Tag Archives: history

Distress Testing The Efficient Frontier

Click to enlarge Many historically inclined residents of White Plains, New York can recount the legend of Sleepy Hollow and what inspired it. The day was October 31, 1776, and our young Revolution was in the throes of a heated battle. One this bloody All Hallows Eve, so stirred by his witnessing of a horrific incident on the Merrit Hill battlefield was American General William Heath that he dramatically recorded the horror of it in his journal as such: “A shot from the American cannon at this place took off the head of a Hessian artillery-man. They also left one of the artillery horses dead on the field. What other loss they sustained was not known.” It was the general’s vivid recollection of this scene that was to be the inspiration for author Washington Irving’s penning of his classic ghostly retelling of Heath’s journal entry, America’s version of a common folk tale dating back to Celtic times when for the first time the Headless Horseman set out on his eerie ride. Today, investors may find themselves wondering just what financial spirits have already been unleashed to darken the legacy of the Federal Reserve’s current head. They know what lingers to ominously shadow two of her notable predecessors. Alan Greenspan will forever be disturbed by the ghost of irrational exuberance, and his successor Ben Bernanke by the vestiges of subprime being “contained.” Given the state of the financial markets today, odds are Janet Yellen will be perennially preoccupied with the death of the efficient frontier. In a perfect world, as we were schooled in Portfolio Management 101, investors maximize their return while minimizing their risk. To accomplish this, we’ve long relied on the work of Harry Markowitz who, in 1952, developed a system to identify the most efficient portfolio allocation. Using the expected returns and risks of individual asset classes, and the covariance of each class with its portfolio brethren, a frontier of possibilities is conceived. Where to settle on this frontier is wholly contingent on a given investor’s unique risk appetite. And so it went – in yesteryear’s perfect world. Unfortunately, the Fed’s fabricating of a different kind of perfect world has all but rendered impotent the efficacy of the efficient frontier. There are countless ways to illustrate this regrettable development, one of which can be viewed through the prism of volatility. Investors are now so enamored of the good old days, when assets traded in volatile fashion based on their individual risk characteristics that the “VIX” has become a household name. In actuality, it is as it appears in its all-cap glory – a ticker symbol for the Chicago Board of Options Exchange Volatility Index. What the VIX reflects is the market’s forecast for how bumpy things might, or might not, get over the next 30 days. As is stands, at about 13, the VIX is sitting on its 2016 lows which are on par with where it was in August following the Chinese devaluation scare. But it has not been uncommon in market history for the VIX to dip below 10 into the single digits, as it did in late 1993. It again broke below 10, but with much more fanfare, in 2007 ahead of a vicious bear market that ravaged investors in all asset classes. Writing up to 16 markets briefs per year for nearly a decade inside the Fed required no small amount of title-writing technique. One of the most memorable of these immortalized in early 2013 was “Fifty Shades of Glaze,” which touched on the very subject of investor complacency using the VIX as evidence. The Wall Street Journal reported on March 11 of that year that investors were “worry free” in light of the VIX falling below 12, a number not seen since 2007. The hissy fit that markets pitched a few months later following the Fed’s threats to taper open market purchases served to send the VIX upwards. But things have since settled down, convinced as markets are that lower for longer is the newest ‘new normal.’ In a seemingly comatose state, the VIX has breached 15 on the downside twice as often since 2013 as it has on average since 2005. “I’ve been making the argument since 2010 that heavy-handed central bank policy is destroying traditional relationships,” said Arbor Research President Jim Bianco, who went on to add “stock picking is a dead art form.” By all accounts, Bianco’s assertion is spot on – the death of stock picking has not been exaggerated. It’s no secret that indexing is all the rage; index-tracking funds now account for a third of all stock and bond mutual fund and exchange-trades fund assets under management. The problem is that the most popular index funds have distorted valuations precisely because passive investing has become so popular. Consider the biggest index on the block, the S&P 500. Now break it down into its 500 corporate components. Some are presumably winners and some not so much. But every time an investor plows more money into an S&P 500 index fund, winners and losers are purchased as if their merits are interchangeable. The proverbial rising tide lifts all boats – yachts and dinghies alike. If that