Last week we were greeted with writings from two of the best investors and thought-leaders: Howard Marks of Oaktree and Murray Stahl of Horizon Kinetics. The decades of wisdom acquired by both Marks and Stahl now share with us youngens via these readings is a gift we must all take advantage of. I am about to grossly oversimplify the points from both of these greats in order to riff off of it into a point of my own. I give this warning both to preempt any complaints about my simplification, and as a suggestion to do yourself a favor and read what both of these gentlemen have to say before going one sentence further here. If you are kind and/or interest enough to return to this site, once done with those piece, please feel free to do so.
Since I received a link to Marks’ memo first, my evening reading started there and proceeded to Stahl’s piece. This was a fortunate coincidence. Marks lays out the case for the role luck plays in living life and attaining success in financial markets, tracing it to the idea markets are mostly efficient, but for those areas with a “lack of information…and competition.” Meanwhile, Stahl examines what he believes to be one of the single largest sources of market inefficiency today in what he calls “indexation.” After reading both pieces, I couldn’t help but think: “we are lucky to be investors in markets in this era of indexation.” This one thought struck me as the perfect conjunction between the two pieces.
Stahl has used the word “indexation” to explain the phenomenon whereby more assets and managers are investing in indices and ETFs which are designed to “provide portfolio exposure to very specific criteria, such as an asset class, an industry sub-sector, a growth metric, a stock market capitalization band, and so forth.” Over time, Stahl has discovered and invested in several of the inefficiencies resulting from such a phenomenon, including the “owner-operator” whose major stockholder manages the company, spin-offs designed to streamline business operations, etc. I recommend reading Stahl as to why these opportunities arise in today’s market.
Why do I say we are lucky to invest in this era of indexation? Because, as Stahl argues, indexation is an incredible source of market inefficiency. As more and more dollars seek out exposure in the broadest of ways, there is ample opportunity for those of us who seek to “turn over as many rocks as possible” to find the right opportunity. Two of my favorite setups fit this bill, although I never specifically delineated these ideas in writing as an outgrowth of indexation. This is so because both setups existed as long as there have been markets, and are in many respects traceable to behavioral traits of human beings. What has changed is that indexation provides a natural outlet through which these behavioral weaknesses are even more pronounced than in years past. I have named these setups “Guilty by Association” and “I’ve got a Label, but I don’t Subscribe.” While there are similarities between the two, they deserve to be thought about separately.
“Guilty by Association”
When a company is “Guilty by Association” they are treated in the same way as another, more identifiable peer group or index solely by some kind of perceived proximity. These tend to be situations that are more macro in nature, where a broader problem is reflected upon a specific company or sector. Some examples might be helpful.
During the crisis period in Europe, all European stocks were hit with equal force. The market “threw the good out with the bad” so-to-speak. One particular class of opportunities we spent considerable time on (and ultimately made significant investments in) was businesses listed in Europe, with a revenue base that was largely global. In other words, these were companies that traded in Europe, though they did the majority of their business outside of Europe itself. In these situations, there was selling, even from investors not situated in Europe, due to fears about the Eurozone’s viability. Yet, these companies themselves were in a position where if the Euro actually collapsed, they were unlikely to be significantly impacted in a negative way. In other words, they were “Guilty by Association” with the currency in which their shares were priced.
Another example would be the hatred of muni bonds in today’s environment. This entire asset class is hated due to concerns about Detroit’s bankruptcy and Puerto Rico’s solvency woes. Because Detroit and Puerto Rico are municipalities, conventional investment wisdom beholds that municipal bonds in the general sense must therefore be in trouble. This kind of extrapolation is abundant and wrong.
Indexation impacts these areas because people who invest in broad-based ETFs or indices sell their exposure entirely, in order to avoid the perceived fear. In doing so, the selling of the basket forces mechanical selling of all the subsidiary components without consideration for which specific constituents are and are not impacted on a fundamental level by the fear. Thus, the good that gets thrown out with the bad and is “guilty by association.”
“I’ve got a Label, but I don’t Subscribe”
This is the micro twin of “guilty by association.” Since so much money is moving into ETFs, and ETFs are trading with all kinds of sector and niche labels, there is pressure to fit each and every company into some kind of cookie-cutter genre. These labels impact how analysts and investors alike think about specific companies. Stocks get assigned to analysts based on the “sector” they cover, and many investors invest in sectors or companies that are in accordance with a specific mandate. I had been planning a blog post for a while called “Beware of Labels,” but I think all of those points would better fit the context of this post. One of the biggest misnomers in today’s markets is the “technology” label. Mr. Market today dumbs “technology” down to mean: a) any company that is on the Internet; and/or, b) any company that makes hardware.
In my opinion, there simply is no such thing as an Internet company. There are retail companies who operate on the Internet (and at this point is there a single retail company who doesn’t operate on the Internet?), there are B2B companies who use the Internet to offer their services, there are financial platforms who provide web-based platforms. To ascribe the label “Internet” to one company and not another is merely referential of the fact that some companies are old and some companies are new. And even that is an oversimplification, for there are older Internet companies that are still called as much, despite being more analogous to marketing companies. And yet somehow, all these various, wide-ranging businesses end up with the “Technology” label despite the fact that their differences are far more pronounced and abundant than their similarities.
In a perfect world, we would throw away the technology label and call these companies what they are, whether that be media, retail, etc., but this isn’t a perfect world and that creates opportunities for us investors seeking out inefficiencies. Heck the “Telecommunications” sector is somehow a sub-sector of “Technology” and includes a company as old as AT&T (though I am aware AT&T today was actually one of