Notes – Horizon Kinetics 2015 Compendium

For the last two years, Murray Stahl and Steve Bregman of Horizon Kinetics have published a “Compendium Compilation” of their various research pieces and market commentaries throughout the year. I recently requested copies of the 2014 and 2015 compendiums and just completed reading through the 2015 compendium. What follows are “stitched together” quotes from several of the essays.

The Indexation Experience

An active manager always can be found to be deficient if underperformance relative to an appropriate index is discovered. In fact, a manager can be found to be deficient if a return generated is equivalent to the appropriate index… one could always purchase the index as the less expensive investment alternative.

How does one judge an index to be deficient?

Since short-term interest rates approach zero in most regions of the world, the valuation environment is very benign… most governments during this period have embarked upon grand fiscal stimulus efforts that are now becoming unsustainable.

When one measures a manager relative to an index, is one measuring investment acumen or marketing ability?

The manager… will purchase a security until the expected excess rate of return is zero. The index… is marketed until the marginal revenue from a product is zero, which is an entirely different concept.

The index is not constrained by valuation.

Most indexes, in the fullness of time, do not earn impressive rates of return.

Problems With Indexation

When indexation excludes the so-called marginal securities, two things happen. The marginal securities are the stocks where the volatility really resides, which means the index is going to lose its volatility. Second, the marginal securities are an important contributor to what would have been the return… their negative impact gets captured on the way down– but the positive return impact does not get captured on the way up.

It is the nature of a market capitalization weighted index that it is always un-diversifying.

Diversification

The problem with such an approach [wide diversification] is that it is quite impossible for any individual, or even a team of individuals, to have a good working knowledge of the individual investments at a security level. The portfolio can only be understood in terms of its statistical attributes… CalPERS… has about 20,349 individual investments.

If a team of 10 analysts were to work eight hours a day for three months, which is 22 business days per month, with no interruptions, the team would have at its disposal 10 x 8 x 3 x 22 man-hours to read 20,349 quarterly reports. This amounts to 5,280 man-hours available to read 20,349 quarterly reports, which equates to slightly more than 15 minutes per quarterly report… It should be obvious that success or failure in this endeavor must depend upon whether the statistical attributes of the portfolio provide the data necessary to make intelligent asset allocation decisions… it is impossible to devise a simple list of fundamental statistics to be used to comprehend a portfolio… because of differences in corporate expenditure practices, depreciation policies, tax laws in various jurisdictions, and GAAP vs. IFRS accounting.

The many diversified funds that purchase the most liquid securities must by definition generally own the same securities, since there is only one set of liquid securities. If the diversified institutions, therefore, own the same securities, when studying the price behavior of those securities, those institutions are, in reality, studying themselves.

If one believes in the Efficient Markets Hypothesis, then securities prices must reflect the beliefs of the holders of the securities. Yet, as shown above, the holders of securities do not study the securities. In fact, given diversification practices, it is not possible to study the securities. It is only possible that the investors study one another. Thus, one is confronted with a feedback loop or a huge self-reference paradox, as one may see in the paintings of M.C. Escher, such as Waterfall or Drawing Hands.

Another interesting case is the Singapore Index… returned 3.2% per annum. The mere fact that the economy of Singapore grew at over 6% per annum for more than 18 years does not correlate well with the stock market return for the simple reason that the Singaporean companies in the index are global companies. These results reflect many factors apart from the economy of Singapore.

Similarly, the Swedish index does not necessarily reflect the economy of Sweden. And the UK index does not necessarily reflect the economy of the UK.

The thrust of these facts is to question, if not actually reject, the geographical form of classification as an asset allocation building block. That calls into question the entire international method of investing. The characteristics of equities have little to do with the legal place of domicile of a given firm. However, on a weekly basis the Investment Company Institute records $3 billion to $4 billion withdrawn from domestic equity funds and deposited into international equity funds in search of diversification and risk control attributes that simply do not exist. As has been the case with many widely held investment beliefs without foundation, this will not have a good outcome.

Inefficient Markets

[Fischer Black] said that there are people who are highly knowledgeable about certain companies– the information traders– and when they trade, they are very well informed. Most others, however, are not so well informed; they are the noise traders.

[Fischer Black’s concept of] efficient markets was that if the bulk of investors were in an index that, as he defined it, would include every stock out there– everything– the noise traders would go there. That would eliminate the bulk of the noise traders from the active marketplace, so only the information traders would be trading. They would not go into the index, because they are highly informed, and the market would be much more efficient in the sense that it would reflect the judgments of informed participants.

