AIM13 Commentary - 2021 Q1
“Quality is more important than quantity.
One home run is much better than two doubles.”
One of the biggest challenges facing investors today is information overload. Based on a survey by OnePoll in September, a typical adult spends over six hours a day staring at a screen, which is up from about four hours a day prior to the pandemic. The average office worker receives 121 emails a day (according to research from DMR), and a McKinsey study once equated this to about 28% of the day just reading and answering emails. It is all truly overwhelming, and it is important to reflect on just how much we now rely on, and more importantly try to manage, our instantaneous access to an enormous amount of information. With so much data at our fingertips, how can we make sure we are focused on the right things? As we discuss below, our approach involves being selective about sources, having a process, and aligning the team to execute with focus and discipline.
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“We are drowning in information but starved for knowledge.”
““Five hundred twenty-five thousand six hundred minutes
Five hundred twenty-five thousand moments so dear
Five hundred twenty-five thousand six hundred minutes
How do you measure? Measure a year?”
These lines came to mind recently as we reflected on managing time in the Internet age. This last year has been a difficult one for sure. However, like any other year, it was made up of a lot of individual minutes and, no matter how hard we tried, we are left with the question, are we maximizing the utility of each of those minutes? William Penn once said, “Time is what we want most, but what we use worst.” It is our most precious commodity, and with the exponential growth of data accessible with a simple point and click, we are increasingly under pressure to use time efficiently.
“Another day of staring at the big screen while scrolling through my little screen
so as to reward myself for staring at the medium screen all week…”
If we assume, as noted above, the average person spends six hours a day staring at a screen and another nine hours or so sleeping and eating, there is not a lot of time to think, make decisions, and be active. We all say how busy we are and complain about the lack of time to do things. However, for many of us, when we get an email, we are expected and conditioned to reply right away. Under these circumstances, how can we analyze and digest data quickly, figure out what is important and not important, and act?
“In many aspects of the economy, from social media to search engines, access to data is a growing competitive advantage. Our capital markets are no different.”
According to the U.S. Chamber of Commerce, in the last two years alone, about 90% of the world’s data has been created. Given this explosion of information and its importance in the capital markets, we need to ask ourselves how we can best leverage data efficiently and effectively to help us achieve our goals. Equally important, how can we avoid being so overwhelmed or distracted by all of the information to the point where it actually becomes counter-productive? The simple truth is that most people waste time absorbing information that is at best useless and at worst misleading or wrong. As a firm investing our own capital and that of our partners, we believe there are a few keys to successfully managing data in the information age:
Be smart and selective about sources: For us, the first principle of information management is to listen to, and focus on, the right sources and be open to the fact that the best sources may not be the obvious ones.
“Don’t listen to the person who has the answers; listen to the person who has the questions.”
When it comes to managing data, we try to filter the information flow and to leverage the intelligence of others we respect to gain insight into what is going on in the markets. Howard Marks is someone who immediately comes to mind. There simply is too much information available to not rely on others to help separate the wheat from chaff.
It is critical to understand the motive of the source. No one believes a car salesman when he tries to sell you a car, and likewise most information these days should be read with a critical eye and a healthy dose of skepticism. All sources have biases, and the first thing we all need to do is understand the bias. Being selective and understanding biases – both with others and within yourself – are required to understand what is true and what is false. Without that discipline and insight, it is easy to be influenced and led astray by inaccurate information. (A related tip: we all have friends on social media who post and re-post things without verifying them. Use www.snopes.com to help fact-check – and prevent the spread of urban legends!) Similarly, it is also always easier to listen to people with whom we agree. Too often executives at companies surround themselves with a management team that is all looking at the same information, reinforcing their own pre-conceived notions in an echo chamber of ideas.
Have a process: Any human endeavor that involves breaking down many things into manageable pieces to achieve an objective requires a detailed process. For us, this is our “wash, rinse, repeat” maxim that we instill in our analysts. We are big fans of checklists and procedures, which require us to regularly draw on multiple sources, references, and qualitative and quantitative information before arriving at any conclusion. We reduce as much as we can to a written process. Even a simple individual profile on our Backstop CRM and data management platform has hundreds of categories, relationships, contact details and other possible fields and tags to complete to help us access the information down the road. Going into any manager meeting, we complete our pre-meeting checklist so that the session is as productive and efficient as possible.
“If you torture the data long enough, it will confess.”
Of course, any single data point or information stream can be manipulated to support a preconceived perspective, bias, or point of view. Put differently, any piece of data can be used to confirm your original thesis. Having a process mitigates this risk by forcing ourselves to go through our progression before we make a decision and take action. In the era of instant gratification and short attention spans, it is more important than ever to follow a process to guard against jumping to conclusions.
