Horizon Kinetics commentary for the second quarter ended June 30, 2016.
Horizon Kinetics 2Q16 Presentation
Horizon Kinetics - Part I: What We Did Early in the Year
Last quarter’s letter reviewed our portfolios’ in-creasing divergence away from ‘the market’ and generic robo-advisor asset allocations:
- the cash reserves that were raised over the prior six months (that is, “active”, strategic cash);
- our index exclusion rule: of large-cap, ‘blue-chip’ stocks at the center of the indexation vortex;
- the initiation of new idiosyncratic (true diversifier) securities less likely to behave like the broad equity market, including positions in:
- a collapsed industry sector that investors had recently fled (AP Moller-Maersk, the world’s largest publicly traded container shipping company);
- an equity asset class that, while it does exist in index form, is excluded from the index flows because it is too illiquid for the needs of industrial scale investing (ergo the 17% NAV discount for the well-regarded Royce Micro-Cap Trust);
One can’t know what the balance of the year will bring. We do know that if the flow of funds into equity ETFs ceases – it has already slowed dramatically versus last year at this time3 – the unsupportable valuations of the largest index-associated companies will begin to impact returns. Why? The marginal buyer of stocks and bonds in the last several years has been the index funds. When the net inflow stops, the marginal buyer (and seller) will, by default, be the active, not the passive, manager. And active managers, who do get to consider valuation in their decisions, do not hold mature businesses with deteriorating balance sheets at 24x earnings – like McDonald’s.
The valuations of companies perceived to be safe yield vehicles simply because they’ve had no downside volatility since their recovery from 2008 lows – traditional blue-chips like Procter & Gamble and ExxonMobil (roughly 3% yields) or traditional yield-based sectors like utilities or REITs (3% and 4%) – are as high as they have ever been relative to revenue and earnings growth (which is nearly nil). That is unsupportable in the long term, which we hope to explain further in a bit.
Since last quarter’s letter, some of our more idiosyncratic investments have added meaningfully to returns and we’ve added more positions that exist entirely outside the operating radius of indexation and institutional analysis. We’ll review some of those and also walk you through one method to locate such securities on your own.
Part II: Some Existing Idiosyncratic Portfolio Holdings
If it has ever been advisable to own idiosyncratic securities – which will rise or fall based on factors specific to each company’s circumstances – as opposed to widely-held stocks that will be priced primarily relative to systematic risks, now is the time. So-called blue-chips like the ‘dividend aristocrats’ and yield stocks like REITs and utilities are trading on their dividend yields, which are exceedingly low. Which is to say that they are trading at exceedingly high valuations.
To be objective, it is possible to consider them fairly valued, if you’re an algorithm or academic using the frame-work of a dividend discount model – meaning that low interest rates justify high stock valuations. At these interest rate extremes, though, that means these companies’ shares have been stripped of most of their individual valuation characteristics and trade as bond substitutes. Therefore, if rates rise by any appreciable degree, the presumed diversification of a bond/stock allocation plan won’t work: they will all fall together. Own a 10-year Treasury or its index fund equivalent, with a 1.35% yield to maturity? It would fall about 18% if interest rates rise to merely 3.5%.
Here’s a better one. The iShares International Treasury Bond ETF (IGOV) has only a 0.26% yield to maturity. That’s exceeded by its 0.35% expense ratio. Its weighted average time to maturity is 9.9 years. Unfortunately, at ultra-low interest rates, bonds possess incredible convexity characteristics. The fund’s performance this year through July 7th is 12.0%. Imagine: It is up 12% with only a 26 basis point yield to maturity. That is incredible. Think of that degree of price volatility in the reverse. If rates were to suddenly be 3.5%, this fund could lose over a quarter of its value. What would the reaction be in the utility and REIT yield equities?
As recently as May, George Soros and Stanley Druckenmiller, two of the more notable public-market-investing billionaires, had either sharply reduced or entirely sold their equity holdings, while making significant in-vestments in gold. They did that through bullion, gold miner shares, or options. Jeff Gundlach, the famed bond fund manager, recently called the term “low-volatility equities” an oxymoron, and likened trying to in-vest that way to a game called “Dyna-mite Shack.” He now owns gold miner stocks. For most investors, though, the allure of gold as a hedge against inflation or financial market panics has failed them over time.
And time is one of the problems, since owning the metal directly entails opportunity cost – the years that can pass while the capital invested in the metal earns nothing. The business risks of mining companies are another problem. Review the data, and it turns out that gold mining stocks are a pretty poor inflation hedge: the increased demand for gold, when inflation rises, also increases competition and prices for workers and equipment; capital expenditures rise dramatically – those added expenses negate much of the expected profit. Then there is the problem of the supply surge of the metal once operations expand, which can depress the metal price.
We bought exposure to precious metals some time ago, but by-passed these problems via the precious metals royalty companies, like Silver Wheaton, Royal Gold and Sandstorm Gold. Since they merely buy royalties or future production, at deeply dis-counted prices (allowing miners to expand without resorting to debt or dilutive share issuance), they have very little in the way of operating costs. Silver Wheaton, for example, needing no equipment, workers or property, and despite its $10 billion stock market value, has all of 35 employees, 12 in the Cayman Islands (where the natural resources are listed as fish and beaches for tourism, not gold). When precious metals prices rise, the royalty companies obviously earn more revenues on their contracts, but without an increase in operating costs. More importantly, when prices fall, they might earn less, but the key fact is that they continue to earn money, unlike bullion or miners, and at very high returns on capital. In the past three months, largely on concern about Britain’s withdrawal from the EU, the shares of these companies rose quite sharply.
DreamWorks Animation, which has been held for years, rose about 60% in late April, when it announced its sale to Comcast. Having long been miscast as a higher-P/E stock, it always traded on the success or disappointment of its most recent film. Largely ignored was the value of the constantly expanding DreamWorks library. That library, which can reissue content at minimal cost for generations, was at times worth nearly the entire market value of the company, separate from the earnings of its current film releases. With a market capitalization of only about $2 billion