sounds like a risky proposition, that’s because it is. Not only are stocks at their most overvalued levels of the current cycle, index funds are even more overvalued, and increasingly so, the farther the rally runs. As Bianco explained, “In today’s highly correlated world, company specifics take a back seat to macro considerations. All that matters is risk-on and/or risk-off. Unfortunately, this makes the capital allocation process inefficient.” The question is, what’s a rational, and dare say, prudent investor to do? In one word – suffer. Pension funds continue to fall all over one another as they jettison their hedge fund exposure; that of New York City was the latest. It’s not that hedge fund performance has been acceptable; quite the opposite. But ponder for a moment the notion that pensions no longer need to hedge their portfolios. Is the world truly foolproof? Of course, hedge funds are not alone in being herded to the Gulag as they are handed down their Siberian sentences. All manner of active managers have underperformed their benchmarks and suffered backlashing outflows. They’ve just come through their worst quarterly performance in the nearly 20 years records have been tracked. And so the exodus from active managers continues while investors maintain their dysfunctional love affairs with passive, albeit, aggressive investing. When will this all end? It’s hard to say. Bianco contends that it’s not as simple as what central banks are doing – they’ve abetted economic stimulus efforts before. Remember the New Deal? What’s new today is the size and scope of the intervention. How will it end? We actually have an idea. Passive bond funds “enabled the borrowing binge by U.S. oil and gas companies,” as reported by Bloomberg’s Lisa Abramowitz. It was something of a vicious process that started with – surprise, surprise – zero interest rates compelling investors to reach for yield. Enter risky oil and gas companies whose bonds sported multiples of, well, zero. It all started out innocently enough in 2008, with these issuers having some $70 billion in outstanding bonds. But every time they floated a new issue to hungry managers, their weight in the index grew proportionately. In the end, outstanding bonds for this cohort rose to $234 billion. “Their debt became a bigger proportion of benchmark indexes that passive strategies used as road maps for what to buy,” Abramowitz wrote. “Leverage begot leverage begot leverage.” Since June 2014, some $65 billion of this junk-rated debt has been vaporized into a default vacuum. Yes, passive investing involves lower fees. But it can also suffer as indiscriminate buying can just as swiftly become equally indiscriminate selling. Such is the effective blind trust index investors have put in central bankers to never allow the rally to die. “The actions of people like Janet Yellen or Mario Draghi matter far more than any specific fundamental of a company,” Bianco warned. “It’s as if every S&P 500 company has the same Chairman of the Board that only knows one strategy, resulting in a high degree of correlation between seemingly unrelated companies.” Nodding to this dilemma, several years ago, the CFA Society raised a white flag on the efficient frontier in a Financial Times article. Any and all applicants were welcome to suggest a new order, a new way for investors to safely design portfolios to comply with their individual risk tolerance. Just think of the inherent quandary facing the poor folks who run insurance companies. These firms have a fiduciary duty to own at least some risk-free assets. That’s kind of hard to do when yields on these assets are scraping the zero bound, or worse, are negative as is the case with some $7 trillion in bonds around the globe. “Investors have traditionally been able to build balanced portfolios with the inputs of risky and risk-free assets,” said one veteran pension and endowment advisor. “Now that risk-free assets sport negative yields in many countries, to earn any return at all, you have to take undue risk. This breaks the back of the whole equation that feeds the efficient frontier.” A while back, Yellen warned investors of the potential pitfalls of owning high yield bonds. She was no doubt studying data that showed mom & pop ownership of these high octane assets was at a record high. Many onlookers balked at the head of a central bank wading into the wide world of investment advice. But perhaps it’s simply a case of recognizing one’s legacy well in advance. Small investors today have record exposure to passive investing. If Yellen fully grasps what’s to come, she’s no doubt preemptively struck and tormented by the future ghost of rabid animal spirits. “It’s like giving a teenage daughter a Ferrari and hoping she won’t speed,” the advisor added. “If central banks keep price discovery in shackles indefinitely, Markowitz will have to return his Nobel prize.” Let’s hope not. If that’s the case, and the efficient frontier never regains its rightful place in the investing arena, we will find ourselves looking back with less than wonderment as the hedgeless horseman gallops away with our hard earned savings.

