Dear Fellow Shareholders,
Readers of our Shareholder Letter for 2015 will recall that in the first paragraph we made reference to exceedingly low interest rates. We did not imagine the appearance of negative interest rates. As far as we can determine, after consulting Sidney Homer’s classic text The History of Interest Rates, we are now in the lowest interest rate environment in the last 5,000 years.
This is important, since interest rates establish value for all financial assets. Consequently, valuations for many types of financial assets are high. The investment opportunity set is, therefore, unusually narrow. It is for this reason that we carry about $49 million of cash and cash equivalents on our balance sheet. Indeed, viewed on a tangible assets basis, we are largely uninvested, since much of the balance sheet valuation of our Horizon Kinetics LLC assets is necessarily intangible.
Last year, we concluded with a strategic commentary. This year, we will begin with the strategic commentary since our worldview animates many of our actions. Although we maintain such a liquid, uninvested balance sheet at the moment, we actually have more corporate investments than we had last year. The commentary will, therefore, follow a somewhat different format.
FRMO – Strategic Consideration
In order to give the reader a sense of the corporate liquidity currently available, we should go beyond mere balance sheet statistics. FRMO has $100 million of buying power in our investment accounts, if we were fully margined and sold no investments. We have about $10 million of liquid investments in our corporate accounts that could, in principle, be sold.
The Polestar Fund, a fund managed by Horizon Kinetics, is only 46% invested in long security positions. None of this counts securities sold short. Thus, the investment posture is very conservative. This fund has $70 million of buying power in a fully margined position. CDK, a small fund also managed by Horizon Kinetics, has several million dollars of buying power over and above its more than $2 million of cash. We could continue in this manner and calculate a total buying power figure; however, the intent is merely to give the reader a sense that the corporation, both directly and through its various investments, has at its disposal very considerable financial resources to a degree never possessed in the history of the enterprise.
Our view of cash is very different from the consensus view. The consensus view is that since cash, at best, yields nothing, it is important to fully invest so that assets earn at least some return. Our view is that zero interest rates and the global movement toward industrial scale investing, not only in its indexation incarnation, is distorting asset pricing positively and, in some instances, negatively. In the latter instance, opportunities, however few, are being created. We will make reference to some of these in other sections of this letter.
It is, of course, needless to say that we have no ability to forecast the future of interest rates. Essentially, there are two possibilities. The first is that rates will increase towards a more historically normal level. This would dramatically reduce the valuations for most financial assets. Perhaps more importantly, given the amount of debt outstanding, the interest charges could be a heavy burden on the economy. For instance, according to SIFMA (Securities Industry and Financial Markets Association), publicly traded debt alone in the U.S. now exceeds $40 trillion. If private debt such as bank loans were included, the number would be far larger. Yet, even $40 trillion of publicly traded debt implies increased debt service of $1.2 trillion if rates rise by 300 basis points. We can well understand the reluctance of any central banker to raise interest rates.
Hence, one must reckon with the possibility that rates remain low for a very considerable period of time. The theoreticians inform us that most investors will have no other recourse than to make even greater use of risk-based assets. This may well be true; however, a minority may well be attracted to those securities and investments that have been excluded from the movement towards industrial scale investing. As contrarians, our strategy is oriented towards this subset of the investing universe. In the balance of this letter, we will describe our activities in this context.
Horizon Kinetics LLC and the Revenue Share
This year, we group together FRMO’s 4.95% ownership interest and its 4.199% revenue share in Horizon Kinetics LLC, as each are different manifestations of an interest in an investment management company. It is worth noting, since it is almost always forgotten, that an investment manager is a fiduciary. This entails that a manager must place the interests of clients first.
In that light, it may surprise readers to learn that we have been actively discouraging investment in some of our strategies. For example, we currently discourage potential clients from investing in our high yield strategy. Although it may seem bizarre, it is important that shareholders understand our thinking.
To illustrate, say that we purchased 100 different high yield bonds, equally weighted, for a given client. We might, without extraordinary risk, achieve a yield of perhaps 6%. This figure is not far removed from the yield to maturity of commonly utilized high yield bond indexes. Let us further suppose that we were the world’s greatest high yield bond analysts, though we assure the reader that this is not the case. Let us suppose that, while we do occasionally choose a bad investment, that results in loss only 20% of the time and that the average loss in this contingency is 20%. Therefore, the result would be as follows:
80% success rate earning 6.00% = 4.80% in a portfolio context
20% failure rate with a 20% average loss = (4.00)%
Net result = 4.80% + (4.00)% = 0.80%
This calculation makes no allowance for transactional friction nor any allowance for management fees. It should be self-evident that the risk/reward ratio of such an investment is not favorable. Incidentally, high yield losses, when these occur, frequently exceed 20%. That is why one is customarily paid a high yield; however, the available yield is not high at the moment.
It is for this reason that most of our investment strategies at Horizon Kinetics have high cash balances. No one knows the future. We certainly cannot predict the future; however, low interest rates turn the risk/reward ratio against the investor in virtually every asset class. We merely use high yield as an example, because the attributes of this asset class are readily quantifiable.
Readers should also be aware that at the end of calendar 2015, Horizon Kinetics sold its index options business to Neuberger Berman. This had been our fastest growing division and had about $450 million in assets under management. It is an example of the rapidly growing field of liquid alternatives.
The strategy involved selling put options on a weekly basis on indexes like the S&P 500. The two primary determinants of option premiums are volatility and interest rates. A standard measure of volatility, the CBOE Volatility Index (“VIX Index”), stands at 11.55 as of this writing. On June 20, 2014, the