Manager’s Quarterly Commentary – Felix Narhi – Q2 2016

Written by Felix Narhi

After a wild ride in the first quarter, the big surprising macro news to hit markets during the second quarter was Brexit. Admittedly, we did not anticipate that the UK would vote to leave the EU because we felt it was in the country’s economic self-interest to remain. As one pundit opined, it was like a turkey voting for Thanksgiving. Yet, the fundamental issues that led to the Leave vote were far more nuanced and complex than simply voting on economic considerations. Besides, the markets have a long history of people behaving irrationally.

Political punditry aside, our portfolios do not have a lot of direct exposure to the UK. On the other hand, it is hard to predict the long-term fallout for Britain at this stage, never mind the potential contagion risks to other EU member countries. Uncertainty has risen and the potential downside risks have increased as companies reevaluate their long-term plans. Globally, central bank response came from well-worn playbooks – further monetary easing to minimize economic impact which pushed global yields further down into uncharted territory.

We are avid students of market history. History may not repeat, but it often rhymes. Pattern recognition is important when handicapping the odds for potential investment opportunities. As such, we are cautious about the risks of “reaching for yield” because pursuing income and yield while disregarding fundamentals has almost universally ended badly for investors. As yields in certain sectors plunge further into negative territory, investors have gone from reaching for yield to lunging for yield, driving demand for perceived “safe” yield extremely high. On a global basis, there is no precedent for today’s conditions. Nobody can be an expert about the consequences of something that has never occurred. Everyone is confused. More surprises like Brexit are sure to be in store. As bottom up fundamental investors, we do not normally spend an inordinate amount of time on macro considerations. Nevertheless, today’s environment is so strange and unprecedented, we feel compelled to provide some perspective.

Bizarro world – Bonds are the new stocks, stocks are the new bonds

According to a recent Bank of America Merrill Lynch report, there was US$13 billion in global negative-yielding debt in early July, up from US$11 billion before the Brexit vote and up from virtually nil just two years ago. This negative-yielding debt is equivalent to about a third of the entire US bond market and almost two-thirds of the market value of publicly traded American companies, as measured by the S&P500. Simply put, there is an enormous amount capital mandated to invest in positive yielding securities in a shrinking pool of traditional fixed income options. As an unintended consequence of central bank easing gone too far, investors are mechanically bidding up “safe” yield wherever they can find it. This has had enormous implications for the financial markets and has led to a strange investment environment, where the rules of capitalism are being rewritten.

In this new bizarro world, high quality dividend-paying stocks have become the new bonds (for investors seeking yield) and longer-dated bonds with minimal or negative yield have become the new stocks (with capital appreciation potential if yields continue to go lower). To date, staying the course with long duration bonds and high quality, dividend paying stocks has worked exceptionally well for investors. Central bank policies have driven demand for high quality, large cap dividend-paying stocks to elevated valuation levels, justifiable only by relative terms when compared to fixed income alternatives because their growth prospects remain anemic. A recent report from BMO noted that the most expensive S&P500 companies, as gauged by price-earnings ratio, are outpacing their cheapest counterparts by more than 20% this year on average. Valuation doesn’t matter as much in this market, but yield does. This “lunging for yield” dynamic also explains why US stocks are near an all-time high, even though the markets are in a “risk off” mood. Investors are paying near record high prices for high quality, safety and yield.

The trouble with a good idea

Investors almost universally prefer high quality companies over their low quality peers. But as value investor legend Benjamin Graham was fond of saying, “You can get in way more trouble with a good idea than a bad idea because you forget that the good idea has limits”.

As a group, investors dislike uncertainty, but those who are more dependent on fixed income are particularly risk averse. It is easy to understand how combining “safe” and “yield” in mature, quality large-cap companies would prove alluring as the traditional pool of positive yielding investments shrinks. Catering to an increasingly crowded trade, strategists at Citigroup have created a basket of stocks for clients they call “bond refugees”, or those investors who want yield but without the big swings in prices typically associated with stocks. Positive momentum begets more positive momentum as participants become entranced with the price action.

Legendary investor Sir John Templeton counseled that investors should “always change a winning game.” Although momentum investing has empirical merit, it is prudent to exercise greater caution after a long run up in stock prices and valuation metrics become increasingly stretched. As the old saying goes, what the wise man does at the beginning, fools do in the end. Of course, quality is a very important factor when investing, but whether any investment is sound depends on the price paid. Paying too high a price for even the highest quality security will make it an unsafe investment.

“Invert, always invert”

Renowned 19th century mathematician Carl Jacobi found that he could solve challenges more easily if the problems were inverted. In other words, working through a problem backwards was a better way to arrive at the solution. We believe this is a very useful mental model which applies to investing. Often the commentaries of asset managers, like this one, will espouse almost universally agreeable “mom-and-apple-pie” aspirations which can be summarized as: we want to own quality companies, run by competent managers that are available at sensible prices. Perhaps a better investment strategy is to invert and simply avoid securities where there appears to be a high risk of a bad outcome.

Looking out of the windshield or the rear view mirror?

According to one of the most diverse and wide-ranging surveys of global fund managers (Global FMS survey), the most crowded trades today are quality stocks, utilities1 and stocks with bond-like qualities that will benefit from further easing by central banks and are likely to have the least downside in the event of a recession. If quality stocks, utilities1 and stocks with bond-like qualities are an overcrowded trade and expensive, which securities are unloved and undervalued? As Carl Jacobi advised: “Invert, always invert.” Perhaps owning companies that retain their earnings to reinvest in growth opportunities instead of paying them all out as a dividends and/or buying back shares at all-time highs? Perhaps owning companies where insiders are buying their own stock at depressed valuations instead of investing in companies where half the insiders fear a looming “death spiral”1 such as the utilities sector? Perhaps owning individual stocks that are trading well below their historic ranges instead of the yield-driven stocks of the S&P500, which are pushing the index to decade high valuations? But perhaps this time is different…

Please do not hesitate to contact me, should you have questions or comments you wish to share with us.

Felix Narhi, CFA
27 July 2016

1 Please refer to a related blog post on Utilities investing and why this “safe” sector may be more risky than commonly perceived.