Monetary Sugar Daddy

I started in the asset management industry in 1993. Since then, industry assets under management (AUM) have grown from slightly under $4 trillion to over $17 trillion at the end of 2013 (source: Yahoo Finance). AUM has grown consistently, except for declines in 2002 ($6.6 trillion in AUM) and 2008 ($10.4 trillion in AUM). The 2002 decline was bailed out by Alan Greenspan and 1% rates (low rates for a “considerable period”). Of course Greenspan’s easy monetary policies created a housing bubble (thank you Easy Al – we sold our house in FL near the peak) and the eventual bust, which caused the industry’s AUM decline in 2008. During this industry recession, Bernanke came to the rescue and outdid Greenspan. The Bernanke Fed lowered rates to 0% and printed trillions of dollars to purchase mortgage debt and U.S. Treasuries, creating massive asset inflation. Asset gatherers and the investment management industry rejoiced – long live the Fed!

The asset management industry has often relied on and appreciated the Federal Reserve’s heavy hand in financial markets. Monetary policy under Greenspan, Bernanke, and Yellen has increased in its influence each market cycle and has helped put a floor under the industry’s AUM and revenue. Initially the Fed’s backstop of the financial markets was called the Greenspan put, but now it’s safe to insert any global central banker. It has been a wonderful relationship and business model for the investment management industry. Even if an asset management business didn’t grow its customer base, it could increase fees and revenues by simply riding the wave of easy money policies and the resulting asset inflation.

Despite record high stock prices and record low bond yields, the easy ride for asset managers appears to be coming to an end, as the industry is now under threat of a structural shift. As most know, the investment management industry is undergoing a major shift away from active to passive management strategies. According to a recent Bloomberg article, “Vanguard managed more than $3.5 trillion globally as of April 30,” with “$148 billion in flows in the first six months of 2016.” The shift to passively managed strategies isn’t new news. However, I believe a major cause is underappreciated.

While many market participants will point to the lower fees as the catalyst for the growth in passively managed funds, I believe aggressive, asymmetrical, and relentless monetary policy has also contributed. Since central banker “emergency” intervention began in 2008, EVERY decline in asset prices has been reversed with central banker policy response — real and verbal. In effect, one of the most important aspects of free markets, the pricing and respect for risk, has been temporarily suspended. Central bankers have replaced free markets with markets that are perceived to only go one direction (up).  Investors are being conditioned and rewarded to believe this time actually is different. If investors believe central bankers can set asset prices and control risk (or at least the perception of risk), it’s understandable they’ll flock into index funds and ride the central banker’s wave of easy money in a low fee vehicle.

Unlike private bank balance sheets that were the foundation of the credit bubble of 2003-2008, current asset bubbles are supported by unlimited central banker purchasing power – their balance sheets, in theory, can expand indefinitely. The perception that central banker resources are unlimited provides investors with a feeling that they can always rely on central bankers to maintain financial stability (stable to rising prices); further reducing investor need for risk management, and in turn reducing investor demand for active management.

Ironically, the investment management industry needs its sugar daddy, the central bankers, to fail and fail miserably. The industry needs to prove active management works and its fees are justified. In a market without properly priced risk and without genuine opportunity, it is difficult to generate sustainable absolute returns and achieve investment objectives (for example, how does a bond fund with an income objective provide sufficient income in a no yield world?). In addition to threatening the business models of banks (flat yield curve), insurance and pension plans (insufficient yields relative to obligations), I believe it’s safe to add the asset management industry to the list of industries the central bankers have inadvertently put at risk.

Opportunity Set From Hell

Depending on your valuation measure of choice, stock valuations are near or at record highs. The valuation measures that I prefer, such as price to sales, are at record highs. The price to sales ratio on my 300-name possible buy list exceeded 2x at the end of Q2 – the highest I can remember, while its P/E exceeded 30x! Many of the mature small caps I follow typically sell closer to 1x sales (makes sense as 1x sales would equate to 15x earnings using 10% EBIT margin). In May, Goldman Sachs noted median stocks trade at the 99th percentile of historical valuations, with EV/Sales at 100% percentile. Bond prices and yields are beyond belief. Over $11 trillion of global bonds now provide negative yields, while the 30-year Treasury recently reached a record low yield, dropping to as low as 2.14% on July 5. Alternative investments aren’t screaming value either. Residential and commercial real estate has appreciated significantly, with cracks beginning to show in higher end properties such as in New York and San Francisco. Private equity returns looks great, as all asset classes do in the rearview mirror of a boom. Some pensions and asset allocators are firing their hedge fund managers and “diversifying” (or performance chasing?) into alternative assets.

