After sending a longer-than-usual annual letter in July, we received a lot of feedback and many insightful questions from many of you. For the benefit of everyone, we would like to share some of them with you along with our responses.
Q: In the annual letter, Aziz writes: “Even in the very unlikely case that interest rates do not rise sharply and quickly, inflation eventually will, which will inevitably eat away at the low to negative returns of those bonds.” Isn’t this partially an ideological statement?
A: That is a prediction, something that regular readers know we rarely do. My colleague Aubrey and I discussed whether we should leave it in or remove it from the letter because it’s clearly against our historical practice of not making macroeconomics predictions. I hesitantly decided to leave it in because I felt that this opinion is important to help you understand why we insist on investing in productive assets like equities as opposed to monetary assets like bonds. Unlike contracts, companies are dynamic and can adapt to changing circumstances and great companies have pricing power that allows them to deal with higher inflation by raising prices.
Q: Is now actually a good time to invest in the equities market?
Let me start by making a distinction between two questions that some people confuse when they are thinking about this matter. The first question is whether today is the best time to invest in equities, and the answer to that is a clear no. The best time to invest in equities is right after they have been battered and valuations are very low, such as early 2009 or the summer of 2011. But that’s the wrong question to ask—unless you happen to have a time machine. The better question to ask is whether equities are a good place to invest your money today relative to other options available now.
Let’s go through our options. I believe that long-term bonds are one of the most dangerous places to have your money right now. Rates will eventually go up and holders of these bonds will probably lose part of their principal. In fact, those buying negative-yielding bonds are guaranteed to lose principal if they hold the bonds to maturity. The risk with cash, on the other hand, is high inflation, which I’ve been worried about for years. While higher inflation is yet to materialize, the risk of it happening is high and if you’re holding cash earning zero that will hurt you a lot.
That leaves us with equities, real estate, and alternative investments. Alternative investments are a mixed bag with hedge funds having a very difficult time making any money of late, and while some do offer diversification benefits, they’re unlikely to produce anywhere near the spectacular results they promise. Private equity fund are chasing a diminishing number of expensive targets with valuations there at or above those in equity markets. Venture capital, especially in the US, is probably at peak valuations. Real estate can be attractive in some cases, especially if the investor has a big enough portfolio to diversify across property types and geographies and has a very long run investment horizon, though cap rates have come down a lot across the world. The same can be said of the general equity market, but small pockets of value still exist and equities have the benefit of liquidity and the ability to be diversified even with smaller portfolios.
I also believe that differentiated active managers will start to outperform passive investing in the upcoming environment. As I mentioned in our annual letter in July, we’re holding assets that have a free cash flow yield of 7% and growing at low single digits. We’re probably not going to hit the ball out of the park with that, but it’s also hard to see how we don’t do well over the long run.
Q: Given your view on the markets, do you think you can continue to outperform?
I’ve shared the following graph of the performance of growth versus value strategies in my December 2015 letter. Here’s an updated chart.
While we have outperformed the market the past few years, value investing in general, as you can see from the graph above, has had a tough decade and the spread between value and growth is still around an all-time low. We continue to believe that value investing works over the long run, even though it does test investors patience from time to time, this time being the longest test. I also believe that in an environment where value in general outperforms, our margin of outperformance above the general market would be even bigger. The next logical question, of course, is why I think the trend of the past ten years will change.
There are two reasons that drive me to believe that. The first is a simple reversion to the mean, an almost natural tendency of these types of relationships. The second, is more nuanced and should be taken with a grain of salt. Look at the chart below plotting changes in interest rates versus the MSCI Value-Growth line that we talked about above.
While the relationship is not a perfect fit—when is it ever in real life—you can see a pretty strong relationship that shows value performing better in rising interest rate environments (tech bubble being an exception). I can only speculate about why this relationship exists so I won’t get into that too much, and the market-timing ability of this relationship is clearly on the weak side, but when coupled with the mean-revision argument mentioned above, it makes me feel a little bit better about rising interest rates potentially being a catalyst.
Q: In the annual letter, Aziz writes: “…depressed corporate earnings, which have been hurt by a strengthening US Dollar, and which in turn makes international revenues (roughly 40% of total) translate into fewer US dollars” – What do you mean by that? Does that mean that a higher US Dollar reduces demand for American goods and services oversees?
