Value Investing

Thornburg Value On The “Coin Flippers” Of Graham & Doddsville

Thornburg Value Fund Q4 2014 letter to investors

Two quarters ago, we wrote about how boring a time it was in U.S. equity markets. Last quarter, things grew a little more interesting. In the most recent quarter, markets turned much more exciting – and volatile.

Crude prices continued their decline from $98 earlier in the year to $54 late in the quarter. Foreign exchange markets suffered tremendous volatility, with the dollar strengthening against almost every major global currency. Russia suffered dire geopolitical consequences for its intervention in Ukraine, and was quickly hit with a plummeting ruble – a reflection of that economy’s overdependence upon oil-export revenues and thus crude prices. Combine all this with mixed messages from the Fed about the rate at which it will remove monetary stimulus. The recent October market bottom, for example, seems to have coincided with unexpected comments from St. Louis Fed President James Bullard on delaying the end of quantitative easing.

No wonder the quarter was volatile.

Thornburg Value Fund: Performance for the quarter

The Thornburg Value Fund rose 4.28% (for the A shares without sales charge), modestly trailing the benchmark S&P 500 Index’s return of 4.93%. For the year, the fund rose 11.50% (A shares without sales charge), versus the index’s 13.69% climb.

We remain excited about our overall progress since mid-2012, when we began to bolster the consistent earning characteristics of the portfolio. Since the end of June 2012 we’ve annualized at 23.92% versus the S&P 500 at 20.49% with improved risk and downside capture characteristics.

That said, the lag in performance for the quarter and the year brings us to a debate that rages periodically within the investment world: the merits of active versus passive management styles. Active managers, such as Thornburg, favor individual stock picking and tend to care little about emulating performance benchmarks. Passive “management” is essentially investing in the benchmark itself (or some proxy thereof). After we touch on the active/passive debate, we’ll look at performance drivers for the fund.

Thornburg Value Fund: Time for a turn? Active management takes a beating

On the first Monday back following the New Year’s holiday, the Wall Street Journal seemed to say to active portfolio managers, “I hope you had a nice holiday because your industry is dying!” After noting Vanguard Group’s massive inflows during 2014, the article observed: “Through Dec. 29, about 74% of active stock funds in the U.S. were underperforming their category benchmarks, according to Morningstar.”

The last several years have been quite tough for active managers, not just 2014. No wonder passive styles have been garnering huge flows of investor dollars and the financial press are reading the last rites over individual stock pickers.

This debate is not new. Thirty years ago, Warren Buffett gave a speech at Columbia University focused on what he called “The Superinvestors of Graham-and-Doddsville.” He was responding to the preponderance of academics who, at the time, were certain that their efficient market hypothesis (EMH) was correct and that all information that is knowable about publicly traded securities is always reflected in their prices. The EMH leaves little room for active managers to outperform over time in aggregate and suggests that those who have are simply lucky coin flippers. Buffett steered attention towards “an extraordinary concentration of success” in this purported coin-tossing contest made up of a group of pre-identified investors that came from a common “intellectual village,” in this case, disciples of Ben Graham. There seem to be too many successful investors in this village for it all to be just chance, Buffett argued.

A quick caveat: keep in mind that we are active managers whose livelihood depends on our ability to outperform over time. We would ask you to focus on two further intellectual villages. First, high active-share managers. Those managers who run diversified portfolios with high active share, or difference from their index, have, on average, outperformed over time, according to “Active Share and Mutual Fund Performance,” by Antti Pettajisto.1 There aren’t many of us left that don’t “closet benchmark,” but those of us that remain have shown a much higher rate of outperformance, net of fees, relative to our benchmarks.

Finally, take a look at one even smaller “intellectual village,” this one even corresponding with a particular geography: Santa Fe, New Mexico, of all places. All seven of the equity funds launched by Thornburg Investment Management, beginning with the Thornburg Value Fund in early October 1995, have performed competitively compared to their respective benchmarks, net of fees, since inception.

Either we are a group of incredibly talented coin flippers, or there is something to our philosophy and approach, our culture, and our location, that has allowed each strategy to prevail over the long term in a contest that some believe is impossible.

We haven’t outperformed every year in every strategy. And high-active-share managers can provide return streams that are lumpy at times relative to their benchmarks. But our philosophy and approach to active management has worked in the long run.

Further, we have attempted to position the portfolio today so that it performs better in a difficult equity environment. It will be interesting to follow whether active managers broadly can provide more protection when we get the inevitable downturn in U.S. equities.

With regard to fund flows, the move from active to passive may continue for some time. This could further impact relative performance of securities in the markets in which we invest. But, the worm has turned in the past, and active managers have often started to outperform just as the multitudes of articles declaring their death reached their peak.

Following this period of significant flows into passive strategies, we like our odds. Back to Buffett: “In any sort of a contest – financial, mental or physical – it’s an enormous advantage to have opponents who have been taught it’s useless to even try.”2

Thornburg Value Fund: The best house in a bad neighborhood

U.S. large-cap active managers have more exposure, on average, to mid- and small-cap companies than does the S&P 500 Index. Large-cap performance walloped small-cap performance in 2014. But interestingly, if we think critically about the current economic environment, the United States looks very good right now, relative to everywhere else in the world. Europe is a mess. Russia is a mess. Emerging markets are weak. China may suffer a severe downturn. Relatively speaking, the United States seems in great shape.

Which U.S. companies have the most business exposure to the United States? Small and mid-cap firms. Which U.S. companies have the most exposure to markets outside the United States? The large-cap multinationals. So, what’s going on? We think the rush of flows into passive index funds in the United States has pushed up valuations of many large-caps.

In the Value Fund, we are finding compelling value in mid- and small-cap stocks in the United States. We’re being mindful about how much exposure we carry to them, but over the course of the year, we’ve grown our exposure to small and mid-caps somewhat. In an environment in which the U.S. economic backdrop looks much better than anywhere else in the world, we’ve increased our exposure to firms that do more business here. Granted, this exposure dragged on our relative performance in 2014.

Thornburg Value Fund: Delving into performance

For the quarter, the