Home Value Investing Horizon Kinetics Asks Why Berkowitz, Gabelli, Winters, And Hawkwins Have Been Underperforming

Horizon Kinetics Asks Why Berkowitz, Gabelli, Winters, And Hawkwins Have Been Underperforming

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The is interesting – note they take a swipe at “Berkowitz, Gabelli, Winters, and Hawkwins”.

Horizon Kinetics’ market commentary for the fourth quarter 2014.

The annual questions: How will the markets do this year? How have we done? Will it be more of the same or differ-ent? Every once in a while, those questions are much more important than usual, not merely of seasonal interest. This is one of those times.

Horizon Kinetics equity strategies were up far more than the market

In 2013, our equity strategies were up far more than the market. Would it have been reasonable to expect another 35% or 45%? No. This past year, the S&P 500 was up almost 14%, much more than our strategies. Would it be reasonable to expect that again (or, for the next two years)? No. Why not? Because it’s not just a roll of the dice or momentum; there are specific and very important activities at work behind these results; to not understand them is to risk being exposed as markets approach a dangerous juncture.

We hope to answer the question as to why, in 2014, the most outstanding mutual fund managers of the past decade or two, collectively and simultaneously, underperformed the S&P 500, and by an enormous margin. They each have different styles and holdings, and well-deserved reputations. Most important, there is no precedent for this common magnitude of under-performance. It is important to understand why. It is also important to understand whether it is because they invested poorly or not. In other words, were they the anomaly for under-performing and is it reasonable to believe that they all lost their touch at the same time–or was it the S&P 500 that was the anomaly for outperforming? If that latter bit sounds nonsensical, it has happened before (although it can never be proven until after the fact). In 1999, portfolios in our Core Value strategy were up about 4% (net of fees) when the S&P 500 was up 21%: under-performance of 17%.

Horizon Kinetics

Why? It’s not that we purchased poor investments. It’s simply that we did not purchase internet and technology and unregulated utility stocks, which traded at bubble valuations. The following year, we outperformed by 30%. Why? We didn’t own internet and technology and unregulated utility stocks.

Horizon Kinetics

An important divide has developed between, on the one hand, the S&P 500 and other major stock indexes such as the Russell 2000, and active managers who select individual se-curities not based on a narrow rule set.

Horizon Kinetics: Outflows from equity mutual funds

Observe the enormous and continuous flow of assets out of equity mutual funds, which we use as a proxy for actively managed strategies, and into exchange-traded funds (ETFs), which of course are indexed. In 2006, before the finan-cial crisis of 2008/2009, more money flowed into mutual funds than into ETFs. In 2008, $229 billion exited equity mutual funds while $143 billion was shifted into ETFs. The financial crisis induced a volatility phobia amongst investors, such that, in every year since, more money flowed into ETFs than actively managed strategies, and as late as 2011 and 2012, $280 billion—more than in the 2008 crisis year—actually left equity mutual funds. In no period, even during the financial crisis, did money leave the ETFs. They are considered safe. In 2014, almost no net investments were made in equity mutual funds, while, once the figures are collected, it is likely that ETFs had the largest annual inflow on record.

Horizon Kinetics

Horizon Kinetics: Correlations of these individual companies with the S&P 500

One effect of the constant shift of assets into indexes is that stocks, more and more, are purchased as part of a basket. Once upon a time, active managers and analysts would distinguish between and select one consumer service or technology company over another. Today, if one is invested in the stock market via ETFs, one cannot be specifically dissatisfied with Coca-Cola, say, or Procter & Gamble. You can sell your iShares US. Consumer Goods ETF or your iShares S&P 500 Growth ETF, but you will be selling your Coca-Cola together with Procter & Gamble together with Apple, etc. Accordingly, the shares of the larger, more liquid companies that are the prime ingredients of the major indexes, have been rising and falling more and more in tandem. The correlations of these individual companies with the S&P 500 itself is now a lot higher than it was a decade ago.

That means that the diversification benefits are being eroded. When, next, the market declines sharply, the traditionally diversified portfolio—some large-cap, some value, growth, et al—will not provide the protections that are expected. There has been developing another form of bubble: a correlation bubble among equity classes. Peruse the table at right, and, statistically, the various equity ETF building blocks—mid-cap value, large growth, etc.—are hardly differentiable.

Horizon Kinetics

Horizon Kinetics: Determining stock overvaluation

Because the marginal dollar of demand is now in the hands of indexes, the active manager of old who might have determined that a certain stock was overvalued and elected to sell it has ever less impact upon share prices. There is no longer a central mechanism for investors to vote with their feet on an individual stock. Taking Coca-Cola, as an example, during the decade of the 1970s, the company generated about 13% annualized earnings growth, some years approaching 20%. For the first 5 years of the ‘70s, the P/E ratio ranged between about 30x and 40x earnings. Few would argue that it wasn’t overvalued. And, as the reversion to the mean principle would dictate, despite a decade of earnings growth that strong, the P/E contracted to 13.6x by 1978 and, over the course of an entire decade, the shares declined by over 45%.

Horizon Kinetics

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