We are quite satisfied with the Fund’s annual return. If we could generate it year in, year out, we would have almost thirty times our capital in 20 years! But even the most optimistic amongst us realises this isn’t going to happen.
So, why are we only “quite satisfied” and not cracking open a bottle of Moët? Because the Fund has benefitted from a period of abnormally high market returns. For example, over the last year the Index4 has returned 14.7%5 – a level we consider to be quite unsustainable. To the extent that the Fund did benefit from the favourable investment climate (such extent being indeterminable), we view those returns unrepeatable over the longer term. Anyone that thinks otherwise and invests with an expectation that the Index will provide a return in the order of 15% over the long term is headed for a severe reality check (the timing of which is, of course, unknown).
The investment objective of the Fund is to “Generate attractive investment returns over the long term without regard to a specific benchmark and with an emphasis on capital preservation”. The evidence suggests that we are on the way to meeting this objective, but we have been privy to the most favourable of market conditions. So, let’s save the mutual back slapping and all-round high fives for ten to twenty years time after a period of less buoyant markets.
The annual return of 18.3% comprised two contrasting half years. During the six months to December the Fund returned 17.6%, but over the following six months it returned a rather measly 0.6% (As most readers would know – compounding – the “the eighth wonder of the world” according to Albert Einstein, accounts for that extra 0.1%). The corresponding difference in Index returns between the half years was far less pronounced (9.8% and 4.5% over the respective half years).
So why did we not keep pace with the market over the second half? Here are a few reasons:
- the Fund held an average of around 20% cash (although admittedly it also did during the first half);
- the cash was predominantly held in USD, which declined in value relative to other currencies;
- the Fund held little investment in Technology companies which returned 13.7% in AUD terms (20.5% in USD) over the second half5 . For example, the Fund did not own any of the “FAANGs” – Facebook, Amazon, Apple, Netflix and Google (Alphabet)6 . These have high Index weights (totalling 5%)7 , and they posted USD returns in the second half of the financial year ranging from 17.3% to 31.2% (average 24.7%)5 ; and
- the Fund only holds securities that are listed on developed global market exchanges – which significantly underperformed business listed on emerging markets exchanges (the MSCI Emerging Markets Index returned 11.8% in AUD terms over the second half)5 .
We do wish that we had listened to the advice from our great mate Harry Hindsight. He suggested to us in late December that we should invest the 23% cash the Fund held at the time in an equally weighted split of the FAANGs. I vividly recall Harry saying “it’s easy, we’re in a momentum market, these stocks are on a roll”. He was right – at that time the FAANGs were already up 15.2% over the prior six months. Had we taken Harry’s advice our returns would have been almost 6% higher – we would have posted an annual return of almost 25%! Perhaps then we would have cracked open that bottle of Moët?
Harry also reckoned the USD was way over-valued – “it will continue going down…you gotta short it!” he said. But over the last year or so we have repeatedly expressed our wariness not only about high equity prices, but also with what we saw as a highly priced AUD. So, again we foolishly ignored Harry’s forecasts. And so – in retrospect – not only did we hold way too much cash, but we also held it in the poorly performing USD (down 5.9% during the second half relative to the AUD)5 . This rising AUD continued to cost the Fund dearly (1.1% over the year).
This begs the question – should the Fund be hedged? As an example of “value add” the returns of an AUD hedged version of the Index were 8.9% over the half year and 20.4% over the year8 . This is significantly greater than the Index returns of 4.5% and 14.7% respectively5 . But in times of market distress the historical experience has been that currencies that are viewed as risky, such as the AUD, have fallen relative to those seen to be “less risky”. For example, in the 2008 calendar year, the hedged version of the MSCI World IMI Total Return Index fell a whopping 39.4% – decidedly more painful than the unhedged version which fell – wait for it – only 25.5%9 . We would rather take advantage of this naturally provided “equity” hedge than incur the costs, time and effort that is involved with hedging the Fund’s currency.
