Dear Investors,
2018 has been a very exciting year in the markets thus far for better or for worse. At T&T Capital Management, we have been concerned with equity valuations for the past year. Many stocks in technology and elsewhere have been priced for perfection. This means that if everything works out perfectly, the stocks should still do adequately. However, if the future isn’t as rosy as market participants are predicting, the stocks can fall off of a cliff. Lately concerns such as trade wars, regulatory changes, and a lack of execution have hurt some of the biggest stocks around.
Over the last week, we have seen incredible market swings, with most of them being negative for the market. The S&P and Dow are now down nearly 3% on the year after an amazingly positive start in January. Many of the most popular stocks such as Facebook, Tesla, Boeing, and Caterpillar have been floundering of late. To be clear, these stocks have been fantastic investments for long-term investors, but there are also many market participants that have chased these stocks up through momentum-following strategies that are hurting now.
What is so bizarre about today’s market environment, is that substantially all of the cash inflows have been to “passive” strategies. These strategies are intentionally blind to any analysis of valuation. They take advantage of the true basic premise that most active managers underperform the respective indices. (Fortunately, at TTCM, we have outperformed over our long-term history.) What is less discussed is that this assumes that one is 100% invested in equities, and that it would be appropriate to do so given their unique financial circumstances. It assumes that one will not sell, as that changes the passive strategy into a very active strategy involving market timing, etc.
This fact alone changes the math completely as market participants tend to buy at the highs and sell at the lows, but I don’t believe most people are being intellectually honest about this fact, as it interrupts the marketing machine that has been so successful. The same arguments for passive investing were made in 2000, until the Nasdaq dropped by 75% over the following few years. Any long-only strategy should look good in year nine of a bull market, particularly after a year when stocks performed remarkably, sending valuations to the second highest levels in history! There is a reason we must always say past performance is not necessarily indicative of future results and I think in hindsight it will be obvious that a very big mistake is being made by the masses.
“Any long-only strategy should look good in year nine of a bull market, particularly after a year when stocks performed remarkably, sending valuations to the second highest levels in history!”
Prior to the Great Recession, there was a pervasive belief that buying a house at nearly any price was the right thing to do, because prices nationally had not dropped since WW2. Interest rates were still low, so despite the fact that incomes were rising far slower than home price appreciation, one had to buy, or they might not be able to in the future. I don’t have to tell you the devastation this incomplete logic based on short-term history caused, as most of you lived it along with me. I remember telling family members to hold off on buying their house as it seemed quite clear that we were in a bubble, but my words had no avail.
I see a similar circumstance now with these passive funds. To me it seems impossible for them to generate anything close to the returns that most seem to be expecting over the next 3,5 and 10 years. If interest rates continue to head higher, the math gets even worse and returns could be flat to negative for a decade. Keep in mind that the United States has seen several decades in its history where stocks had flat to negative returns, so this would not be unprecedented by any means.
“Investors are concerned that the tech giants have grown so much and so fast in recent years that they now carry outsize weight. Combined, the five largest U.S. technology and internet companies account for more than 14% of the S&P 500 index’s weighting. Their rapid gains have come alongside heavy inflows into passive funds that track indexes like the S&P 500, leaving millions of investors susceptible to greater downside.”
Warning Sign: Tech Stocks Are Dominating Global Markets Like Never Before
These passive strategies have funneled so much money into the biggest stocks, irrespective of valuation that if you are in a passive equity strategy, it is almost impossible to avoid the damage as they breakdown. As the stocks tank, these so-called long-term investors will likely run for the exits, causing even more selling. It is a huge risk and the upside is very limited given current valuations.
Technology is now a staggering 27% of the S&P 500 and is very expensive based on valuation. Almost always when a sector gets to such a level, it has proved to be a bubble historically. The second biggest sector is financials at around 16%. While they trade more cheaply than the market overall, we’ve reduced our exposure to the big banks’ and have hedged them with covered calls, as they no longer have the high reward and low risk profile that they had over the last few years when we bought them at significant discounts to tangible book value. Some smaller banks that aren’t huge parts on the indices such as Ally Financial are still really attractive, but I think most banks have fairly average prospects moving forward.
I do not like being a pessimist without a plan or a solution and I do believe that our accounts are well prepared to deal with this new reality. Our focus is and has been on special situations that aren’t reliant on a buoyant stock market, or even a great economy to do well. We just need the worst-case scenarios implicit in the valuations to not occur. If this happens, we should make a lot of money. For instance, our bond insurance investments have been dragged down due to their exposure in Puerto Rico, where the news was grim in 2017 due to hurricanes.
