A must see discussion of today’s index investing distortions

http://horizonkinetics.com/market-commentary/4th-quarter-2016-commentary/What will turn the tide for active investors. Or read commentary below:

What We Do When We Come to the Office

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?

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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.

Grant’s Conference Presentation


Q2 2016 Commentary FINAL (See section on ETFs vs. Individual Stocks)

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