Broyhill Asset Management letter to investors for the month ended August 31, 2015.
“The easy money has been made.” This is a phrase you might hear hanging out among traders after an investment has rebounded sharply from prices which, in hindsight, reflected too much pessimism1. It is not a phrase you are likely to hear very often today as the “easy money” is very hard to find.
Monetary policy has left investors with very uncomfortable choices – accept zero returns on cash or stretch for yield in liquidity-driven and increasingly speculative risk assets. There are no easy choices. There is certainly no easy money. Choose wisely.
Broyhill Asset Management – Divergent
Over time, monetary cycles across the globe have become more synchronized. Central banks now react to similar developments with similar tools in an increasingly connected global economy. However, interest rates can and will diverge from time to time, and when they do, monetary policy demands greater attention as divergences can have a significant impact on relative asset prices.
Today, uneven economic performance around the world has created sharp contrasts in monetary policy. Until recently, the symptoms of divergence have been greatest across interest rates and currency markets where volatility has been most extreme. JPMorgan Chase Chairman and CEO, Jamie Dimon, for example, referred to the intraday swing in the ten-year bond last October as a 7-8 standard deviation event that is “supposed to happen” about once every 3 billion years.
Domestic equity markets, on the other hand, traded in their tightest band for the first half of any year since 1928. The S&P 500 Index had gone almost 1,000 days without a 10% correction3. The absence of volatility had lulled investors into complacency.
Beneath this seemingly calm surface, cracks are appearing in our aging bull market. Momentum is waning. Market breadth is deteriorating. Earnings expectations are falling. Oil prices are collapsing. Uncertainty is increasing around the stability of a certain monetary union. And the effectiveness of government intervention in a certain “mainland” stock market is being called into question. As a result, stocks were largely unchanged through the first half of the year – the worst start to a pre-election year since 1941.
Against this backdrop, investors continue to obsess over the impact tighter monetary policy will have on elevated stock and bond prices4. While it is true that tightening monetary and credit conditions have preceded most bear markets, experience suggests that tops are more often processes than discrete events. It takes time for asset prices to respond to tighter credit conditions. The first hike rarely convinces anyone that the party is over. The chart below illustrates this process. During the last two hiking cycles, it took multiple rate hikes (dashed blue line) over the course of several years for tighter monetary policy to stall the aging bull market in stocks (grey line).
The experience in bond markets has been similar and understandably counterintuitive. During the last cycle, the fed funds rate climbed from 1% in 2004 to 5.25% in 2006. Over that period, the ten-year bond yield barely nudged higher while the thirty-year bond yield actually declined. A rising policy rate is more often coincident with a flattening yield curve. If the past is prologue, a flattening yield curve would, should translate into healthy gains for several closed-end municipal funds in the portfolio today.
Despite ongoing apprehensions permeating high yield credit markets, we see little cause for concern outside of the energy sector. It is important to note that credit spreads have historically behaved similar to equity markets in response to policy changes. As illustrated below, high yield credit spreads (grey line) actually compressed during the Fed’s last hiking cycle (dashed blue line). Counter to conventional wisdom, spreads didn’t widen until the Fed actually began cutting rates.
Corrections are natural and inevitable occurrences within stock and bond market cycles, but the worst sell-offs have typically been associated with recession5. While there are a number of indicators flashing yellow today, we do not yet see the traditional signs of a looming bear market that would warrant a significant reduction in risk. Outside of recession, we believe our current allocation to event-driven, distressed credit represents a compelling value today with the average bond in the portfolio trading near 70 cents on the dollar and a yield approaching 10% – a coupon far greater than the expected returns on offer across broad equity indices.
Broyhill Asset Management – Risk Management & Value Investing
Stocks entered the year overpriced based on any objective, long term measurement. But valuations can stretch a long way before they break. We know major stock indices are very expensive (those arguing to the contrary have a different agenda). We know major stock indices have fallen spectacularly from previous peaks of this magnitude. And we know another bear market is inevitable. We just don’t know when (those that claim they do likely have the same agenda as noted above). We also know that most investors will overact when it does.
Short term market volatility is notoriously difficult to time and most long term investors are better served to ignore it. This has certainly proven to be the correct approach over the last several years as declines have been particularly short and shallow. Nonetheless, we believe an emphasis on capital preservation over capital gains will prove prudent in the seasonally weak period ahead. We are not hiding in the basement with guns and ammo. Instead, we are preparing our shopping list and hope to be buyers of good businesses at lower prices in the future (perhaps sooner than we had initially thought). In the interim, we have taken some precautions.
In the absence of a severe economic contraction, it would be foolish to liquidate risk assets and sit on the sidelines for an unknowable period of time. Risk management is not the same as risk avoidance. Eliminating risk eliminates returns.