The Fund’s returns simply reflect the result of operating our investment process. And this process applies rules with the intent to ensure risks are kept within levels with which we are comfortable. This means the businesses we hold must be:
- priced reasonably;
- of sufficient quality and not at risk of financial distress;
- available across a variety of sectors and geographies; and
- accessible via well regulated exchanges in developed markets.
Otherwise, we will simply hold cash.
It was very pleasing that during the buoyant markets of the first six months of the year, despite investing in this manner (that we consider conservative), we still managed to surpass market returns. However it simply could not continue. To have generated a similar return in the second half (and even to match the return of the broader market) would have required us to accept risks beyond our “comfort level”.
So what has led to this extraordinary high market return? We believe it is largely a result of the increased prominence of index investing. This has not been a short term phenomena. Since 2008, US managed fund investors have withdrawn more than $800 billion from actively managed funds and invested $1.8 trillion into index funds10 . In the US Vanguard now owns 6.8% of S&P 500, and more than 5% of issued capital in more than 485 of those companies in that index10 . But the pace appears to have increased to the point that during the first quarter of this year, for every dollar invested in US active funds, nearly $5 was invested in passive funds10 .
Index investing is a momentum based strategy. As funds flow in, they are directed toward companies based solely on their size, which then become larger, and which subsequently attract more funds flow. As a result, the share prices of these larger companies are increasing without necessarily any commensurate improvement in the underlying businesses they represent. It’s all great until the fat lady sings….(that is, until the funds flows stop).
The whole phenomena continues to surprise us – and we are not alone11 .
“The success of passive investing has created unusual opportunity because of the distortions that have developed with money flows into indexes and out of actively managed strategies. We have been in a multiyear bull market where the relentless flow of money to passive funds has caused the largest index components to outperform regardless of earnings multiples, growth potential or business strength. There is certainly an important place for passive investing, but it is essentially allocating capital to stocks that S&P 500 and its competitors have selected predominantly based on market capitalization. Autopilot is deciding where investors’ money goes. I don’t believe the valuation discrepancies caused in part by passive investing are sustainable, making the present time an especially favourable environment for stock pickers. Index portfolios don’t recognise risk. A somewhat lower return with much less risk may be very desirable. I believe professionals can judge risk of portfolios and the process that produced them. There will be a time where the fork gets stuck in index funds and the bubble bursts. As everyone runs for the exits, the professional investor will be there to find opportunity and value in the rubble.”
And for the fans of the movie “The Big Short”, from the trader that worked with Steve Eisman at Frontpoint Capital12 .
“If you look at any company…there’s a chance that 7 of the largest 10 shareholders of that company are ETF’s. And so you’re better off knowing what ETF owns your stock than what this company even does. And that’s scary to me. And that’s when fundamental investing goes by the wayside…..and so, as a CEO of a company, I no longer care about meeting with Fidelity, I care about meeting the criteria of what these ETF’s have in them. It will all come out in the wash eventually…in order for that to happen I feel the market needs to have a major correction.”
An example of business fundamentals not mattering, and the cost to investors, is VanEck’s decision to change its rules relating to its exchange traded fund (ETF) of junior gold stocks announced in April. This ETF had become too large (at USD3.7 billion it was approaching a 20% interest in some of its holdings). The announcement prompted buying and selling of companies in anticipation of index trading which, according to some, cost the ETF more than USD300 million13 .
Perhaps we are wrong, and business quality will no longer determine long term returns? We doubt it. Or perhaps we are concentrating on the wrong fundamentals, that the critical drivers of business value have changed, and that we are just not smart enough or too old fashioned in our approaches to recognise it? Possibly.
This leads to the question – what are you trying to achieve from your investments? And the follow up question – what is the appropriate benchmark? With our absolute return objective, the Fund inherently includes an element of asset allocation – we have no requirement to be fully invested, so when we do not see opportunities we simply will not buy. This means it is managed with a different mindset to the more common equity funds.
The Fund will underperform the Index at times. And it may result in what some may consider a perverse situation of it incurring a performance fee despite it failing to achieve a mere market return. However this is not so perverse when viewed from a different perspective – that in such a situation the Fund would have achieved its absolute return hurdle despite it investing in a conservative fashion.