If one reflects upon this matter [Carl Icahn’s letter to Apple], one will see that Mr. Icahn has posed an exceedingly profound question to all investors, and especially academics. Apple is the largest company in the world. It is arguably the most ubiquitous company in the world. Billions of people use Apple products daily and are very familiar with those products. If there is any equity in the world that should be priced efficiently, it should be Apple.

Yet, Apple has a lower P/E than companies such as Exxon, Coca-cola, and even Philip Morris International. One might debate the future prospects for Apple, but surely these are more robust than those of Philip Morris International. Does anyone assert that demand for cigarettes will increase?

The money manager industry is not populated by Homo Economicus, carefully and rationally evaluating different investment opportunities. The money manager can only survive by attracting assets to manage for a fee.

Modern financial theory cannot explain momentum because, if the stock market is efficient, there should be no serial correlation observed in securities… momentum investing is not a new innovation. It is a concept virtually as old as the idea of a stock market, although it has not always been called “momentum.” Technical analysis is essentially a search for securities with momentum.

It is now possible to raise substantial sums for almost any index if the rate of return is sufficiently high. It is nearly impossible to raise money for any index if the rate of return is insufficiently high, let alone if that return happens to be negative. This is not the asset allocation process. This is the momentum process. The industry makes use of a substantial marketing budget, It clearly influences the valuations not only of individual securities but of entire sectors, and it dominates, for the time being, the investment process.

Other Remarks

  • Is modern risk control methodology actually serving to reduce risk or is it merely convincing professional investors to accept, perhaps unwittingly, another type of risk?
  • It should be noted that the real was not always the currency of Brazil. There were cruzeiros, there were cruzadoes, and now we have the real. That in itself should tell the reader something about the stability of the currency.
  • Historically, that is what emerging market debt was: questionable claims against governments.
  • Bonds should be thought of in the following way: they offer risk with no possibility of reward, especially if you are a taxable investor.

 

Advertisements

Notes – Horizon Kinetics 2014 Compendium, Skepticism About Indexation

For the last two years, Murray Stahl and Steve Bregman of Horizon Kinetics have published a “Compendium Compilation” of their various research pieces and market commentaries throughout the year. I recently requested copies of the 2014 and 2015 compendiums and just completed reading through the 2014 compendium.

The Scourge of Indexation

The single biggest trend that Stahl and Bregman have been criticizing for years is the rise and dominance of indexation as passively-managed ETFs as the practical consequence of widespread adoption of the Efficient Market Hypothesis. I collected comments from several different essays and stitched them together into a meta-commentary on the phenomenon:

We are reliably informed by many academicians that growth, value, momentum, yield and volatility are fundamental attributes for portfolios and, as such, are the determinants of performance. Numerous studies assert this as true. However, the studies were all done on the opportunity set of stocks, not actually on funds organized upon the findings of the research. In other words, these studies predate the implementation of the conclusions of the studies.

The efficient markets hypothesis is subject to no serious scholarly challenge. Indexation is by far the largest investment strategy and it is growing in acceptance by the day.

One could argue convincingly that markets are efficient if the market place is made up of a multiplicity of active managers gathering information and, by their trading, expressing that information in the prices of securities. However, as we saw in the Facts and Figures section, if the majority of the dominant investors, who are also the marginal buyers and sellers, are now passive, and if this dominance is growing, how can one be sure that the efficient market model remains a valid assumption?

What does it mean when one — that is, the investment ecosphere — creates multi-trillion-dollar managers that are valuation indifferent?

You cannot merely have trillions of dollars invested in indexes and assume that everything will be the same as it was before they were investing in indexes.

For 40 years, indexation worked because of four trends. There was a strong fiscal stimulus to promote the demand in most countries. Companies engaged in cost-cutting and eliminated marginal products and divisions, thereby increasing margins. Corporate tax rates have been declining for 40 years, and interest rates have been declining for decades. Companies, however, cannot count on those four benefits anymore.

We are going to replace poor judgment with no judgment whatsoever.

…an unintended consequence of the indexation movement is the creation of quasi-permanent holding companies for [S&P 500 and other major index stocks]

To my mind, the rise of indexation represents something of a corporate governance crisis in this country and any other where passive index funds account for a substantial proportion of the total shares outstanding in the market place (for purposes of this argument, I’ll peg that number at 20% which just so happens to be how much are currently owned by passive funds according to a recent New Yorker piece). Looked at in very simple terms, that is 20% of the shares of the average public company that have no active agency behind them, that is, there is nobody scrutinizing the operations of the company and the efficacy and honesty of its management by or on behalf of the shareholder whose capital is at risk. Given how many individual and even institutional shareholders are already “actively disengaged” from their duty to provide capitalist oversight of the companies they own, this is a troubling context to invest in if you believe that sound corporate governance is a key ingredient for above average investment returns and safety of capital at risk.