Rather, managing risk means working hard not to lose money. Most of the time, this can be accomplished by buying right. Buying right also provides the value-oriented investor with a margin of safety.
Broyhill Asset Management – Consequently, value investing is synonymous with risk management.
Most value investors stop here. Knowing that they have invested with a margin of safety, they choose to remain fully invested at all times, so as to maximize their exposure to the long term growth of the economy which is ultimately reflected in the long term uptrend in stock prices. There is nothing wrong with this approach – so long as investors are willing (and able) to ride out large intermittent drawdowns.
Many of the top minds in the business have generated impressive long term returns doing just this. It is worth noting, however, that their investors’ actual returns are often significantly lower than reported returns.
Since the average investor tends to buy after a good run and sell after a bad run, actual returns to investors in more volatile strategies are often lower than those generated by more conservative approaches. The results are a predictable consequence of human behavior.
At Broyhill, value lies at the heart of our investment process. We construct portfolios piece by piece, conducting rigorous fundamental research on various opportunities, but limiting purchases only to those securities trading at a discount to fair value. Buying right is the single most important determinant of our long term success, but it requires patience and discipline.
Today, stocks and bond prices are greatly distorted and trading at elevated valuations. There is increasing evidence of herding among market participants. Buying right is a much greater challenge in more speculative, liquidity-fueled markets.
Rather than follow the herd, we have allowed dry powder to build in portfolios. This is a natural by-product of our patient and disciplined approach. Holding cash over the past three years has without question resulted in lower returns than what we might have achieved if fully invested. The upside of holding cash is lower volatility. Since inception, our equity strategy has captured two thirds of the market’s gains while only participating in one third of the market’s losses7. The result is a portfolio which has generated acceptable returns with lower risk.
During speculative rallies, our investors should expect very strong absolute returns which may trail broader indices. During bear markets, we demand much stronger relative returns given our focus on capital preservation. When you put the two together, we expect this combination to generate superior long term returns with lower volatility. This is consistent with our long term objectives and consistent with what our clients expect from us. Furthermore, the experience of our average investor is likely to be very similar to our own. This is explicitly by design.
Broyhill Asset Management – Portfolio Strategy: Keep Your Pants On
Losing your shorts in a bear market and bailing at the bottom is not a particularly healthy long term investment approach. Yet this is the script followed by many who commit capital to a fully invested manager who has just had a good run.
The best trailing five year records at this point in the game were likely generated with an equivalent amount of risk by fully invested and unhedged heroes. We doubt the same brave group will come out on top over the next five years. There are no guarantees in this business, but it’s a safe bet to assume that this approach will greatly increase the probability that the next wave down takes your pants and your capital with it.
Keeping our pants on is the cornerstone of our strategy at Broyhill. Like value investing, it sounds simple enough, but is much harder than it looks. Resisting certain urges is key. Perhaps the most difficult is the urge to lower our standards the longer the party goes on. It is natural to take another look at opportunities we quickly passed on earlier. Were we too judgmental? Were we too strict in our definition of quality? Maybe two or three of those other opportunities could provide similar returns while we wait? Those balance sheets really aren’t that bad, are they?
This is the type of thinking that normally precedes losing your pants. We won’t do it. We won’t lower our standards or settle for relative bargains because absolute bargains are more difficult to find. We will keep looking and we will keep learning to deepen our understanding of both our existing investments as well as our pipeline of opportunities while we wait.
Despite inflated valuations, we are still finding a modest stream of new ideas, but have raised the bar in terms of committing capital to new investments. We made no new purchases last quarter (although we did increase a few existing positions on weakness). We performed extensive due diligence on several businesses, leveraging research on existing positions to expand our circle of competence. We passed on two financial companies that lacked an adequate margin of safety and continued our work in the industrial sector where poorly timed energy acquisitions have weighed on otherwise good businesses. One was recently acquired by Berkshire Hathaway before we completed our research – a disappointing result after many hours of research, but perhaps a clue that we were on the right track. The other is still a work in progress.
Maintaining your standards and your pants also requires an ongoing evaluation of existing portfolio holdings to ensure that one’s margin of safety has not dwindled since the initial investment was made. When markets are high and rising, many investments, once shunned by peers, come to be viewed in a more favorable light. Others don’t quite turn out as they seemed. We parted ways with one of each during the quarter. We eliminated our position in Post Holdings, locking in a healthy gain despite nerve-testing volatility. Shares are more fully valued today and the leverage in the business does not leave much margin for error. We hope to have another affair with Mr. Stiritz in the future, but on a cheaper date. Realized gains at Post were more than offset by one large realized mistake in Awilco, which we’ve discussed in prior letters. Clients who wish to learn more are welcome to request our post-mortem on this investment, which reviews our initial thesis and the evolution of our thinking over time. This is a learning exercise we perform on every sale with the intent of avoiding the same mistake twice.