To be fair, it’s not an easy environment for asset allocators and it’s even more difficult for absolute return investors. Let’s face it, it’s an opportunity set from hell. With asset prices so high and yields so low, are adequate absolute returns possible? While I can’t speak as confidently about other asset classes, I believe at current prices, small caps will struggle to provide sufficient absolute returns (sufficient = positive returns that appropriately compensate for risk assumed). I believe small cap stocks are extremely overvalued. Assuming the price to sales ratio of most mature small cap stocks revert to more normalized and justifiable levels (2x sales declining to 1x sales), I believe many small cap stocks could be cut in half. While large declines are uncommon and may sound extreme, small caps saw similar declines in the bubbles of 1999-2000 and 2008-2009.

What is an absolute return investor to do in such an environment? Be patient and remain safe and liquid is the best answer I can come up with and it’s what I am doing. Participating and playing along is great if you can time markets – I can’t, I don’t, and I won’t. Is this why the investment management industry has become so obsessed with relative investing? Relative investing provides cover for professional investors to stay fully invested even when valuation metrics are flashing red. Relative performance investors (most professional managers) have few options, but to play along. They have inflexible mandates and may fear losing assets under management, so they stay invested and practice relative value investing (buy overvalued securities, but not the most overvalued).

We can debate why prices are where they are in another post, but I believe most value investors would agree that many assets are artificially inflated and expensive. I have no special insight on when this cycle ends. Again, I can’t time markets. Nonetheless, if we are in fact in the third asset bubble in only 17 years, I believe it too will end as no amount of touting T.I.N.A (there is no alternative) can keep overvalued markets inflated indefinitely. In investing, although it may feel this way, we do not have guns to our heads that force us to overpay. We don’t have to do it. There is a choice. There is a decision. As an absolute return investor, I’m saying no and refuse to invest in the current opportunity set from hell. There will be better ones in the future – that I’m confident of.

Unemployment — First Day

Yesterday was my first day of unemployment since 1988 when I started as a Baskin Robbins trainee. By 1989 I had moved my way up to “Head Scoop” and increased my hourly wage from $3.15 to $4 (including best employment perk of all times: all you can eat ice cream)! As a teenager with few obligations, I was crushing it financially and I was young enough to burn off all the calories/free ice cream. At the end of the summer, I decided to buy a CD at my local bank with all of the money I saved. I still remember the exact amount — $750. I was rich! Even better, the one-year CD I invested in was yielding 7%. From that day forward I was hooked on the power of compounding.

As an absolute value investor I long for the days of 7% risk-free returns. Are such risk free returns even possible now? If the yield curve shifted upward 500-600bps, developed countries would become insolvent overnight. Total US debt of $19 trillion x 0.06 = $1.14 trillion increase in fiscal deficit = game over. Has global debt reached a point that makes normalization of rates impossible? The math doesn’t support normalization; hence, the consistent delays on the emergency monetary policy exit. Is the Fed data dependent, or terrified of the normalization process?

Absolute Return Investing — Utilities

I’m not an investment snob. To achieve attractive absolute returns over a market cycle, I believe it’s important to keep an open mind and your opportunity set as wide as possible. At times, I’ll be interested in areas some investors will avoid either due to their rigid beliefs or perception fears. There are times during market booms and near cycle peaks that boring stocks, such as utilities, are often forgotten and left behind. In a raging bull market, utilities may be considered too risky to hold for professional investors obsessed with relative performance. Portfolio managers may avoid boring stocks as they try to keep up with the herd, providing opportunity for absolute return investors.

