Just about every investment era has its fad. In the 1960’s it was the Nifty Fifty where market participants believed any price was okay for the major conglomerates. In the 1980’s it was junk bonds, which financed leveraged buyouts and worked until they didn’t, ultimately resulting in the Savings & Loan Crisis. The 1990s were all about technology stocks. 25 year old money managers were trouncing the likes of Warren Buffet due to their exposure to popular tech companies, despite the fact that many of these companies had no revenue or identifiable business model. Like most investment fads do, the Tech Bubble burst and the Nasdaq dropped 75% from peak to trough, while value investing greatly outperformed. In the mid 2000’s everybody and their grandmother was speculating in real estate. I distinctly remember friends with virtually no income getting a mortgage and then taking a home equity line of credit to buy furniture. When I asked why they would think about doing such a thing, I remember my friend telling me that his in-laws assured him his home appreciation would more than make up for the additional debt. Of course we had the Great Recession and the carnage that it brought upon the world, which we still are feeling the effects of today. Between 2009-2012, many people swore off stocks. It was during this time that just about every other commercial was an advertisement for gold coins and commodity products like CTAs. Unfortunately, being in the financial industry my whole life starting in college, I’ve know quite a few of these people that pitch gimmick products at precisely the wrong time. Unsurprisingly gold, MLPs, and CTAs have been very poor performers.
Now it is 2016. Markets are more expensive but certain areas like financial stocks are still regularly in the political and social spotlight as being what ills society. Record amounts of money are flowing to index funds and away from active management. Keep in mind, this would have been a very reasonable course of action during 2009 when stocks were incredibly cheap, but that is no longer the case. Low fees are an attraction without a doubt, but when most of the money coming in is going to the same 500 companies the prices are pushed up irrespective of value. This can last for a while and lead to strong performance as flows of funds are a very important factor in short-term stock performance. A few years of outperformance of any industry, sector, or investment product often leads to strong money flows like sheep moving along with the flock. But then something happens. Some of the major components of the index go down and drag the index with it. Some selling begets more selling and the sheep are now heading the wrong direction. When there is no basis or thought about what is the intrinsic value of what you own, this is an inevitability. I’m not saying ETFs or index funds are bad products although many ETFs have fundamental issues that are problematic such as high-yield fixed income. What I am saying is that by not focusing on value, one is setting themselves up for permanent losses of capital and long-term underperformance. Nobody gets fired for owning Apple. In fact, I’ve gotten fired for not owning Apple when it was at prices higher than it is today. When your strategy and ideas are different, it can create a tension because it is not going along with the consensus.
This is why we are now at a point where I feel our portfolios’ are more undervalued than they have been since 2009 with respect to intrinsic value. It is impossible to justify current prices for our large positions, barring a recession equal to 2008, which is not in the cards. When the shift happens it will have seemed very obvious. Books will be written about the opportunity to buy the best financial companies in the world at steep discounts to tangible book value, despite them having double the liquidity and double the capital. Even better, they are finally in a position to be buying back stock and raising dividends so these distortions are very unlikely to last long, Below is an excerpt from Bill Ackman of Pershing Square’s annual letter. I definitely agree with his assessment and for those of you in index funds or ETFs, I’d encourage you to really think if you know what you own.
Is There an Index Fund Bubble?
We believe that it is axiomatic that while capital flows will drive market values in the short term, valuations will drive market values over the long term. As a result, large and growing inflows to index funds, coupled with their market-cap driven allocation policies, drive index component valuations upwards and reduce their potential long-term rates of return. As the most popular index funds’ constituent companies become overvalued, these funds long-term rates of returns will likely decline, reducing investor appeal and increasing capital outflows. When capital flows reverse, index fund returns will likely decline, reducing investor interest, further increasing capital outflows, and so on. While we would not yet describe the current phenomenon as an index fund bubble, it shares similar characteristics with other market bubbles.
Consider by analogy the period leading up to the technology stock market collapse in early 2000.During that period, Berkshire Hathaway and other leading value investing practitioners’ portfolios dramatically underperformed technology stock managers. This caused investors to withdraw capital from value managers and allocate capital to growth and technology investors until valuations reached bubble proportions. The tech market subsequently collapsed, with value investing dramatically outperforming so-called growth investing in the ensuing years. Last year, a similar phenomenon occurred as Berkshire Hathaway underperformed the S&P 500 index by more than 1,300 basis points despite the benefit of the market support provided from it being one of the index’s largest components.The fact that most of the investments that we have identified in recent years have been found outside of the S&P 500 perhaps is suggestive of the major index components’ relative unattractiveness from a valuation perspective. It also explains why the shareholder bases of these non-index companies is comprised mostly of hedge funds and other active managers who, like Pershing Square, use discount to intrinsic value as a primary investment consideration.