Recently I read an article whereby a financial advisor correctly stated that “active managers promote their funds on the basis that they can achieve better returns than you can get by simply investing in the index”. But we would argue, like the quote above from the Wall Street Journal, that there is merit in investing in active funds not just for the higher return potential, but also for a lower risk profile than an index.
In times of increasing market returns, one may see this in a similar vein as to how they view an insurance policy. Whilst the manager may not deliver market returns, if the return they did deliver was achieved with lower risk, then the difference in return can be likened to an insurance premium – but where no claim was made.
“The best way to measure your investing success is not by whether you’re beating the market but by whether you’ve put in place a financial plan and a behavioral discipline that are likely to get you where you want to go.” – Benjamin Graham
When making comparisons with indices and competitors, one naturally does so in the most objective possible way – by considering raw returns and by either not accounting for risk, or assuming that risk is solely a function of volatility (which may well be convenient, but it has been well proven to be nonsense).
These discussions always seem to revert to a common theme – what is risk and how do you measure it? We don’t have a straightforward answer. What we can do is explain our investment strategy and the types of businesses we view as less risky investments than others (and why). Investors can then form their own views.
To help illustrate this, let’s look at three of our core long term holdings which comprised (at year end) 11.6% of the Fund: Wabash, Michelin and Transcontinental (the WAMITs)6 . We will compare these with the far more commonly held FAANGs – which represent almost 5% of the Index (the WAMITs Index weight is less than 0.1%)7 .
Consistent with most of the Fund’s holdings, the WAMITs operate quite “boring” businesses – manufacturing trailers for trucks, producing tyres, and making boxes/printing pamphlets. Not real sexy industries compared to the FAANGs. But they still managed to grow earnings per share (EPS) by an average 18.7% per year over the last three years (yes, we concede the FAANGs growth was superior at 43.7%)14 . And they still achieved a 22.9% return on their invested capital (which was even better than the FAANGs 18.0%)14 . And what about pricing? At June’s end, according to our analysis the WAMITs were trading at an average unlevered earnings yield of 11.8% and an average free cash flow yield of 8.9%. Quite a lot higher than the comparable FAANG’s yields which were 2.8% and 2.6% respectively14 .
But the real difference between the WAMITs and the FAANGs is market expectations of their future earnings. To provide an indication of this, with some hesitation and for the first time in years we referred to broker estimates (don’t be too concerned – we only looked at the “consensus” level). And they are suggesting that the WAMITs average EPS will remain relatively stable over the next two years, whereas the FAANGs EPS will increase by an average of 25%14 . (We have not wasted our energy delving into the details to try and understand how these forecasts account for employee stock issuance in both the earnings and share count – but our suspicion is that it is unlikely to be conservative).
We admire the “tech visionaries” and we readily acknowledge there is value inherent in the FAANGs businesses. After all, with the exception of Facebook we both use their products/services. However, we are not visionaries, nor are we tech gurus. We are not even active on social media. We certainly do not see ourselves as having any edge in analysing these enterprises and perhaps even more importantly, we are sceptical of anyone’s ability to accurately foresee business plans, growth options, consumer tastes, new competitors…the list goes on. There’s only one sure thing when it comes to forecasts: they will be wrong. And we believe the degree to which they will be wrong is greater when the forecasts involve these types of businesses compared to businesses with a more steady stream of past earnings.
In our view, the inherent assumption that a business will merely maintain earnings or grow them at a slow and steady rate, is more reliable than an explicit assumption of strongly growing earnings. So we have a preference for the double digit earnings return presently available via investing in the WAMITs over the similar level of earnings return which may potentially be provided by investing in the FAANGs at some point in the distant future. Will this be five years time (assuming 25% earnings growth over that period), or ten years time (if we were to assume earnings growth of 25% per annum for two years, 15% for the next five years and 10% thereafter), or some other timeframe? To us, the more certain and imminent earnings return available by investing in the WAMITs is simply less risky than the less certain (but admittedly potentially greater) earnings return possibly provided some time in the future by investing in the FAANGs.