The Power Of Quantifying Market Expectations For McDonald’s And Williams Companies

” It’s difficult to make predictions, especially about the future. ” This quote has been repeated so many times that no one quite knows who said it first. Perhaps it was baseball player Yogi Berra. Or humorist Mark Twain. Or Danish physicist Niels Bohr. The point is, this quote has become a part of our cultural fabric, and it has done so because it expresses a simple and fundamental truth. Accurately forecasting what’s going to happen in the future is incredibly difficult, almost impossible. Few areas illustrate this difficulty more profoundly than financial markets, where analyst projections of earnings are regularly off by 10+% . Sometimes, even the most well recognized experts make shockingly bad predictions . No one truly knows (legally) what the market is going to do next, and the risk involved in that uncertainty is what creates the potential for significant returns. The Alternative To Making Predictions Of course, those returns are only available to those that participate in the stock market, and participating in the market implies some sort of prediction about the future. Even if you just buy a broad-based index fund, you’re predicting the broader market will go up. Otherwise, why make that (or any) investment? However, there’s a better way to invest. Instead of making your own prediction about the future, you can analyze the market’s prediction by quantifying the cash flow expectations baked into the market’s valuation of a stock. Then, you can make a more objective judgment about whether or not those expectations are realistic. This method, termed ” Expectations Investing ” by Alfred Rappaport and Michael Mauboussin in their book of the same name, can be incredibly effective. It’s effective because it removes the need to make precise predictions about the future. By quantifying market expectations across thousands of stock as we do, it’s easy to find pockets of irrationality and identify companies that are over or undervalued. How To Quantify Market Expectations There are a couple of methods we use to quantify market expectations. One of the simplest is to calculate a company’s economic book value , or the no-growth value of the business based on the perpetuity value of its current cash flows. This value can be calculated by dividing a company’s LTM after-tax profit ( NOPAT ) by its weighted average cost of capital ( WACC ), and then adjusting for non-operating assets and liabilities. Figure 1: Why We Recommended McDonald’s Click to enlarge Sources: New Constructs, LLC and company filings. The ratio of a company’s stock price to its economic book value per share (PEBV) sends a clear message about market expectations for the stock and can be a very powerful tool for investors. Figure 1 shows how PEBV influenced our decision to recommend McDonald’s (NYSE: MCD ) shares to investors in late 2012. Shares at that time were trading at a PEBV of 0.82, an unprecedented discount for a company with MCD’s track record of growth and profitability. The market’s valuation suggested that MCD’s NOPAT would permanently decline 18% and never recover. Those expectations seemed overly pessimistic to us. As it turned out, MCD did end up struggling significantly after our call. Increased competition from fast casual restaurants like Chipotle (NYSE: CMG ) and Panera (NASDAQ: PNRA ) that appealed to health-conscious diners compressed MCD’s margins and sent its sales slumping. Despite its struggles, however, things never got quite as bad for MCD as the market predicted. Between 2012 and 2015, NOPAT fell by only 16%, not the 18% projected by the stock price, and recent signs of a recovery have sent shares soaring to all-time highs. Figure 2 shows how MCD has delivered significant returns to investors since we made our prediction despite lackluster financial results. Figure 2: Disappointing Profits No Obstacle To Shareholder Returns Click to enlarge Sources: New Constructs, LLC and company filings. Though MCD’s poor results caused it to miss out on the bull run of 2013-2014, its surge over the past twelve months has it at a 51% gain since our initial call, outperforming the S&P 500 (NYSEARCA: SPY ) on a capital gains basis while also yielding a higher dividend. We didn’t know exactly how McDonald’s was going to perform when we made the prediction in 2012. We simply knew that the expectations baked into the market’s valuation were so pessimistic that even if the company’s profits significantly declined, as they did, investors could still earn healthy returns. Delayed Gratification As Figure 2 shows, basing investment decisions off a quantification of market expectations doesn’t always deliver immediate results. In the case of MCD, it took nearly three years for our call to come to fruition. Short-term sector trends and market forces can allow a company to stay valued at irrational levels for quite some time especially when we know that very few people practice Expectations Investing these days. Roughly three years ago, we warned investors to stay away from Williams Companies (NYSE: WMB ), calling it an example of the “sector trap.” Analysts excited