A: There are two questions here. The first is about what I wrote specifically, and the key word in the sentence is “translate into fewer dollars”. When the Euro was at $1.30 two years ago, a shampoo that P&G makes and sells in Germany for €2.00 produces revenues for P&G (which reports in US Dollars) of $2.60 two years ago but only $2.20 today, even if the costs to produce are all Euro-based. It’s simply a translation effect even if the volume of units sold hasn’t changed. There is of course a second effect on US exporters whose products become more expensive if they keep their prices fixed in USD terms. The first effect (translation) is a much bigger one as most multinationals produce globally to try to match their costs with their revenues.
Q: Why do you have many consumer product companies in the portfolio? Is it because you prefer stable businesses, or should we infer as readers or investors that you only understand consumer products since you only invest in things that you understand?
A: A little of both. I wrote a piece in my blog back in May called “My Circle of Competence” (https://profitfromfolly.wordpress.com/2016/05/06/my-circle-of-competence/).
The outcome of that exercise showed that more than half of my successful investments were in the consumer staples and consumer discretionary sectors and those sectors had a very high “success ratio” for us. Of course, that’s not a random trial. I chose to invest more in these sectors because I believe that I can find many more companies that fit our criteria of “great businesses” in these sectors. Whether my ability to find them is because of my knowledge of the sectors themselves or an underlying feature of those sectors that makes such companies more prevalent is a difficult question to answer, though there are studies that show the latter to be the case. Some of that may have to do with the higher percentage of emotional decisions by consumers (e.g. brand effect) and the frequency of purchase (habit forming). It may also be because buyers don’t necessarily focus on negotiating a deal to make their bosses happy.
That being said, we have had good success in a handful of other non-consumer industries as well, and we try stay within our area of competence. Our current non-consumer investments include Linde, Express Scripts, Expeditors, IBM, Google (the customer is the advertiser), and LabCorp. We currently have half our portfolio in non-consumer stocks, which is pretty much in line with our history.
Q: In the annual letter, Aubrey writes: “Whilst we tend to avoid deeply cyclical stocks such as commodities, which usually possess little to no economic moat, every company is exposed to some form of business, capital, or replacement cycle.” Does that mean that the further we go from commodities, the less cyclical the market of the product and the companies’ stocks are going to be?
A: In general, that is correct. The more value you add to a product the less cyclical the business usually becomes. Commodity producers and even industrial companies have their stocks swing by huge amounts ~50% in a year vs a more muted ~20-30% for non-cyclical stocks, but of course there are some exceptions to the rule. While we tend to avoid commodity businesses in general, there are situations where there is enough margin of safety embedded in the price paid that it may make the stock a good investment. It’s very rare for us to find something like that, but the returns from such a situation can be very exciting.
Q: As an investor, is it better for me that your AUM get bigger?
Q: Why should your scalability be important to me?
A: As the fund size grows, that growth comes with several benefits and drawbacks. On the benefits side, we gain economics of scale in our operating costs because many of the fund’s direct operating costs are either fixed or on a declining scale (e.g. custodians will charge 15 basis points or 0.15% for safekeeping if you’re a $10 million fund but this could go to say 3 or 4 basis points for a $300 million fund). Size also helps in negotiating lower fees for things like brokerage and FX fees. Another benefit of scale is that the fund could get access to deals that smaller investors do not get (e.g. Buffett during 2008). A third and indirect benefit is that the manager of a bigger fund has more financial resources to invest in research.
On the other hand, there are drawbacks to size, especially after crossing a certain threshold. The biggest drawback is that size limits the fund’s universe of investment opportunities because of liquidity or regulatory constraints that make it hard to buy a big enough position in a company you like. Many big funds are thus limited to a narrower choice between the biggest listed companies. When the market is cheap those universe constraints do not matter much, but when the market is fairly-valued or expensive, finding new investments can become a challenge for very big funds. Each strategy and market would have different limits here. A longer-term strategy should scale more easily than a short-term trading strategy, holding everything else equal.
Another challenge with size is that some types of strategies require substantial incremental human capital on the firm level to scale up. This is more relevant in illiquid markets such as private equity and real estate, but does come up in public markets in certain cases. This brings to the table the question of whether the portfolio manager and his/her team can handle the additional workload from investing bigger amounts and whether the support functions such as back office, reporting, and investor relations can handle the bigger amounts and bigger number of investors.