Without a data collection and management process to methodically gather information, it can be “garbage in, garbage out” – you may have a lot of information but no way to step back and see the mosaic of what it is telling you. One of the most successful investors we know, whom we have worked with for years, always keeps an investment journal. We strive to do the same. When evaluating managers, it is important to document the process so there is a record of why we passed on or hired a manager. With that record, we can look back and, after the fact, see if the decision-making process worked or could be improved in some way.
Be efficient and execute with a disciplined focus on the common goal: Having a team is important so that there are different ideas and experiences, but equally important is having the same goal and priorities. People always have personal preferences, and motivating a group of people to a single objective can be challenging. However, if the team is not aligned and focused, capturing all of the information in the world alone will not bring the organization any closer to its goals. Indeed, we have found that keeping the team working off the same script is harder today than it ever has been. With the distraction of the Internet and the unending stream of interesting things to read at the click of a button, we are constantly challenging ourselves to stay on course.
“Success comes from doing better at what you do well and improving the things you do poorly.”
Everyone in the organization should have a voice but a successful team needs a coach, a quarterback, and a game plan that everyone buys into. Some individuals will want to read only the sources they like, do only the parts of the process they enjoy, and resist subordinating their interests to the goals of the firm. It is natural for people to do what they like, but an effective team is made up of members who are willing to do what is necessary and execute where they add the most value – not necessarily what they enjoy. This discipline can be uncomfortable, and we sometimes need to steel ourselves against a “coddling” environment that lets everyone do what they want. At some point, someone needs to corral the data and inputs and make a decision. Everyone will not always agree, however, execution is the way to avoid “information paralysis.” In this regard, absent consistent execution, it is difficult to distinguish arbitrary luck from repeatable skill.
With the challenge of a constant barrage of information, aligning individual goals with the firm’s goals becomes a little like keeping the two rails of a train track aligned; the further down the line you go with just a small amount of deviation among the team, the more widely diverged the rails become.
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We strive to constantly improve ourselves within this framework – winnowing down and scrutinizing the information we receive, enhancing our processes, and keeping everyone on the same page. It is the only way to avoid “information overload” and to gain insight and knowledge rather than just data and facts. However, even Ted Williams, considered one of the greatest hitters of all time, “only” batted .406 in his best year – in other words, only getting a hit about 40% of the time. In many ways, achieving success in the information age – by getting the complete “real story” – can be as hard as getting a hit in baseball.
Due Diligence Tip: Misinformation in Analyzing Portfolio Liquidity
“Our liquidity is fine. As a matter of fact, it’s better than fine. It’s strong.”
Our due diligence tip this quarter is tied to our focus on gathering the right information to make decisions. Any investor who has lived through periods of significant stress knows the importance of portfolio liquidity – and, as the quote above illustrates, the importance of not taking things at face value. We are continuously monitoring the liquidity in our managers’ portfolios to mitigate the risk that they will not have sufficient liquidity when they need it, either to take advantage of investment opportunities or to meet redemption requests. Failing to manage liquidity causes forced selling which is never good for investors. The recent Archegos sell off was for some a painful reminder of this.
For investors keeping an eye on fund liquidity, one troublesome trend we are seeing more frequently is the characterization of some widely-traded stock positions as Level I securities (most liquid) when in fact, for reasons specific to the manager, the manager cannot readily trade them. For instance, a manager may have invested in a private placement (which is increasingly common among hedge funds these days), and then once the stock IPO’s, the manager may list the position as Level I consistent with FASB guidelines. However, they would be subject to lock-up provisions that would preclude selling the stock for a period of time. Alternatively, an activist manager with a large stake or board position with a company may list its holding as Level I but would face trading limitations because of its access to inside information.
In these cases, while a stock may technically meet the definition of Level I for valuation purposes (marked to market based upon “readily observable market prices”), it is not liquid for purposes of the manager’s trading – and when things get stressed, that is what matters. Ascribing a level to a particular asset is a part of the annual audit process when the designations must be blessed by the auditors. However, for interim periods, the auditor control does not exist, and this provides the manager more leeway. For this reason, we drill into the “liquidity buckets” in manager tearsheets, especially in the footnotes. Sometimes managers will represent that they can liquidate 100% of their portfolio in under 30 days, however the footnotes clarify that the liquidity buckets only contain equity positions traded on an exchange. We have also seen managers change the way that they define “large cap” stocks buried in the footnote or add a disclaimer about excluding positions under 1%.
“We live at a time when the disinformation and confusion that permeates the political arena has infected the investment world as well.”