about the company’s exposure to the rapidly growing natural gas sector were pumping up the stock, ignoring its low and declining return on invested capital ( ROIC ), significant write-downs indicating poor capital allocation, and the high expectations implied by its stock price. Specifically, our discounted cash flow model showed that the company would need to grow NOPAT by 13% compounded annually for 15 years to justify its price at the time of ~$37/share. Those expectations seemed to be clearly unrealistic given the company’s 7% compounded annual NOPAT growth over the previous decade and a half. For a time, WMB continued to gain in value despite the disconnect between its current cash flows and the cash flows implied by the stock’s valuation. As recently as mid-2015, the stock was up nearly 60% from our original call. However, as Figure 3 shows, WMB crashed hard when the market turned more volatile. It now has fallen nearly 60% from our original call, and it has significantly underperformed the S&P 500, the S&P Energy ETF (XEP), and peers Spectra Energy (NYSE: SEP ) and Enterprise Products Partners (NYSE: EPD ). Figure 3: Short-Term Gains, Long-Term Declines Click to enlarge Source: Google Finance Stocks with overly high expectations embedded in their prices can still perform well in the short-term, but they tend to face a reckoning eventually. Stocks Due For A Correction Roughly a year ago, we put engine manufacturer Briggs & Stratton (NYSE: BGG ) in the Danger Zone . Back then we argued that BGG’s history of value-destroying acquisitions, significant write-downs, and declining profits made it unlikely that the company would hit the high expectations set by the market. Specifically, our model showed that the company needed to grow NOPAT by 10% compounded annually for 17 years to justify its price at the time of ~$20/share. BGG actually did manage to meet this goal in year 1, growing NOPAT by 14% in 2015. However, we think this growth rate is unsustainable, as the company’s ROIC remains mired below 5%. Moreover, the company keeps spending money it doesn’t have on acquisitions, dividends, and buybacks, so it now sits with almost no excess cash and $660 million (68% of market cap) in combined debt and underfunded pension liabilities. Despite the balance sheet concerns, the market only seemed to pay attention to the GAAP earnings growth, and BGG is up 13.8% since our call. At its new price of ~$23/share, the market expects 10% compounded annual NOPAT growth for the next 11 years . Despite one good year in 2015, there’s no reason to suspect that level of growth is sustainable for BGG. High market expectations mean this stock should drop hard the moment growth slows down. On the other side of the coin, we still believe last year’s long pick Fluor Corporation (NYSE: FLR ) has significant upside. Despite slumping commodities prices affecting its oil, gas, and mining businesses, FLR still managed a 21% ROIC in 2015 and finished the year with a larger backlog than it had at the end of 2014. Investors only saw the downside though, and they sent FLR down 11% Due to this decline, the market continues to assign FLR a low PEBV of 0.9, just as it did last March when we made our original call. Given the recent rebound in commodities, we don’t think a permanent 10% decline in NOPAT from these already low levels seems likely. Strong profitability and low market expectations lead us to believe an investment in FLR will pay off sooner or later. Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style, or theme. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Bigger Is Better? For Investment Managers, Maybe Not

It’s no secret that America has long operated under an obsession with size. Over the last couple of decades, the average house size has continually increased (even as lots are shrinking ), cars have become supersized , food portions have grown, retail stores continue to sprawl, and even our waistlines have gradually expanded. Everything, it seems, is increasing in mass or breadth , as our national focus on size-above-all becomes ever more pathological with each passing year. This “bigger is better” mentality bleeds over into our financial lives, as well. Even as we rail against the “Too Big To Fail” banks for destabilizing our economy and extracting rents from working-class Americans, we continue to bank with them en masse, lured by the convenience and security of working with a known brand name. As a result, the big banks continue to get larger still, to the point that they’re now bigger than ever (and, coincidentally or not, failing some government-led stress tests). Click to enlarge Unsurprisingly, this same mentality holds true when it comes to our investments, and the advisors we choose to work with. Most individuals simply default to working with the big wirehouse brokerages (Morgan Stanley, Merrill Lynch, Wells Fargo, etc.), even when they could be obtaining better service (and true fiduciary advice ) by working with a smaller, independent Registered Investment Adviser firm. And yet, there’s a growing body of evidence that smaller (and not bigger) might actually be better for many things, including our investment