There are many things absolute return investors have in common. For instance, most absolute return investors prefer avoiding crowds, as crowds and value rarely coexist. Theme parks are a good example. Have you been to Disney lately? Along with the crowds and long lines, you’ll find high and rising prices. In fact, according to Bloomberg, Disney recently announced it was raising park prices 1.9% to 4.9%.
As a dedicated contrarian and absolute return investor, I prefer Legoland over Disney. At Legoland you will find fewer crowds, shorter lines, and lower prices. In my opinion, it’s simply a better value relative to risk assumed. We’ve been several times and went again last week for spring break.
During our visit I didn’t spend much time monitoring the markets. However, out of curiosity, on Thursday I decided to break away from the rides to take a glance. I should have stayed on the roller coasters! Investors appeared confused. Should they buy stocks in anticipation of the reliable quarter-end entitlement rally or should they sell stocks as Trump euphoria shows signs of fatigue?
It is times like these that I’m very grateful I’m not required to be fully invested in inflated assets. With my absolute return portfolio currently positioned 100% in patience, I’m not very concerned about the near-term direction of the stock market. It can spike higher or it can crash. To accomplish my absolute return objective, the exact heights equity prices reach this cycle is irrelevant. It will be the prices I ultimately pay when I allocate capital that will determine my future returns.
While I’m comfortable ignoring the markets and remaining patient for an extended period, I admit I’d prefer being fully invested in wonderful businesses selling at attractive valuations. Unfortunately, owning a portfolio of high-quality small cap businesses at today’s prices is off limits. My process and discipline is very clear about this – overpaying is not an option. Therefore, while I prefer being invested, during periods of rotating bubbles and broadly dispersed asset inflation, large allocations to patience, or cash, is often necessary.
Relative return investors view patience and cash differently. Regardless of valuations, most relative return investors remain fully invested throughout the entire market cycle. As an absolute return investor, this has never made sense to me. Think of all of the rules of successful investing, such as: buy low sell high, don’t lose money, or be fearful when others are greedy and greedy when others are fearful. What do all of these rules require? Patience. And how can investors be patient without the ability and willingness to hold cash?
With equity prices and valuations near or at all-time highs, instead of selling high, avoiding losing money, or being fearful, most active managers appear to be all-in with mutual fund cash levels near record lows (approx. 3%). While many of our investment heroes preach the importance of being patient and selective, when I open the hood of many actively managed funds, I see signs of “full throttle” late-cycle investing.
It’s understandable. In extended bull markets, the pressure and urge to do something and keep up with the herd can be overwhelming, while the rewards of being patient and doing nothing appear nonexistent. But doing nothing is exactly what I believe is required during periods of inflated asset prices. Why force invest in inflated assets if you don’t have to?
Unfortunately, many portfolio managers feel that they don’t have a choice and must remain fully committed. To some extent, this is true. Due to investment mandates requiring managers to be fully invested, a portfolio manager’s view on valuations, opportunity sets, and future returns may be irrelevant when determining the amount of cash a manger holds.
The growth in passive investing has also placed increasing pressure on managers to keep up during market cycle booms. Passive funds are aggressive competitors that do not care about valuation, do not hold cash, and are incapable of practicing patience.
I’m sympathetic to the position relative return investors find themselves in at this stage of the market cycle. Although many professional investors may be well aware that their opportunity sets are expensive, career risks often override investment risk concerns (thanks to a reader for sending the following article on career risk: link.) Jeremy Grantham (the leading expert on career risk) writes, “The central truth of the investment business is that investment behavior is driven by career risk.” In effect, for many professional managers, looking different is simply too risky from a business and asset under management (AUM) perspective.
I often wonder if the modern-day goal of risk management is to monitor the risk of losing assets under management instead of the risk of incurring losses on client capital. I’ll never forget being told after a good year of performance and bad year of asset under management growth, “Eric, you can make the best dog food in the world, but if the dog won’t eat it, it doesn’t matter.”
Regardless of the business challenges associated with absolute return investing, I’ve spent most of my career committed to maintaining the flexibility to hold cash and avoid overpaying. My absolute return objective attempts to protect capital during periods of inflated asset prices and act opportunistically when being adequately paid to assume risk. To achieve this objective, holding a large cash weight during certain portions of the market cycle has been required.
There are times when my process and discipline has been labeled a broken clock. Whether intended to be or not, I view this as constructive criticism and an important reminder of how absolute investors should not be positioned. Given cash is an awful long-term investment, I believe it’s important to avoid remaining patient throughout an entire market cycle. There should be a period during each market cycle when investors are being adequately paid to assume risk. In other words, during every market cycle, there is a time to be patient and a time to be opportunistic. Full-cycle broken clock investing should be avoided, while flexibility and decisiveness should be embraced.
Lastly, I want to make clear that my patient positioning is not an attempt to time the market. Instead, portfolio positioning is a direct reflection of the number of stocks within my universe of high quality small-cap business that pass my absolute return hurdle rates. It’s also important to be aware that holding cash can result in significant opportunity cost. However, during periods of excessive overvaluation, I believe opportunity cost is preferable to overpaying and risking substantial losses to capital. Furthermore, I’ve found opportunity cost can be quickly recovered once market cycles conclude and prices adjust. Conversely, significant losses resulting from overpaying can be much more difficult to recover from and can even be permanent.
In conclusion, I continue to prepare for the future as current prices and valuations do not interest me. As has been the case in past cycles, I expect equity valuations will ultimately normalize, causing price dislocations and sufficient opportunity. Although my patient positioning may cause my absolute return portfolio to lag the markets, I believe it is essential in achieving my objective of generating attractive absolute returns over a full market cycle. Patience and cash allows me to limit mistakes during periods of overvaluation and act decisively (without selling existing holdings) when opportunities return. While cash can be extremely boring during market manias and relentless bull markets, allocating it when prices plummet and the bids disappear can be extremely rewarding. I can’t wait! On second thought, I think I can and I think I will.