that a $10,000 investment in Microsoft’s IPO in 1986 would now be worth $6.7 million (a truly mind-boggling return), keep in mind that $10,000 invested in Microsoft stock in December 1999 would be worth only about $10,900 today 

A Note on Terrorism

The recent horrific attack in Manchester showed us once again of the importance of vigilance in our everyday lives. Our thoughts are foremost with the victims and their families; we cannot fathom the pain caused by this particularly depraved strike, targeting as it did young people. We accept that the terrorist threat remains very high in the metropolitan area we call home and all across the United States. Unfortunately, the arbitrary nature of terrorism, and the reality that no system can eliminate the risk, mean that we must adjust and adapt as best we can, disciplining ourselves and our families to never let our guard down, just as we do with our investments. For now, as the tragic event remains raw, especially for every parent that has a child who could have been there enjoying a hugely popular musician, we can only stand by our British friends and recommit ourselves to doing whatever it takes to rid the world of this evil.

We welcome any questions or thoughts you may have.

Sincerely,

Alternative Investment Management, L.L.C.

 

Blair Cohen