returns. In early 2013, a study released by Beachhead Capital found that among approximately 3,000 long/short hedge funds, the funds managed by firms with total assets under management (AUM) between $50 million and $500 million outperformed those run by larger firms over essentially every time period studied. And the amount of outperformance was significant — 2.54% per year over five years, and 2.20% per year over ten years, with the outperformance concentrated in the years immediately preceding and following the financial crisis of 2009. Risk measures were roughly the same for the different types of firms, so the outperformance can’t be explained by greater risk-taking. And while “dispersion” measures were greater among the smaller advisors — meaning that returns varied more for smaller firms than for larger ones — the overall difference in performance is too large to be ignored. These findings run counter to what much industry research might predict. Whether at hedge funds or at investment advisory firms, scale is generally expected to improve purchasing power, and to allow for access to a broader range of investment vehicles (like certain swaps and derivatives or other over-the-counter products that smaller firms simply can’t access via their existing custodial channels). If nothing else, size is supposed to improve the terms that managers are able to negotiate, whether via lower commissions or fees or via improved investor protections in potential bankruptcies or other corporate restructurings. And yet, intuition aside, these benefits of scale simply don’t seem to be flowing through to the bottom line, for the firms or their investors. Beachhead presented a number of potential explanations for the disparity, a few of which I’ll paraphrase here. Some investments don’t benefit from scale Contrary to conventional wisdom, bigger isn’t always better in the markets; sometimes, size can be a limiting factor, constricting the types of investments that a firm can realistically add to its portfolio. Take the case of the Harvard Management Company, the group tasked with managing Harvard University’s sizeable endowment . For years, HMC’s investment performance was top-notch, consistently beating its peers as its talented managers consistently generated high double-digit annual returns. But as HMC’s portfolio continued to grow, it found itself running out of viable places to put all of its money. In many markets, they had already become the single largest owner of available shares, and to increase the size of their stakes in those investments would impede their ability to exit (or trim) those positions in the future. In some markets, HMC had effectively become the market, simply by virtue of its size. Funds (or managers) in that position are left with two basic options: either begin to branch out into ever more esoteric investments and asset classes, or else pile into the so-called “hedge fund hotels” , those few investment vehicles that have the opportunity for outsized gains, but are also large and liquid enough to accept massive inflows of capital without enduring wild market-moving price shifts. Neither option is particularly attractive, from the investment manager’s point of view. Choosing the “esoteric investments” route often means accepting significantly less liquidity (and an attendant increase in volatility), which tends to limit flexibility while also exacerbating the impact of downturns on fund returns. Indeed, this is exactly what happened to HMC during the 2009 financial crisis, a dynamic that led to a reconsideration of overall investment strategy. But the “hedge fund hotel” route is similarly problematic: for one, how can a fund distinguish itself from its peers when all funds own the same investments? Wouldn’t larger firms then, by definition, simply trend toward standard “average” market performance over time? And, perhaps more concerningly, what happens when a majority of the large funds all run for the “hotel” exits at the same time? At best, the fund is, again, forced to endure greater portfolio volatility, and at worst, the managers are trampled like so many young men in Pamplona . The fact is some investment opportunities are small enough that only a small advisor can really avail itself of the benefits — the market for the investment could be so limited that the large manager’s entrance would simply overwhelm the market and thus eliminate any mispricing opportunity. Even if the large fund were successful in its trade, the gross size of the gain might be so small as to barely impact total fund returns. Think of the old parable of Bill Gates stooping down to pick up a 100 dollar bill (or a mythical 45,000 dollar bill ) — reaching down to pick up that $100 would have little to no impact on his net worth, and it might even be a complete waste of his time to bother with picking it up. For a panhandler, though (or a poor college student, or me or you), that $100 would make a meaningful impact on our bottom line. The same holds true in the markets: sometimes, the available opportunity in a specific investment is limited to a set dollar amount, an amount that will certainly help improve small manager returns, but