Steven Romick letter for the month of May 2017, titled, Two Decades Of Winning By Not Losing.
To some of you, all Americans are exactly alike. I may as well be President Trump. Like him, you have no idea what I’m about to say.
Well, check that: it often seems he has no idea what he’s about to say, and that’s a major source of uncertainty in all of our lives, both personally and professionally… that can create an insecurity on which much of the business media preys.
The business media, like President Trump, looks for winners and losers…. They’ll highlight the stocks du jour that are either performing really well, and then, in the next breath, show a graphic of those that tanked. Stocks go up…. Stocks go down…. Sectors do well, sectors do poorly. It’s entertainment. Ultimately, I don’t find it very valuable. It’s no more than tabloid reporting. It’s their version of who is sleeping with whom and who has fallen off the wagon. Short-term market price movement does not tell us anything about long-term value.
At any given moment, the media highlights whichever few stocks are driving the stock market. In the U.S. in 2015, it was the FANG stocks – Facebook, Apple, Netflix, and Google.
In the UK in 2016, it was just three rebounding commodity companies and one financial that accounted for more than three-quarters of the FTSE’s 14.4% return.1
For as long as I’ve been investing, it has generally been the case that just a few stocks drive these indices; and that these few stocks pull the lesser performing stocks along with them. The investing community has come to define this law of financial physics as “positive skew.”
“Positive skew” now joins “active share” in that lexicon.
Passive management advocates don’t use this phrase to praise the active manager, but rather to poke at us.
What the passive manager would have you believe is that, thanks to exorbitant fees, to transaction costs, and to not picking winners, it's always better to index. I’ve read that maybe just 10% of the managers can outperform the market over time, and the odds that you will find that manager: even lower still.
Armed with some selective data, some critics of our approach say that that it is unlikely an active manager will consistently own those few stocks that drive stock returns in any given year, let alone year in and year out. Let me read you an excerpt from an essay in the Financial Analysts Journal:
“Disagreeable data are streaming out of the computers of…the... performance measurement firms. Over and over and over again, these facts and figures inform us that investment managers are failing to perform.”
Charles Ellis wrote this more than 40 years ago.
So these arguments have been around a long time. But I am not here to tell you that there isn’t truth to Mr. Ellis’ 1975 essay, which he called: “The Loser’s Game.”
Fundamentally, passive investment is always going to look great during a long-lasting bull market.
If someone wants market rates of return and can withstand some volatility, then it can also serve as an efficient, low-cost tool. The further you get away from a bear market, the greater the number of people who have convinced themselves they can handle the downside – until the next time, of course.
In the interim, if the indices are performing well, then you can bet that many investors – individuals and professionals, alike – are going to feel pressure to do whatever they can to ride the bull.
They fear being different. Tracking error is bad. Owning too many securities in every sector is a sure way to avoid being fired for being different. I’d rather spend my time surfing than to have to invest like that.
Thanks to the accelerated increase of passive investing – now around 40% of the U.S. market – I’m confident that there will be a period when it will look really easy to beat a benchmark – followed by another time when, again, it won’t.
This academic argument against active investment is fundamentally flawed because it’s built on a false premise, which holds that only the best performing stocks will drive returns. The argument doesn’t consider the other side…. A maxim I’ve taken to heart….
If you avoid the worst performing stocks, you can still put up good numbers. (I’ll leave it to you to conclude if I’m just talking my book.)
Further, these critics place too much weight on performance in each year… and ignore performance over a full-market cycle.2 This leads to short-termism. And short-termism is a breeding ground for all sorts of cognitive dissonance to which smart people fall prey when trying to adapt and join the crowd.
People viewed the internet as a fast-growing disruptive game changer in the late 1990s. And so it was, but as you know, internet stocks of that era were largely priced at wholly illogical levels.
Yet, many smart people couldn’t handle not participating. Maybe they were worried about not making as much as their friends. Or maybe they were worried about being fired. Whatever the reason, if they participated they generally lost badly.
In 2008, we sat on the precipice of a depression and many investors quickly liquidated their stocks and bonds, believing the economy would get worse, and stocks would continue to decline. It appeared correct to do so… for a time.
Some of those who exited the market realized their mistakes and came back to the market… down the road… after the economy found firmer footing… but also after prices had already rebounded.
Patience, a long-term focus, and avoiding the fads are key for successful investing. Some of the most successful stock investors of the last few decades in the United States aren’t known for finding the latest and greatest.
I give you as just a few examples: Warren Buffett, Seth Klarman, Jean-Marie Eveillard, and my former partner of two decades, Bob Rodriguez. Each compiled a long track record respected by investors of all types.
Each had their share of winners, but none created their enviable performance by owning those few golden stocks of a given year. They won by not striking out, rather than by hitting grand slams. In other words, they won by not losing – emblematic of our approach.
