Tag Archives: portfolio-strategy

Historical Rates Impact Common Stocks

Summary We think there is a recency bias surrounding interest rates. Historical rates are in the band between 3% and 6%. We believe rates will rise when there is a demand for credit, which can be a good thing for common stock owners. Time and coincidence often cloud our own perception. Consider interest rates. Baby Boomers and Generation Xers became adults (25 or older) between 1965 and 2005. During that period, these adults witnessed an aberration in the history of interest rates. They saw moments of monumental highs (20%) and levels consistently above historical norms. The chart below shows that long- and short-term interest rates in the United States have spent most of the last 400 years in a range between 3% and 6%. We contend that this deviation clouds the judgment and expectations of many of today’s investors. There are numerous implications for long-duration common stock owners arising from the examination of historical interest rates. Intrinsic Value Computations The father of value investing, Ben Graham, concluded through his years of research that 10-year corporate bonds averaged 4.4%. Therefore, in his revised intrinsic value equation, he used 4.4% as the numerator for adjusting intrinsic value based on interest rate fluctuations. This long-term interest rate chart supports the validity of his choice, and is right in the middle of the 3-6% historical range. One could argue that long-duration equity investors have been using discount rates in their intrinsic value calculations much higher than historical interest rates justify. This is likely due to the unusually high rates of the period between 1965 and 2005, a recency bias. Commitment of Capital to Bond Investments In 1980, the prime interest rate at the major banks was 20%. Long-term Treasuries peaked at 15% in early 1981. Inflation topped out in 1981 at 11%. Thirty-year fixed mortgages were issued as high as 17%. What people didn’t realize at the time was that they were living through a five-standard deviation event, according to history. Even if inflation had stayed at 11%, those interest rates offered investors very high inflation-adjusted returns. As the famous bond investor Bill Gross has argued, this laid the groundwork for more than 30 years of declining interest rates and a normalization back into the band between 3% and 6%. This has rewarded bond investors and got them addicted to an asset-allocation commitment based on lookback returns which are statistically unlikely. Interest rates are currently below the historical 3-6% range, and will likely rebound over the next 10 years into the historically normal band. We believe common stock buyers should include that likelihood in their stock selection methodology, whether in their intrinsic value calculations or in the effect that higher rates in the U.S. have on the U.S. dollar and overall economic growth in the country. We contend that the surprise in the U.S. will be how much stronger economic growth will be than what is expected. How else can rates go up, unless someone demands the capital via borrowing? Need for Solid Returns for Investors Owners of wealth in the form of liquid assets have an economic need in both low and high interest rate time periods. They need to earn a return above inflation to defend the purchasing power of their liquid asset pool. Ownership of long-duration common stocks has proven to be superior to that of other liquid assets over long time periods, except for the 10-year stretch from 1999 to 2008. As 10-year Treasuries fell to 1.6% in 2008 and stocks were liquidated in the financial crisis, two five-standard deviation events conspired to elevate bond investments in popularity and thrust bond portfolio managers into god-like status. We think a good rule of thumb is to avoid portfolio success stories created by five-standard deviation events. These only happen 2.5% of the time. Rather than being preoccupied with the consensus of investors, we believe building our portfolio around high-probability events is much more valuable to the long-term investor. Industries Benefited By Higher Rates in the 3-6% Range We have argued ad nauseam that common stock investors have two possibilities in front of them as it pertains to interest rates. If interest rates were to rise back into the 3-6% historically normal band, there must be forces which demand the money and industries which benefit from the forces that cause the rise in rates. If rates stay below the historical band, intrinsic value calculations using discount rates above the historical average will undervalue common stocks. Certain industries would welcome higher interest rates. Insurers must earn interest on collected premiums, banks would like to charge more for loans, and homebuilders would like to have so many customers for new homes that the resulting demand for money drives up interest rates. Consumer discretionary companies would love to see a level of prosperity which would drive retail sales and liberal advertising budgets. Drug and biotech companies would like everyone to be able to afford the fantastic new medicines they will introduce in the next 10 years. In summary, above-average returns don’t come along without taking risk. Investors have become very comfortable with today’s historically low interest rates, and fear continued poor economic growth rates. Equity portfolio managers use discount rates higher than today’s actual rates because of the abnormally high rates of the last 40 years. Lastly, the contrary long-duration common stock investor should be attracted to industries which benefit from the gravitation back into the historically normal returns from the bond market. The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Bill Smead, CIO and CEO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past 12-month period is available upon request.