I admit I like utilities. I’ve often used utilities to help generate absolute returns, especially when they’re being neglected by the go-go relative performance crowd. Utilities are simple businesses and mostly regulated. In effect, they’re easy to value. If you can buy a utility near or slightly above book value, an investor can earn near the utility’s allowable (what regulators allow utilities to earn) ROE. Customer growth and the moderate use of leverage can also add slightly to growth and enhance returns further. I often use tangible book value as a starting point in my utility valuations and apply a realistic allowable ROE (adjusted for regulatory lag) to determine the expected cash flow from the utility. I then view it more or less as a perpetual bond with a no to slowly growing coupon.

Near the last cycle’s peak (2006-2007) I was able to find attractively priced utilities which allowed me to soak up some cash in a very expensive small cap market. The herd was avoiding boring utilities in favor of more exciting returns, such as those found in cyclical and commodity stocks. Unfortunately, this cycle utilities are not attractively priced and are not being ignored — utility stocks are on a tear and have been one of the best performing sectors for the first half of 2016. According to Yahoo Finance, Utilities increased 21.2% during the first half of 2016. Select water utilities have done even better with California Water Services (CWT) up 52% and Middlesex Water increasing 65%. So much for boring and forgotten – charts of water utility stocks look like internet stocks in 1999! As mentioned earlier, I prefer buying utilities near or slightly above book value. Currently most utilities are selling at meaningful premiums to book value and significantly over historical price to book ratios. Water utilities are selling near 3x book value on average, which implies P/E ratios near 30x based on allowable ROEs of approximately 9%. These valuations make little sense to me given risks and historical and expected growth rates.

I think most would agree that utility stocks are being chased for yield this cycle, as long term Treasuries yields collapse to 1-2%. As their stocks surge, yields on utility stocks are falling and no longer appear as attractive and defensive. Yields on water utility stocks are particularly unappealing. According to Dividend.com, the water utility stocks in its group are only yielding 2.04% on average, with some water utilities, such as American Water Works (AWK) yielding below 2%. As utility stocks have outpaced gains in long term Treasuries (ETF TLT up 16% first half of 2016), their dividend yields are also becoming less attractive relative to Treasuries.

While investors may point to the collapse in bond yields, especially Treasuries, as a reason to own utilities, lower Treasury yields can increase regulatory risk. Regulators often look to competing yields, especially risk free yields, when determining a utility’s allowable ROE. Assuming interest rates remain depressed, it is within reason to assume regulators may reduce (or continue to reduce) allowable ROEs, which in turn would reduce the cash flows and ultimately what an investor is willing to pay for the business. While lower allowable ROEs and lower rate hikes would benefit utility customers, it would not be great news for utility investors.

In addition to lower yields, I believe utilities have benefited from investors flight into quality. I believe quality is very expensive for this stage of the market cycle. Many investors were burnt last market cycle by piling into riskier cyclical businesses. When the 2008-2009 crash hit, many of these lower quality stocks were destroyed. Investors have learned their lesson this cycle, or have they? While high quality businesses, such as utilities, have more certain cash flows and are less risky businesses, are they lower risk investments? Given current valuations, I do not believe they are. We’ll have a lot more time to discuss the excesses I’m observing in high quality stocks (very important and underappreciated topic), but for now I just wanted to point out that I believe utility stocks were benefiting from the rush into quality.

 

Welcome to Absolute Return Investing

Over the past 18 years I’ve been managing a strategy that is focused on and has generated attractive absolute returns. I believe absolute return investing is superior to relative return investing. Relative return investing has never made sense to me. Investors, big and small, think in absolute returns (think pension return assumption of 8% or an individual return goal of “making money”). Nevertheless, the investment management industry has consistently gravitated more and more to the world of relative investing. In relative investing, losing 30% of clients’ capital is an achievement if the market declines 32%! In the following posts I will attempt to shine light on absolute return investing and why I prefer it to the relative world. Furthermore, I plan to provide current updates on the business environment through the eyes of 300 small cap companies — many of which I’ve followed for 10-20 years. As I recently recommended returning capital to clients (due to the excessive small cap valuations and broadness in overvaluation), I’m using this blog, along with managing my own separate account (which is now 100% cash), as a way to stay engaged until my opportunity set improves and I eventually return to the asset management industry.