Thus, you want your manager to keep growing the fund up to a maximum of either:
(a) The limits of the strategy to scale in the market, or
(b) The ability of their team and support functions to scale.
In today’s world, with the ability to outsource many functions and many things being computerized, usually (a) is the lower limit. For example, we estimate that operationally we would be able to scale up our business by a factor of twenty or thirty in a matter of weeks. The real limit will come from the market.
In summary, there is a “sweet spot” or optimal size in terms of fund size for each investment strategy. For our strategy, we believe that we will experience net benefits from size up to around $1 billion in assets; we will almost certainly hit some limits to our strategy once assets exceed $10 billion; and in between $1 billion and $10 billion it will be a net negative sometimes and a net positive at other times.
Q: Why do you use outside service providers for many functions instead of doing things in-house, and how does that impact our expenses as investors?
Using in-house versus outside service providers has no impact whatsoever on the cost to investors as all these services are paid by the firm and not the fund. My preference for using outside service providers for many functions is driven by two considerations. First, it frees up my time to focus on the more important job of managing the fund as opposed to managing the firm. The second reason is scalability, which is very important for a firm our size where we are doubling in assets every 12-18 month and outsider service providers can handle that rate of growth much better than us trying to recruit and hire a fast-growing support team.
Q: With regard to how you spend your resources, how much time do you spend on communicating with existing investors, marketing to new investors, and managing the Fund?
A: My communication with investors is limited mostly to the quarterly and annual letters. That has two benefits; the first is freeing up my time to focus on managing the fund. The second is that it ensures that all investors have equal access to information because everyone gets the letters at the same time. For the same reasons, I also don’t spend a lot of time marketing the fund to new investors. The downside of my approach is that we would have a much bigger fund if I spent a lot more time on marketing and dealing with investors, but I think that our performance would suffer and that is not a compromise I’m willing to make.
Q: Many managers have hundreds of positions while you hold only 20 to 30. Why is that, and which approach is safer?
If you start with a portfolio with 3 holdings, adding one extra holding brings substantial diversification benefits to the portfolio. However, once you cross 15 or 20 holdings, the incremental diversification benefit from each new holding becomes very small whilst your ability to have deep knowledge of each holding becomes harder. Value investors differ a lot on this issue and there probably isn’t a universal answer that is optimal for everyone, but I really struggle to understand the rationale behind adding your 100th idea to the portfolio. I find that for me as a manager 20-30 holdings with roughly 50-60% in the top ten names is a good number.
First published in Mayar Fund’s Letter to Partners – September 2016 (portions have been redacted)
Subsequent to sending out this report, an investor sent us a question about a recent HSBC report warning of a severe market drop à la October 1987. Here’s my reply.
Thanks for sharing the article. Here’s my view on this report from HSBC and others like it:
– I personally do not think I can predict short term movements, it’s not a skill that I have, and therefore I do not try.
– Instead we focus on buying stocks that will be worth more 5 and 10 years from now. Whether they drop 20% tomorrow, next month, or next year is not important to us. If that happens, we will buy more of them.
– I have yet to meet or read about someone who has actually been able to consistently predict short term movements in the stock market. One issue that makes timing the market difficult is that you have to be right twice; the time you sell and the time you buy again.
– Selling at the wrong time is dangerous. Studies have shown that missing the best 10 days in an average year reduces your annual returns in stocks by 38%! Therefore, for the short-term market timing strategy to work you would have to have been correct 75% of the time. I don’t think anyone can be right 75% of the time and I doubt HSBC can. If they could, I imagine they would not be publishing this research, they would instead keep it to themselves to invest their own money.
– Thus an investor who had started out with $10,000 would have seen their portfolio grow to only $32.7 thousand over 20 years by getting the market timing wrong, instead of growing to $65.6 thousand if they had simply stayed invested in the market.
– The stock market is always volatile, so you need to take a long term (5+ years) view. If you need the money to buy a house next year you should not have that amount in the stock market. If you are in the market for the long run you are better off staying invested in a strategy that you believe in.
– Finally, if the market does drop 20% next week–it is possible–then we have many companies on our wishlist that we are ready and excited to buy if offered at such an opportunity, and that will enable us to generate superior returns in the long run.