Concentration: The Age-Old Question

Summary I’ve made the case for concentration before, and while I still advocate concentration, my original “time” argument was misplaced because of diminishing marginal returns on time. Concentration is largely a function of risk tolerance, which makes it far easier to find an appropriate level for an individual investor than it is for a professional. There is a lot of value in thinking about position sizing in terms of “starter” and “core” positions. Concentration is a subject I’ve written on before. In one of my first SA articles , I made the radical argument for a form of hyper-concentrated investing termed “Focus Investing” whereby one holds 3-10 positions… or even just one. Concentration is still a topic I give an inordinate amount of thought too and I wanted to share some of those thoughts here. This post also follows my first post on stock screening in a series communicating my investment process and philosophy. On Time My thoughts on position sizing have definitely evolved since my first article, and in hindsight, some of my arguments, while nice in theory, don’t hold in reality and my use of them demonstrated my inexperience as an investor. For example: Time The responsible investor follows each and every one of his holdings. It takes a constant amount of time per week to stay up on a company. I would advise at least an hour per week. Again this time is constant, whether that company makes up 2% of your portfolio or 100%… He could own 10 companies and still diligently follow them, but he’d have to devote ten hours instead of one. But wait, if he was willing to devote 10 hours total to stock market research when he held 10 companies, why not spend the same time researching, but while only holding one company? He could spend 5 hours per week keeping up on Apple and another 5 researching potential investments, comparing them against Apple, only considering them if they seemed much more attractive. My argument that investments require a constant amount of time and that 50% of an investor’s research time spent on a single investment is a good strategy ignores one very important principle: diminishing marginal returns or, more practically, the 80/20 rule. See one of my favorite Seeking Alpha articles , which discusses this subject, before continuing. The first hour of research yields more information and more valuable information than the 100th hour. The other problem with the time argument is sunk costs. We all know that a sunk cost should not influence decisions, but that they often do and, sadly, this is true even for decisions that we (the same people who are aware of the phenomenon) make. When you spend weeks researching a company and preparing an extensive, tidy investment thesis and article on the stock, it’s just harder not to take a position, independent of the actual prospects of the investment. While my time argument was somewhat off the mark (though it does hold in extreme cases; time is a serious problem for an actively managed portfolio of hundreds of stocks), I’ve still been a proponent of concentration, to a lesser extent, recently. Professional Constraints Concentration is largely a function of risk tolerance. This is not that meaningful if you are only managing your own money. All it means is that you must discover your risk tolerance and volatility tolerance and find a commensurate concentration level. Thing get tricky, however, when you are managing money for others. Introducing clients means more than one brain and in turn, risk tolerance is involved. What is the appropriate level now? If you are a manager like me with one strategy and one portfolio, then you should stick to the concentration level that you think is best for total returns, but I don’t think the story ends there. There needs to be some consideration that you are a professional and are managing other people’s money. There is a higher standard. This is one good reason to find like-minded clients. If you can withstand volatility, are long-term oriented, and are okay with concentration, look for clients with the same approach. Good luck- they’re rare! My other insight is that adopting a concentrated strategy as a new manager is tough because it requires credibility, to some extent, to be very concentrated. The base rate in investing is market returns and those are derived from a market portfolio, which is very diversified (500 stocks if we assume S&P 500 = market). Naturally, the more concentrated your portfolio gets, the more different it gets from the market and the further from the base rate its returns. You are going further out on a limb. It’s tough to do that with no professional track record. The logical next step is that if you’re a new manager you should be very diversified, but that’s a dangerous path I don’t want to take because it eliminates my positive optionality of earning extremely good returns and I’m in the investing industry for more than just money. Intellectual stimulation and an interesting, meaningful career is the most important thing I seek and the use of money as a means of keeping score and creating value is a big part of the financial aspect. In short, if I’m to succeed, I want to do so on my own terms and that rules out heavy diversification. If that means a slower ramp for my firm, so be it. “Starter” and “Core” I’m at a point now where my view on concentration is somewhat nuanced. Because I employ both deep research and empirical, systematic methods in my portfolio, not all positions will be sized equally – far from it. Right now, I have some positions that are 15-20% of my portfolio and some that are less than 1%. I think this dual concept of “starter” and “core” positions has been very helpful and is worth discussing. For me a starter position is 1% and a core position is much more than that, but the numbers don’t matter as much as the way of thinking about position sizing it represents. A starter position represents something that should, based on empirical evidence, outperform. That is a firm requirement. I talked about this extensively in a previous post . A starter position is also something I’ve done some research on, find interesting, and can model a good expected return with little to no downside on in an adverse case. But for some reason, it’s not fit to be a core position yet. The most common reasons are: I’m not sure I understand it, i.e. it may not be within my circle of competence The expected return I model is not high enough to exceed my absolute return hurdle, i.e. it’s not quite juicy enough I’ve not done enough research or thinking yet, i.e. I need more time Starter positions are crucial to my investment process because they allow me to slow down. Doing research needs to be a treasure hunt for me. I’m only interested in learning about companies when there is the possibility of it being in my portfolio and making me and my clients money. During the research process, it’s so tempting to act on research and invest. It’s hard to delay gratification. The problem is that good long-term investment decisions are made slowly. Gratification must be delayed. However, I’ve found that taking a small starter position up front helps to hold me over. Of course, I don’t do this for everything I research, but obviously far more than I end up taking core positions in as the chart above shows. It also provides an extra incentive to continue to dig deeper in the research. As Tom Gaynor says : When I buy some of something, I’m buying a library card. One of the reasons I buy some of something is to make myself think more deeply about it, read the reports and be more aware of it. It’s hard to overstate the positive impact starter positions have had for me. Not only have they performed well in aggregate, which is how I look at their performance, but they’ve rejuvenated me as an analyst. There was a rough patch where I only published four articles and made four investment decisions, not all of which were good ones, over a period of almost 8 months. (click to enlarge) I researched more than just four companies over this period, but not at as high a rate as I am now and not as effectively. The lack of gratification in the research process demotivated me. There’s no rule saying research needs to be fun for you to be a good investor, but for me I think it does need to be or I won’t find anything to invest in. It needs to be a treasure hunt and starter positions help a lot on that front. At the same time, when my research does, on rare occasions, generate what I think is a really good idea, I’m not going to only put 1% in it. There are times when the level of conviction and opportunity costs make anything but a big position a bad decision and that is when I am willing to take a core position. That is where concentration is needed. And in aggregate, you still end up with a pretty concentrated portfolio. More than half of my portfolio is in 6 stocks despite the large cash position. So I still advocate concentration, but clearly have a more nuanced view now and recognize that position sizing is a far more difficult issue than I initially had thought.