“Analysis is concerned primarily with values which are supported by the facts and not with those which depend largely upon expectations.” – Benjamin Graham
And, aside from pricing, our analysis of the FAANGs financials suggests to us that they are generally a more risky investment proposition than the WAMITs. In fact, at present three of the five FAANGs presently fail to meet our financial strength rules (mainly due to either their cash flows relative to their earnings or their ever increasing shares on issue).
So despite the WAMITs and the FAANGs providing a remarkably similar return to investors over the second half (23.6% and 24.7% respectively)5 , in our view the investment risks associated with holding each batch of businesses were entirely different.
We would like to make an important additional point here. Our view, even in hindsight, of how risky it was to hold interests in those businesses is independent of the investment outcome. So although we were fortunate to have experienced healthy share price increases, had the WAMITs performed poorly, then provided the business fundamentals were the same, our view in regard to risk taken would be indifferent – to us they would still have been sensible investments at the time they were made and therefore a good investment decision. We again stress the importance of viewing risk from the perspective of process, rather than outcomes (refer Musings with mates).
Continuing that theme, we maintain our view that investors are best to choose fund managers based on the manager’s process being “in tune” with their way of thinking and having a like-minded philosophy. By doing so, provided the investor trusts the manager to continue to run that same process as communicated and to operate in a fair and transparent manner, then they will most likely have the fortitude to stick with the manager during testing performance periods.
We will continue to adopt what is for us a lower risk approach by investing in businesses that have a demonstrable track record, that we think have a reasonable chance of carrying that track record into the future, and which are available at a reasonable price. For us, this is low risk investing. Our edge is having a long term investment horizon, the discipline in place to ride out volatility, the preparedness to ignore the herd, the confidence in our process, and the willingness to ignore the Index.
Our note in the March quarterly report (regarding consistency of returns and Ponzi schemes) did elicit some feedback. Apart from prompting us to recommend a movie (“Wizard of Lies” starring Robert Deniro and Michelle Pfeiffer)15 , it also provoked thought as to how the Fund has fared in terms of return volatility. Now that we have been operating the strategy for two and a half years there is at least some vaguely relevant period of time to assess this. And, whilst we dislike referring to the Index as a comparison (and we do not consider it to be our benchmark – please refer to the investment objectives of the Fund), we can appreciate its usefulness in some respects.
We have performed some basic analysis on returns on both a monthly and a quarterly basis. Provided below is a summary of some of the quarterly data we looked at:
Table 1: Quarterly Returns Since Inception
Some of the key takeaways, which would come as no surprise to many, were:
- the Fund’s returns are more volatile than the Index;
- the Fund’s returns are often lower than the Index (60% of the time on a monthly basis and 40% quarterly);
- the worst monthly return of the Fund was -6.3%, some 2.5% lower than the worst Index return;
- the worst quarterly return of the Fund was -4.4%, somewhat better than the worst Index return of -5.8%;
- the Fund managed to mitigate poor returns in declining markets, particularly when viewed on a quarterly basis. For the two quarters that the Index has posted negative returns (June 2015 and March 2016) it was down a total of 6.1% whereas the Fund was down a total of 0.9%, so it only captured 14.5% of those negative returns (“Downside Capture”)16 . For the 14 months where the Index returns were negative, the Fund outperformed half the time and fared better than the Index by not experiencing the full extent of those negative returns (Downside Capture of 74.0%); and
- the Fund failed to capture all of the Index returns in positive months (“Upside Capture” of 97.6%) but more than captured those positive returns when viewed on a quarterly basis (107.3%).
The overriding key takeaway though – the shorter the time period of analysis, the greater the amount of “noise” in the data. Please refer to our article Distractions, Dentist, DOS, De-cluttering for a more complete discussion on this. And, if it is consistency of monthly returns you are seeking – we are not for you.
“Volatility is the price you pay for performance.” – Samantha McLemore
We hope this helps readers understand and appreciate why we report quarterly rather than monthly. It is because we believe it to be in your best interests (and also ours).