On behalf of our Chief Investment Officer Tim Travis…
Successful long-term investing often means finding a route quite different from the path of least resistance that the investing “herd” takes. Wall Street and financial charlatans play on storylines, which can be sold to scared or perhaps naïve investors. For instance, there was a tremendous volume of sales into expensive annuities (often 6-8% upfront commissions) in the period from 2009-2011, despite that being one of the best times to be investing in cheap stocks in the last 50 years. Investors that piled into annuities have endured a very significant opportunity cost through missing this 5-year bull market. For those of you that have been following my writing since that period, you might remember me recommending against those investments and the salesmen pitching them that were preying on scared market participants. During the same time frame, I recall seeing commercials for gold coins on at all times of the day. Once again, these are hugely cost-inefficient products that took advantage of the decade long rally in gold prices, but investors that got in after the rally had already occurred, have seen truly dismal returns. Once again, we presented a very negative view on gold prices that eventually proved to be quite prescient. I’m not saying that annuities and gold are never good investments, but when interest rates are near all-time lows and stocks are dirt cheap, annuities don’t make sense. Similarly, when fear is at extremely high levels and after 10 years of rallying prices, gold made no sense, let alone gold coins with incredible expenses generally associated with purchasing them.
Because many retail and institutional investors have been overly cautious in the aftermath of the Financial Crisis, we have witnessed a surge of money piling into equity funds despite market valuations being quite expensive. This completely goes against Warren Buffett’s message of “being fearful when others are greedy, and being greedy when others are fearful.” Logically, if stocks were deemed to be too risky for investors in 2009 when valuations were some of the cheapest in history, why would they be appropriate at this stage in the game when future returns will inevitably be much worse moving forward because of the higher valuations that are now prevalent? For evidence of the risks inherent in today’s market valuations, one need look no further than the cyclically adjusted price-earnings (CAPE) ratio. This metric is at 25.4 currently versus an average of 15.4 going back to the late 19th century. There have only been 3 periods where the ratio has been higher, which happened to be in 1929, 1999 and 2007. These years of course occurred before very strong bear markets.
Most investors that I speak with are very aware that markets are far more expensive than they have been in recent years, but the recent memory of positive returns has them willing to take enhanced risks. Once again, many financial advisors are preying on that by recommending things like index funds, which expose the investor to virtually the entire stock market. These might not be nearly as costly as investments in annuities or gold coins, but they also require very little effort and skill to manage, allowing these advisors to focus solely on bringing on new clients. Because many of the market participants that are piling into them are the same people that weren’t invested in stocks for the majority of the 5-year bull market, it is very likely that these market participants will not have the temperament to maintain a long-term investment discipline when the broad markets eventually pullback. Therefore, the herd is once again buying high and will likely sell low.
The pitch for index funds is that most managed funds underperform the indices over the long-term and have higher fees. These facts are undeniably true, but they are not true in relation to investors that follow a deep value investing strategy like that employed by T&T Capital Management (TTCM). Most of the great long-term investment track records from the likes of Warren Buffett, Bruce Berkowitz and Seth Klarman are practitioners of value investing; they actually were the model in which T&T Capital Management’s strategies were devised from. This article is not meant to scare investors away from all stocks, but investors should be scared of the overall market and/or index funds at current prices. Our portfolios are invested in concentrated positions in deeply undervalued securities. Most of our stock purchases are companies trading at large discounts to both book and intrinsic value. Considering that the current price to book value of the S&P 500 is 2.78, this is a huge statement and is a key reason as to why I believe that we will post strong results over the next 3,5 and 10 years despite my belief that the general stock and bond markets will not perform very well.
In addition, we utilize strategies such as selling cash-secured puts on stocks that we would love to own at cheaper prices, which provide a much lower risk proposition than just owning stocks outright. Often these cash-secured put investments provide us with a 10-25% cushion before we would begin taking losses, assuming we hold the options till expiration, and our worst case scenario is owning stocks that we want to own at cheaper prices.
Today’s market reminds me very much of the period between 1998 and 2000. Stocks in general were expensive, with various pockets such as the Nasdaq being outrageously priced. When the bubble collapsed in 2000, the Nasdaq proceeded to drop 75% over the next few years from peak to trough. Despite those headwinds, those value investors that I mentioned before posted stellar results through investing in the areas of the market that were deeply undervalued. While the market is not as expensive as it was then, we also have a far worse global economic situation then we had then, with much less slack to cut interest rates to bolster economic growth if need be.
In summary, now is not the time to pile into index funds. When stocks are dirt cheap, index funds are not terrible options. The below article references a quote by Warren Buffett in his latest annual report, which seemingly recommends index funds for many investors. What it doesn’t reference is that fact that from all available sources of knowledge, Buffett himself has never invested in index funds despite managing tens of billions of dollars. If your choices are index funds or bad managers and highly expensive products like gold coins and annuities, the choice is obvious, go with index funds. Still, you would want to be very cautious in terms of the price of the overall market, especially if your history shows that you are not willing to patiently endure significant market downturns. I believe that right now is a great time to make money, but the way to do it is by ignoring the crowd and investing in the most hated areas of the market, such as financials and selective emerging markets. I also believe it is intelligent to take advantage of unique strategies such as selling cash-secured puts, which can help investors whether enhanced volatility and manufacture cheaper entry prices into stocks. If you need any assistance, such as a free portfolio review or if you’d like to make some adjustments to a long-only portfolio, please don’t hesitate to contact me directly at 949-630-0263.
Thank you very much!