It reminds me strongly of one of the quotes from my recent review of Panic, “Underpinning the ideology of modern finance is the notion that the insight, judgment and even diligence of the entrepreneur are irrelevant for investing in public securities markets. These markets, we are told, are special, too powerful and too perfect to allow any entrepreneur’s judgment to matter.”

This indexation phenomenon has gone beyond influencing the markets to the point that it is “making” them, an inevitable consequence of gamification:

BlackRock… has issued a call for reform… [their] paper calls for the standardization of features of newly issued bonds. For example, an issuer would not be free to issue bonds with any features it wanted; it would have to issue them in certain standard packages, which are defined in the paper. BlackRock’s proposed change is an example of how indexation as a business is beginning to reflect the market as it impinges upon the index providers’ business needs.

Bonds have different characteristics because they represent different kinds of risks with different kinds of borrowers and lenders. While it’s possible to standardize anything for most applications, this is decidedly a “new era” where the standardization process is not being driven by the desire to reduce costs and confusion for borrowers and lenders per se, but rather it is being driven by the desire to efficiently index such media whose performance can then be captured in an ETF. It’s an important difference considering the fact that risk can not be standardized away just so that an investor can more easily allocate his funds.

In time, these indexes just end up playing themselves, as Stahl warns:

It is important to keep track of how the indexes are going to be tilted because that has two sets of implications. First, it has implications for the businesses of the index orchestrators, but second, it has implications for the entire marketplace. Whichever way a given sector gets tilted, either positively or negatively, the amount of money involved is so huge that it is going to be either the best-performing sector or the worst-performing sector.

Some Other Strange Side Effects Of Indexation

I captured a few other anecdotes related to indexation and EMH that I thought were memorable. One concerned the changes occurring in the utility industry. Stahl shared numerous statistics demonstrating the rapid rate of increase in solar power production, explained the different economics of solar (especially once installed) compared to gas, coal or nuclear powered generation and then surveyed the effect that the reach for yield and the indexation of the utility industry have created “priced to perfection” conditions in the publicly traded utilities firms. He concluded:

The asset allocation to yield-oriented stocks relies upon historical data regarding stability of dividends, which date back decades. The allocators treat this data as if they are immutable, scientific constants… They are completely unaware that a dividend quality constant is about to manifest a certain degree of inconstancy… This is an important phenomenon happening in the world of utilities, and people should remain very cognizant of it.

He also commented on the role volatility plays in the EMH:

In theory [institutions] are all fleeing volatility, but in reality are they merely fleeing volatility or, said another way, is volatility merely wherever they are going to be?

Connected to that idea is the degree of correlation which many investments are experiencing:

One can sell all of one’s investments and replace them with gaming stocks, and still have a correlation of 0.9726 with the S&P 500. It is an incredible statistic when you think about it.

Why should a presumably rational investor buy the more volatile Russell 2000 Index for a long period of time only to see it fail to outperform, or even underperform, the less volatile S&P 500 index?

And he brought further scrutiny on the idea of boiling down the predictive performance of a stock to one or two variables, such as volatility:

Companies possess many characteristics so it is difficult to assign causative factors to any one of them without knowing the other characteristics in that factor universe.

Miscellaneous Ideas

I also enjoyed Stahl’s commentary on including land in one’s diversified portfolio (again, these comments are stitched together from various essays):

Land held its value during the Great Depression.

Comparing and contrasting land with gold, it is clear that there were many periods when gold did not appreciate.

Government regulations sometimes affect the value of gold, but it is hard to envision government regulations that would affect the vast panoply of land resources in the world in some uniform way. Therefore, land is worth considering as a portfolio asset.

Land is not a hedge against political instability, which gold is because gold is mobile. Land is not mobile so it is only a hedge against inflation, not against political instability. Sometimes political instability and inflation come together.

He shared a contrarian view on eliminating an equity from consideration simply because it carries a high earnings multiple:

We cannot merely assert that if a company trades at 57x earnings, we will dismiss it as an investment. That would be an escape from reality… a Google at 15x earnings would be preposterously valued.

As long as it is possible to create companies at this scale of revenue, then not a few companies will trade at high P/Es. it looks like it is going to be a permanent part of the investment landscape.

Google’s valuation at the time it went public was around 57x earnings, and it’s market cap exploded from there. An interesting question is why it wasn’t valued even more highly given its realized potential?

Stahl observed a dichotomy between bond market interest rates and duration:

The interest rate is more or less engineered by the Federal Reserve, but the weighted average life reflects the risk preferences of bond investors.

Finally, I really liked this “bubble” related quote he shared from G.K. Chesterton:

There are no rules of architecture for a castle in the clouds.