Horizon Kinetics letter for the fourth quarter ended December 31, 2016.
Sometimes due diligence teams from other investment firms for which we manage client funds come to our offices. There are the audit types of questions about internal controls, and trade and execution protocols. To these, there is, properly, only one of two answers, yes or no. Do you time stamp each trade, maintain a permanent accessible trade record, or observe a randomization protocol for the order in which purchases are allocated to client accounts?
Then there are the questions closer to what they really want to know. How do we select securities; what is our process? Now, their process in trying to elicit our process is still based on the checklist approach. What market capitalization range defines a given strategy; what valuation parameters qualify a buy, hold, or sell; if it is earnings-multiple based, what is the average weighted P/E of the portfolio; what is the maximum weighting of a position; what is the maximum cash position; what precisely determines the maximum cash weight; what maximum time limit to invest a new portfolio; what is the minimum number of positions; what is the maximum number of trading days to exit any position? They want to confirm that the process is defined, consistent, repeatable – in a sense, a scientific methodology reducible to a spreadsheet that is an efficient tool for comparing to other managers in the present, and comparing to the same manager over time. This is just the warm?up.
There are the broader questions about how the philosophy is implemented in a consistent quantitative fashion. An appropriate form of answer might be: we employ a searchable database of the 1,000 largest companies in the U.S.; we screen them on such and such parameters, such as a minimum market cap of $1 billion, a minimum 5? year dividend growth rate of X%, a maximum P/E of Y, maximum debt?to?equity ratio of Z. We then end up with 200 candidates to which we then apply further screens to arrive at our priority list of 100, and so on. And we apply that consistently, so that whatever the market conditions, we don’t stray from our process and we always select the top 10 percentile of companies from that universe of 1,000. They want to make sure a manager who buys smaller companies one year doesn’t buy larger companies the next. If a manager hasn’t held cyclical companies in the past, it would be a methodological danger signal to buy cyclical companies in the future, because that is not a documentable or repeatable process. Do that and you’re on the watch list, if not dismissed outright.
And while this is the approach that, obviously, indexation epitomizes with perfection, it is also the rule amongst active managers who practice particular strategies. They come into the office and work hard to be consistent to their methodology. Even as the market changes. If high quality stocks become more expensive, it is important to continue to own the best of them. They know what they’re going to do every day. We don’t. We don’t know what we’re going to do, because we do not struggle against the market. We accept the market. Or, rather, we take what the market gives us, not what it doesn’t.
Once upon a time, Horizon Kinetics wasn’t known at all. We had no due diligence teams visiting us. And there came a time, 1999 or so, when the market became enamored of technology and internet and unregulated utility stocks. They went up and up and up. That didn’t give us anything but risk. So we continued to hold what the market had given us a few years earlier: really high quality blue?chip companies that were extremely profitable, like big drug companies and American Express and AIG. Each, in their turn, had disappointed and become cheap. And as the internet stocks went up, these bluechips went nowhere and then, as the internet stocks went up some more, nowhere again. And then as the bubble began to collapse, the flight to quality made those hapless blue chips we held soar, and they became their own bubble, at 30x earnings. So we gave them back to the market. Which meant we raised a lot of cash, And we kept that cash, because the market didn’t give us anything else that we wanted. Some more time passed, and by early 2003, when the dust of the internet bubble settled, there were the most extraordinary gifts lying there, discarded by the market: bonds of certain distressed/recovering utilities and other corporate victims of that party, trading at 50¢ on the dollar, even 20¢. We took it. Then Horizon Kinetics became just a bit better known.
If there had been any due diligence teams evaluating us at that time, each of those actions violated any acceptable process that would have been documented. First, with our high quality value names, we underperformed our peers who dipped a toe or two in the frothy waters of the bubble sectors; then we changed our asset allocation, never before having had anything like plenty of cash; then we violated our asset class category by purchasing fixed income securities in equity accounts. We wouldn’t have been allowed to do any of it. Nevertheless, in the aftermath, we now had due diligence teams visiting us, because we didn’t collapse during the bubble; in fact, we had positive returns.
So, we don’t know what to do or buy when we come into the office – we can only take what the market gives us. The scientific method applied to the securities markets is a dangerously fallacious approach. It presumes a linear type of repeatability; whereas, the marketplace is fluid, reflecting the endless capacity of humans to interact and respond. Any fixed rule or process is reacted to and gamed and, ultimately, doomed. You don’t fight that, you use it. To express it visually, here’s a warm?up exercise – a kid’s puzzle, really – having to do with adaptive versus categorical thinking. It’s the picture on the right. What is this a picture of?
That was the warm?up. Here, below, is the one we’re interested in. What’s this?
This is a road painted by a sober painter according to the engineer’s blueprints, but paved by a drunken paver. You can be sober and precise and process consistent, and it can work for quite a while. But the road, the market, eventually turns, and a straight line will take you right off the road.
The next couple of sections are simply to confirm that the market as people generally understand it probably isn’t giving you much anymore, at least not sustainably. It’s important to realize that, because once you do, you can figure out when and how to take what the market is offering or will offer.
Horizon Kinetics – Part I: The Departure Point
This past year was interesting on so many more fronts than 2015. And this coming year could be more interesting still. In 2016, the financial markets saw all sorts of records and precedents – and not in a good way.
- Record low