Kinetics Mutual Funds conference call transcript for the third quarter ended September 30, 2016.
Also see 2016 Hedge Fund Letters
Chris Bell: Hello, everyone, and welcome to today’s call. I’d like to remind everyone that all of our presentations and mutual fund factsheets are available on www.kineticsfunds.com, and you can also see samples of our research and white papers at www.horizonkinetics.com.
It’s always nice to have a quarterly call when performance is strong. Year-to-date through September 30, 2016, our flagship Paradigm Fund (no-load shares) has returned 13.19%, compared to 7.84% for the S&P 500 Index, while the Small Cap Opportunities Fund (no-load shares) has returned 14.74%, compared to 11.46% for the Russell 2000 Index.
Kinetics Mutual Funds
The Paradigm Fund (No-Load Class) has outperformed the S&P 500 thirteen times over the last seventeen years, underperforming in 2008, 2011, 2014, and 2015. While our one-, three-, and five-year performance numbers don’t look very good, our numbers since inception are approximately 400 basis points above the S&P 500 (by clicking on the website list above, you can access the standardized performance figures for each fund). In the last few years, we haven’t owned REITs or utilities, because we believed they were pricey, and we didn’t own any of the bank stocks or pharmaceutical stocks in the Paradigm or the Small Cap Opportunities portfolios.
I’d like to turn it over to Peter, who has some market comments. Peter is a founder of Horizon Kinetics and Kinetics Funds, and President of the Kinetics Funds. Peter, please take it away.
Peter Doyle: Thank you, Chris, and good morning to everyone. Chris gets a little bit more excited about recent performance than I do. James and I tend to look at what we hold and how the business operations are going for those companies, rather than at short-term stock returns. So, I’m going to repeat what I’ve probably said 50 times in the past on these calls.
Our success or failure as investors is going to be predicated on the business operations of the companies that we own. With the passage of time, and in efficient markets, we believe that, if we own companies that have high returns on capital, and we have bought those companies at similar valuations or more attractive valuations than the overall market, it logically follows that we will outperform by that margin. That’s really what has happened since inception, with the exception of those four years of underperformance (in 2008, 2011, 2014, and 2015) mentioned above.
In fact, even in the years where we underperformed, the underlying businesses that we owned were actually performing better (with respect to business results) than the broader markets. It’s just that the stock prices weren’t keeping pace with the underlying businesses:—they got behind. We tend to ignore that, and we tend to have the fortitude and the patience to let that play out for us. That’s been our philosophy from Day One, and it will be our philosophy going forward.
The reason, we believe that our funds, going forward, are likely to get back to their historical outperformance—I can’t guarantee it, but I believe that it will play out this way for us—is that we’ve had, really going back now four or five decades, a trend of lower corporate taxes. You’ve had global markets that opened for companies to exploit. You’ve had tremendous fiscal stimulus, and you’ve had monetary stimulus, particularly in the last seven or eight years, where you’ve had central banks that have increased the size of their debt by $16 trillion.
All of those things have benefited global stocks and large-cap multinational companies to a great degree. It’s hard to envision how that’s going to be replicated in the future. As a result, we think the return characteristics of those large multinational companies, where the bulk of people have their money invested in equities, are going to be far lower than what they have been historically.
We’re doing the mirror opposite of that. We’re off the beaten path. We own esoteric, eclectic type names. And we think that’s the way to get returns going forward. It’s starting to play out in our funds, at least for this current calendar quarter. But we think it’s going to play out well into the future.
It’s clear to us that the global markets are betting on interest rates, and taking risk on or risk off. And now you have the Bank of Japan, the European Central Bank, where they have over $15 trillion of negative sovereign debt—that obviously has an effect on the pricing of assets. The market environment is pushing people into riskier assets, and people are looking at high yielding equities, companies like McDonald’s or Procter & Gamble, as fixed income substitutes. Those stocks are being priced accordingly, based on the low interest rates and the alternatives that they can get in other fixed income investments. We think that’s a very dangerous game. James is going to elaborate on what could happen just by minor shifts: either a rise in interest rates or a change in some other variable within the model that he’s looking at.
The funds have been very defensive this year. We’re still carrying a fairly large amount of cash in most of the funds, despite our outperformance. The reason for that is the opportunity set is not really that attractive. We’re just waiting for opportunities to arise. That’s essentially how we’ve positioned our funds across the board.
With that, I will let James step in here to discuss what could happen if interest rates were to rise slightly, and to talk about some of the individual names.
James Davolos: Thanks, Peter. Just to reiterate something that Peter mentioned: our success or failure is going to be predicated on the operations of the businesses, in conjunction with the price that we pay for those businesses. Unfortunately, the price element of these companies has not been very accommodative. We think that an immense portion of that is related to interest rates being low, and remaining low.
I don’t think that it’s an overstatement to say that risk-bearing assets worldwide are almost universally, and in a very highly correlated way, going short interest rates. And by “short interest rates,” I mean that a lot of investments and a lot of valuations are predicated on the continuation of low rates, or even lower rates than are currently in the marketplace. That’s not a risk to which we want to expose our portfolios. We want to have a highly idiosyncratic portfolio that isn’t necessarily embracing this same element of risk as the broader markets.
Before I go into our portfolios and a specific name or two, and how these are so idiosyncratic, and why we believe that they aren’t as sensitive to the global economy as a lot of the indices are, I’ll talk about a name that we’ve liked to pick on for a while now: McDonald’s. It’s a good company: it’s a franchise model, generates a lot of cash flow. But, again, you need to look at every business within the context of share price relative to the earnings power of the business. I think this is really going to illustrate how profound of a risk