Broyhill Asset Management – Waiting For The Next Shoe
Successful investing requires a heavy emphasis on avoiding mistakes because protecting capital through challenging times is inconsistent with maximizing returns in good times. The key to capitalizing on periods of market turbulence is coming through with your capital and your judgement intact, while most participants are paralyzed by fear and losses (as often happens when one loses his pants). Allowing cash to build in the portfolio as we liquidate holdings, rather than redeploying capital into our “next best” idea, provides us with this peace of mind.
It is impossible to navigate through market disruptions without planning ahead. But planning ahead requires patience which can and will be tested while waiting for the next shoe to drop. At Broyhill, the flexibility to hold cash in the absence of opportunity is a significant advantage in this regard. Our rigorous approach to research which results in concentrated portfolios rather than diversified baskets of mediocrity is another advantage relative to our peers.
These aspects of our process are ongoing and continually refined. They are also complemented by the occasional use of options to hedge a portion of the portfolio or limit capital at risk. We discuss a few approaches below.
Let’s start with the basics since we tend to keep these positions extremely simple for our own benefit. An investor worried about declining stock prices may purchase put options to hedge against a decline below a pre-specified price. If the stock were to decline below that price, the value of the option would increase by the same amount. That being said, we rarely hedge individual positions and rarely buy put options. They are expensive. They represent an ongoing drag on performance. And the timing is particularly difficult to get right. However, at the right price, and under certain conditions, we will consider hedging a portion of our risk through the purchase of index put options.
When equity market volatility is low, and consensus sentiment is high, these options are often priced too cheap. We felt this was the case last summer and allocated a small percentage of the portfolio to index put options prior to October’s “flash” crash. We began adding them back last quarter and increased our position later in the summer as turmoil in Europe and China increased the odds of another shoe dropping. While we have sold a portion of our hedges on last week’s spike in volatility, we intend to maintain a fairly consistent level of protection across portfolios during the seasonally weak period ahead.
Spikes in volatility also provide us with an opportunity to sell or write put options against positions we would like to own at lower prices. If exercised, we will own businesses at prices we want to own them. If not, we will settle for handsome returns on our cash while waiting for lower prices and a wider margin of safety. We did not sell any options during the second quarter, but recent volatility post quarter-end has allowed us to increase our exposure to a couple core holdings.
Both of the strategies discussed above are short term in nature with maturities often ranging from three to six months. Longer duration options can also represent compelling opportunities for value-oriented investors as the option market is very idiosyncratic and Black Scholes is not particularly useful beyond a few months. At quarter-end we held one long term call option on a core position marked at a loss. As we are working to uncover additional mispriced options amidst the current sell-off, we are providing this transparency for investors to better understand our existing holdings and decision-making.
Unlike most option market participants, when analyzing long term options, we always start with the fundamentals of the underlying business and a range of estimates for fair value. At the right price, we will consider buying long term options to increase our position and further leverage our research efforts. Importantly, we do not look at options through the same lens as consensus. We are not short term traders. We are not quants. And we certainly don’t rely on the Greeks. The decision to invest is driven by simple rules: one, set the strike price at the lower end of our estimate of fair value; two, confirm our estimate of fair value in two years is substantially higher than the strike price; and three, limit option purchases to those opportunities which provide at least 10x leverage to the portfolio.
While these positions will always represent a very small percentage of our assets, they may have a disproportionate impact on volatility and returns. Consequently, it is important to recognize that they will be sized accordingly and losses are always limited to how much we have invested. Our goal is to magnify our returns over time while minimizing the amount of capital we put at risk.
Broyhill Asset Management – House Cleaning
“When I write, I feel like an armless, legless man with a crayon in his mouth.”
– Kurt Vonnegut
Writing quarterly letters has a similar impact on my well-being. While I love to write and benefit greatly from the experience and the opportunity for self-reflection, the quarterly deadline weakens this process. I imagine most managers do it because it is expected of them, because it is “standard” practice in the industry, or because they always have. These just aren’t good reasons. We prefer to write when we have something unique to share rather than when the calendar demands. Given our longer term investment horizon, our views and our portfolios just don’t change much quarter to quarter. Consequently, we plan on writing to you semi-annually going forward. We will continue to publish our more in-depth research from time to time and won’t resist the urge to write if we have something to say in between. In the interim, feel free to visit The View From The Blue Ridge if you are suffering from withdrawal.
Finally, please do your best to embarrass Mike Loeb by sending a congratulatory email to [email protected] Mike recently passed Level II of the Chartered Financial Analyst exam, barely making note of it around the office so as not to draw any unnecessary attention. The pass rate this year was 46% – people bleed for this exam. Mike took it to the woodshed. I can assure you that any blood at his desk was from our weekly pre-market boxing sessions and not the CFA. Two down. One to go.