that would have little to no measurable impact on the returns of the larger fund. Beachhead refers to this dynamic as the “broader opportunity set” dynamic, and it is very real. If it weren’t, then “hedge fund hotels” would never have existed in the first place. As it stands, the larger you get, the fewer markets (or opportunities) you can find that are large and liquid enough to accommodate your increased size. Hence, in some markets, smaller advisors are at an inherent advantage in terms of percentage performance. The “talent” gap It’s generally assumed that the most talented managers will be enticed to work at the largest firms, since those firms have the greatest resources and opportunities, enabling young and talented advisors to thrive and become rich. However, there’s a counter-narrative in play that makes at least as much sense. If you’re truly talented, and capable of generating outsized returns, why would you want to sell that skill off, enabling a large corporation to profit from your work? Wouldn’t you be better off launching your own firm, so as to profit off of your own work, rather than counting on your boss (or a board of directors) to determine your ultimate compensation? Indeed, there’s an argument to be made that smaller advisors represent a specific type of self-selection: only those advisors who are very confident in their ability to survive on their own will even bother to break away and start their own operation. Yes, they’ll be smaller by definition, but their talent and ability to generate returns for investors will be unaffected by a switch in the logo on their business card. As demonstrated above, the advisors might even be able to open up their investment opportunity set by doing so. Arguably, those who choose to work at the largest firms (and stay there for the long run) are simply those who crave the stability and comfort that those firms provide or promise. Particularly for the millennial generation, there seems to be a trend toward entrepreneurship and betting on oneself , and that trend impacts the investment advisory industry as well. If you’re an investor, do you want to hire the manager who needs (or who thinks he needs) a big brand name in order to succeed, or one who trusts in his ability to swim on his own, even without the resources and advantages that the larger firm provides? That remains an open question, but the evidence is beginning to mount in favor of the smaller firm. The importance of each individual client One dynamic that Beachhead does not mention, but that may be particularly important for those looking to choose an investment manager, is what I will call the “burning platform” issue. At a large firm, complacency can often be a very powerful force. For the big wirehouse brokerages, a sudden loss of 1 or 2 or clients (or even, say, 5-10% of clients) may not be meaningful enough to really impact the bottom line over the long run. Sure, a few layoffs and restructurings might result, but the viability of the business is rarely threatened. At smaller firms, though, the experience and importance of each individual client is amplified. A period of sustained underperformance that leads to client attrition could , in fact, threaten the long-term viability of the firm, as well as the paychecks of the managers in question. The closer a manager is to the end user — and the greater the importance of each individual client — the less room for complacency and apathy there will be. At smaller firms, there’s simply less room for ignorance of client needs — you either perform or you’re history, generally speaking. At the end of the day, while we all might derive some comfort from size, research shows that betting on smaller managers can often be a savvy move. Ultimately, brand names are little more than a signalling mechanism — “we’re safe, we’ve been vetted,” say the big brands. You can trust them, they’d argue, because their size indicates that many others have (presumably) done their research and chosen to work with them already. 50 million Elvis fans can’t be wrong , right? Thus, when we blindly choose to work with the big brand name, what we’re effectively doing is outsourcing our due diligence to others. Instead of choosing to learn about the firms or managers in question, we simply rely on the brand name to protect us, because it’s the seemingly “safe” play. Increasingly, that approach doesn’t hold water. As an investor, take it upon yourself to learn more about the actual services that are offered, the actual philosophies that guide different offerings, and really get to know the diversity of service offerings. All of the various industry players have different strengths and weaknesses, the relative merits of which may or may not be important to you; don’t assume that the big guy has exactly what you want and need just because they’re big. In reality, it’s rarely the case. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Business relationship disclosure: The author is a contract employee and partial owner of myFinancialAnswers.com, and he is compensated to provide industry commentary for the site. The opinions provided here may also be published at myFinancialAnswers.com.