We allow ourselves the opportunity to participate on the upside… while protecting ourselves on the downside…. And we focus, more centrally, on fundamental research on companies that can create value over time.
I’d like to show you from my own experience in managing money over the last few decades, that some of the best investment decisions in my career have been acts of omission – avoiding those securities, industry sectors, and asset classes that we believed offered a poor risk versus reward.
FPA’s Crescent Fund (“the Fund”) operates with a global, go-anywhere mandate and invests across the capital structure, using mostly stocks and corporate bonds to seek equity rates of return, while, at the same time, avoiding a permanent impairment of capital.
Let’s look at just the stock returns of our FPA Crescent Fund3 in this past decade (gross of fees). You can see there were times we underperformed. When compared to the global indices, we underperformed in just one year of the past ten. When compared to the U.S. market, we underperformed in three. Our worst relative showing was just -2.4% vs the S&P 500 in 2015. Our average underperformance of these four years was just -1%.
There were five instances where our equity holdings outperformed the global indices by more than 5%; and, there were four instances where we outperformed the U.S. market by the same percent. The average alpha delivered in the years when we bettered our benchmarks was 6-7%.
This has aggregated into some poor periods when the bulls were a runnin’. Our fund has underperformed about 87% of the time when the S&P 500 has booked a trailing five-year return in excess of 10%.
However, we beat the market in 100% of the trailing five-year periods when the market declined; and, almost 98% of the time when the trailing five-year returns fell in the 0-10% range. In addition, unlike the S&P 500, FPA Crescent has had positive performance in every rolling five-year period. We exceeded our goal of doing as well as the market mostly by avoiding permanent impairments of capital. This is in line with how we expect the Fund to perform.
Our way of investing gets little play from the broad business press. That’s a blessing, not a complaint. The reasons for this are that there are very few like us in the public arena who practice value investing without arbitrary capital structure, asset class, or geographic borders.
Frankly, in this age of Instagram and Snapchat… when immediate gratification seems to rule our lives, few portfolio managers have the patience to remain disciplined through their inevitable difficult periods, and even fewer clients are willing to stay with their underperforming managers.
Thanks to poor relative performance in the late 1990s, and lacking Berkshire Hathaway’s permanent capital, or the long lock-up capital of Mr. Klarman’s Baupost Group, from 1997-2000 First Pacific Advisors (FPA) and Monsieur Eveillard’s firm First Eagle saw assets under management drop by more than 50%. Now, both firms received a lot of flak at the time. But we argued that we were taking the prudent approach in protecting our clients’ capital.
This cautious stance can bruise a business in the near-term, but in the long-term, it benefited those clients who stuck around. As I wrote when Bob retired from FPA this past December, “He taught all of us what it’s like to put investors first, whether they like it or not.”
I’m not going to lie. I’d love to be loved all the time. But you can’t be a value investor and expect that. If I want to win over time, I’ll just have to settle for periodic appreciation.
There’s risk to operating in our unconstrained idiosyncratic fashion. We won’t be fully invested at all times regardless of valuation. And, although we may be avoiding losers, there will be times when our winners aren’t keeping up with the market. This will periodically lead to relatively poor performance; and, we will invariably lose clients as a result.
We will avoid whole sectors of the market for years, if not decades. We benefited by not owning technology stocks when they declined 78% from 2000 to 2003.5 It also helped that we didn’t own much by way of financials in the 2007 to 2009 time frame, as they collectively declined 76%.6
Since we aren’t closet indexers, our returns will therefore usually look vastly different than our benchmarks – for better and worse.
As an unconstrained manager, we don’t have to do anything… and we certainly don’t have to do everything.
Think of all of these companies that this approach can help you avoid…
You know… we have to make a Valeant effort to always PayLess as we travel Countrywide and make our Global Crossings to find our Blockbuster investments. We might as well take a deep breath of the Swissair…as we seek our Barings….
I know by reading the financial press that many firms like to offer a degree of certainty, even though they’re not allowed to actually promise anything. They use words to offer investors a confidence that their rates of return will be stable… will be solid… maybe offering a visual of a calm sea.
Our approach does not offer certainty. Because we’re different, we may even breed insecurity.
We do what we think is best to deliver our clients a good risk-adjusted return. We believe we have shown that it is advantageous over time to operate with such a broad charter.
Let me give you some specifics.
First, I want to take you through the history of our firm… which will give you a sense of our values….
I started our Contrarian Value go-anywhere strategy in 1990, and introduced its flagship public mutual fund, FPA Crescent, in 1993. Not long after joining FPA in 1996, I found myself in the middle of the biggest valuation bubble in seventy years.