From December to now, many of these PR bonds that they insure have doubled in value. That is a very good sign and the economic data has been far better than many had anticipated. My analysis tells me that companies like AGO and Ambac are well reserved to deal with these challenges, and both stocks have a realistic chance to double over the next 3-5 years, even if you saw a flat stock market overall. If we can double our money on some large positions over the next 3-5 years, even while the market does fairly poorly, that would be a huge advantage and that is what we believe to be a very realistic scenario given the strategy we have been implementing. The key requirements are patience and discipline, as investing by definition takes time.
“The key requirements are patience and discipline, as investing by definition takes time.”
Rising interest rates can often be seen as a negative for real estate companies. The reason is that rising rates, generally increase capitalization rates because there is more competition for yield. That can mean buildings are worth less than they were when rates were lower, and it also increases interest costs. While I believe rates are heading higher, I believe that the significant selloff in many real estate companies such as Kennedy-Wilson, CBL, WPG, and SKT have been overdone. These companies all offer very high dividend yields, and the stocks also have the potential to move materially higher if the worst-case scenarios implied by their stock prices don’t play out. In fact, these stocks and our bond insurance companies have held up extremely well during this recent market correction, which I believe is indicative of the trend we will see over the next 3-5 years assuming we get more realistic pricing in the stock market.
In addition to deep value stock selection, we are also employing our alternative strategies such as distressed debt, cash-secured puts, and covered calls. These strategies help in hedging our portfolio and increase our cash flow generation. These strategies hurt us in 2017 when the bubble market rocketed straight up, but they benefit us when markets correct.
“These strategies help in hedging our portfolio and increase our cash flow generation.”
Recently I read a book I thoroughly enjoyed called Skin in the Game by Nassim Nicholas Taleb. He is one of my favorite authors and I’ve learned countless lessons from his writing. In today’s financial industry, I see the lack of skin in the game as being a huge problem for the following reasons that few people will tell you:
- Many financial advisors invest your money in a collection of ETFs and mutual funds for the safety they see in crowds to protect their job security. One doesn’t generally get fired recommending the S&P 500 or a total bond index.
- Many financial advisors have no investment skill or are even willing to make the effort to research investments, instead focusing nearly 100% of their energy on marketing for new clients. They might have a good golf game and conversation, but you are paying for financial advice and acumen.
- Many financial advisors don’t invest their own money in the same way that they recommend for clients because they don’t believe in the actual strategies that they are recommending.
In a bull market, these negative issues get swept under the rug as most people are making money. When markets correct, as they inevitably will, these issues shine brightly:
- That 100% long only strategy has no protection whatsoever, so investors will get creamed in the next bear market, but the advisor will just blame the market and feel comfortable because most of the crowd lost big too.
- The advisor’s job really doesn’t change as it is simply a marketing machine. There is no risk to them because they aren’t really vested in the decision making. As long as they can bring in new clients, they are fine, regardless of the actual performance for the clients that are depending on them to protect and grow their hard-earned capital.
- The advisor didn’t put their own money in the same strategies, so they don’t feel the same pain. I know of multiple Ponzi schemes that advisors unknowingly put their clients’ money into and as hurt as they may be about it, they didn’t put their own money into it. This is usually due to conflicts of interests and sales fees that the advisors get for pitching these products. At TTCM, we are totally independent and don’t sell any 3rd party products whatsoever.
At T&T Capital Management, we have more skin in the game than any other advisory that I am aware of. I invest 100% of my family’s liquid assets into the same securities and strategies that I do for clients. We spend little to no time marketing. Instead I spend nearly all of my time researching. Our business grows through portfolio growth and via referrals. These factors are highly relevant because we feel the same pain you do when we lose money, and we feel the same satisfaction when we make money.
“At T&T Capital Management, we have more skin in the game than any other advisory that I am aware of. I invest 100% of my family’s liquid assets into the same securities and strategies that I do for clients.”
I have serious concerns about the overall market, which I describe to you with no filter. I invest your money with the same focus on protecting and growing your capital that I do for my own money. To me it would be committing financial suicide to simply own index funds at current levels. We don’t want to wait roughly 10 years to get back to even like many had to after 2000 and 2008. I would never do any investment for a client that I wouldn’t do myself and this creed and promise has served us very well since we started T&T Capital Management. I’m very confident that the best times await us even if the environment continues to weaken; my money is where my mouth is.
As always if you have any questions, please don’t hesitate to contact me directly at 805-886-8140!
Sincerely,
Tim Travis