These issues reinforce for us the importance of looking at multiple sources of information and tearing apart the information to avoid being misled. As an investor, if one just looks at the ADV, or just the number of names, median market cap, etc., in the portfolio, any one of those data points may not signal anything troubling. However, they may disguise a strategy drift or something worse that only becomes apparent when reading it all together. This is a common phenomenon when a manager does well and assets grow, and investors become less critical. In short, investors are getting a lot of information these days but they are not always getting the right information or putting it together to see what is really going on.
Market observations
The S&P 500 index hit its 26th record close in 2021 on Friday, May 7th, reaching the 4,233 mark. The market began the year at about 3,756. In December, Barron’s ten investment strategists widely diverged in their forecasts for the year – from 3,800 to 4,400. However, in just over four months, we are already nearly two-thirds the way to the highest forecasted levels for the year. Truly astounding.
There are more signs that the bull market in stocks is in its final innings, with risk-seeking reaching the highest levels since 2007 and 1999. According to Financial Industry Regulatory Authority data, as reported by Axios in early April, as of late February investors had borrowed a record $814 billion against their portfolios. That represents a 49% year-over-year increase and the highest level since 2007. The prior high was during the dot-com bubble in 1999. Moreover, according to a report in the Wall Street Journal, stockholdings among U.S. households increased to 41% of their total financial assets in April, the highest level on record.
Other things we are seeing in the markets that trouble us include:
The pension fund dilemma. Bond return expectations continue to be at their lowest levels in decades, and this creates a big problem for pension funds. These funds typically expect at least a 7% overall return. In fact, they need that return to meet their actuarial assumptions. However, bonds are currently yielding just about 2%. Assuming for simplicity a straight stock/bond portfolio and ignoring alternative investments, with bond returns where they are, stocks really need to drive the fund return to achieve the overall target return. The data in the chart below, courtesy of Mebane Faber, illustrates this dynamic:
According to the CFA Institute, a typical pension allocates 50% of its portfolio to equities – at which level stocks need to post low double digit returns to meet the overall return targets. We think that is aggressive, especially considering the S&P 500 has annualized at just about 8% over the last 20 years.
Challenges shorting. The chart below, courtesy of a manager we respect, brings home just how hard making money on shorts has become. The chart illustrates the performance of the decile of stocks with the highest short interest versus the decile of stocks with the lowest short interest on a trailing 12-month basis since 1991:
Over the past twelve months, stocks that are the most heavily shorted outperformed the stocks with the least short interest by close to 80% - well above the record over the prior 30-year period. It is no surprise that the median short interest in S&P 500 stocks sits at just 1.6% of market value, near a 17-year low, according to Goldman Sachs. In fact, short selling on Wall Street is at its lowest point in decades:
Covenant lite leveraged loans reach new heights. We have written before about the dangers of covenant lite leveraged loans, but every time we revisit the subject, the picture is bleaker than it was before:
These loans lack traditional requirements for companies to maintain certain financial levels that are designed to protect investors who pay for them. This means that companies that are not doing well stay afloat longer, which further disguises the true health of corporate America.
The skyrocketing price of lumber. In the category perhaps of “no place to hide,” on April 16, 2021, the price per thousand board feet of lumber reached an all-time high of $1,104, according to data published by Random Lengths. As the chart below illustrates, that is up over 200% from just a year ago:
Traders in the futures market have seen lumber futures contracts increase as much as 375% in the space of one year (April 2020 to April 2021), according to a Forbes article in mid-April. There are various factors for the surge in prices, most obviously a slowdown in production last year during the pandemic, the related interest in new home construction outside of cities, and DIY’ers working remotely and doing home improvement projects. The 2017 tariffs of up to 24% on softwood lumber imports from Canada also play a role, and many are calling on our new President to reverse his predecessor’s policies in this area.
CLOSING THOUGHT
We believe that it is a miracle that the COVID-19 pandemic is nearly behind us. We also feel very fortunate that our team and our families have largely been spared the disease’s most horrible outcomes, and our hearts go out to those who have suffered losses. While there is much for us to be grateful for, we also are concerned over people’s frustration with when we can return to life as we knew it before the pandemic. Just like in the markets, we do not get to decide. Unfortunately, as we have observed in our letters over the past year, too many people have not thought about others when it comes to basic precautions that can be taken to reduce the spread of the disease. It is with great regret and embarrassment that we acknowledge how our country could have done more to prevent the over 585,00 deaths we have experienced so far – one of the higher per capita death rates in the world. This is particularly shocking considering the sophistication of our hospitals and medical care.
We welcome any questions or thoughts you may have.
Alternative Investment Management, LLC (AIM13)