Compared to any broad equity benchmark, the Fund’s performance in 1998/99 was pretty horrible. Market valuations reached levels we’d never seen, nor even read about. Yet, the capitalization-weighted indices hid something key: that many stocks were very very inexpensive. Small-cap stocks were trading at the biggest discount to large-caps stocks in history, and were absolutely cheap. High yield bonds were inexpensive as well, trading with double-digit yields.
Thanks to the pricing disparity between the loved and unloved, we were able to make money in each of the subsequent three years post-1999, even though the broad U.S. market dropped each year. We simply avoided the detritus as it cascaded from peaks that should never have been scaled. That was good enough to place us way ahead of the benchmark for the five years, even though we started deeply in the hole.
By the way, we didn’t own any of the best performing stocks in the Russell 3000 in any of those five years, but we didn’t own any of the worst performing stocks either.
This was the Fund’s first big test and we passed it by avoiding losses. Although our patience and discipline allowed us to prevail, that didn’t benefit the majority of the fund’s investors who capitulated along the way.
Amidst scant opportunities, I closed to new capital in 2005. The best way to avoid unnecessary losses is by understanding what you own (or might own) – the business and its industry. I therefore focused on building a best in class research team in order to ensure we could continue to win by not losing.
Our second big test came in 2007. A few years earlier, we had begun to document the rapid rise of subprime debt and the attendant risks faced by many overleveraged and overvalued financial institutions. In order to effectively frame the opportunity, we need to understand both risk and reward. Determining what can go wrong enables us to evaluate the downside.
Evaluating the potential return is the other part of the equation.
Stock and corporate bond valuations weren’t low enough to justify the risks of excessive leverage in the system, so we positioned ourselves conservatively. By October 2007, we had 45% in cash (close to an all-time high) and just 4% in high yield (which, at the time, was an all-time low). And yet, the Fund was still able to best the market that year although we did own one of the top five performing stocks.7
We communicated to our clients why we were maintaining such a cautious posture and this time they trusted our rationale. We were therefore prepared when the markets wilted in 2008. Our fund declined as well but our losses were just 55% of the market’s (S&P 500).
In late 2008 and early 2009 we used our cash hoard to aggressively buy distressed corporate bonds, many of which offered yields-to-maturity in excess of 20%. The high yield market rebounded quickly and our new investments were drivers of our 2009 return, allowing us to outperform the market once again without any of the top five performing stocks. If one were to look at 2008 and 2009 cumulatively, winning by not losing allowed us to be one the few managers in our space to book positive performance.
This brings us to today, with an impending third test due to come before too long – or, maybe too long, but one day. The S&P 500 is in its 99th month of a bull market – the second longest since 1926. The US market hasn’t had at least a 20% correction since 2009; while, the US economy is in its ninth year of economic expansion – the third longest since 1900.8 US stocks currently trade at historically high valuations, supported more by low interest rates than by earnings growth.9
On the other hand, stock markets in the UK, the rest of Europe, and Asia ex-Japan have seen their markets suffer 20% drawdowns in the last couple of years – making them relatively cheaper. This leaves global valuations looking a bit better than the US, but the median MSCI ACWI stock still trades at levels higher than the prior two market peaks; while, Asian and Emerging Market stocks are trading closer to their median valuation. For the most part, we would argue that the valuation disparity reflects more of a relative value when compared to overpriced markets, than absolutely cheap offering great investment opportunity.10 I also will offer that like-to-like on a business quality comparative, companies in these markets are not as inexpensive as they might at first appear.
As a result, we aren’t finding many investments where the juice is worth the squeeze. It feels like it’s a better time to emphasize avoiding losses rather than seeking gains.
Nevertheless, we’ve made a few investments that are interesting.
The travails of Sears Holdings in the U.S. have been broadly covered. It’s even poorer relation just north of the border, Sears Canada, is less well-known.
Sears Canada faces the same existential challenge as so many other retailers, as it sells non-price competitive products out of an over-sized box in an increasingly empty mall versus the greater breadth, pricing, and ease of delivery available online.
Sears Canada could very well go bankrupt at some point.
Therein lies an opportunity for those with capital. Sears Canada needs money and we were happy to lend them some.
Given our view of Sears Canada’s tenuous finances, we underwrote the loan, focusing on its liquidation value, independent of the company remaining a going concern. We have secured collateral in the form of inventory, receivables, and real estate – about 1.7x the loan amount – so if the company doesn’t make it, we should still be paid in full. Thanks to a 2% commitment fee and annual interest of LIBOR plus 9.75%, we should have at least an 11.3% IRR11. I say “at least” because in the event the company were to restructure prior to maturity, our IRR would be higher, particularly if it happens inside of three years when we would be due an additional prepayment fee. Our projected return is almost six points better than the current 5.5% yield-to-worst of the U.S. high yield market, and higher than what we suspect the stock market might do.
See the full PDF below.