CIO’s Quarterly Commentary – Felix Narhi – Q3 2017

To date, 2017 has been a much better year for the S&P500 than we had imagined. The flip side of an above average year, especially within an extended bull market, is that prospective returns will likely be more muted. With the major indices regularly hitting new records and valuations at historic highs, finding good value and the proverbial “needles in the haystack” is increasingly difficult. Nevertheless, we believe there will almost always be mispriced securities available in some corner of the market, whether the S&P500 is at all time highs or not. However, an investor needs to have a contrarian mindset and the capacity to follow an idiosyncratic approach to find them.

The shift toward passive investing and other forms of rule-based investing, such as index funds, factor-based investing, quantitative investing and exchange-traded funds (ETFs) is raising important considerations for investors. The decline of active investing means that, in many cases, stock prices have become more correlated and more closely linked to a company’s “characteristics”, such as its index membership, ETF inclusion or other quantitative-factor attributes. As a result, companies’ stock prices have become less correlated to their own fundamentals and cause market distortions, particularly over the short term and for stocks that are liquid enough to absorb large inflows.

However, it is important to keep in mind correlations between similar firms based on their “characteristics” break down when observed over longer durations. The longer one owns a stock, the more its returns will reflect the underlying economics of the business itself. But stock prices frequently detach from their fundamentals over the short term. Being on the other side of the trade of investors who care less about valuation and other important factors that drive long-term returns is not necessarily a bad thing in our view. It is an opportunity for those investors who dare to be different, take a bottom-up value-based approach to investing and maintain a long-term view.

A trade only occurs when two parties have contrasting world views, different investment strategies or other motivations for buying and selling a stock. Increasingly, the counterparties are not even human, but rather algorithms that have been programmed by humans to mechanically follow rules-based trading strategies. Unfortunately, these rules are often limiting or worse, misleading.

For example, the S&P500 index represents a portfolio of 500 of the largest US headquartered firms. If the S&P500 holdings were to be split up between two ETF groupings in order to reflect opposing world views, say “value” or “growth” investing, one might understandably think the total would still add up to 500. That is not the case. Consider that the iShares S&P500 Value ETF has 349 holdings while the iShares S&P500 Growth ETF has 331 holdings. Collectively, these two funds hold 680 names. Why does ETF math add up to more than 500? Because a number of holdings are cross held in the both the Value ETF and the Growth ETF. Instead of remaining faithful to the demarcation lines that traditionally separate “growth” and “value” stocks, the designers of these ETFs had other more important priorities.

Since there are only a limited number of S&P500 stocks that have enough liquidity to satisfy the needs of ETF manufacturers, the most liquid stocks of the S&P500 will go into both indices, regardless of whether they have “value” or “growth” characteristics. Regrettably, an iShares S&P500 Value ETF investor who thought she was getting the representative “value” stocks of the S&P500 actually got a lot of very liquid “growth” stocks as well, and vice versa. Not surprisingly then, the long-term returns have been very similar for both ETFs, because the funds are highly correlated to each other due to their ownership of the very same liquid large stocks. And this is just the tip of the misleading ETF iceberg. When it comes to ETFs, it is still important to do your own homework on what is actually in the ETF and not “judge a book by its cover“. (Note: this ETF example aside, we believe value and growth are actually connected concepts rather than opposing investment styles (see For a Winning Portfolio, don’t just think Value vs. Growth).

Risk evaluation is at the forefront of our investment process (see How Pender Thinks about Risk). One of the three pillars of our Trinity of Risk (Montier) framework is Valuation Risk. If an investor over pays for a stock, it doesn’t matter how well the underlying business performs, the returns will likely be mediocre or worse. Prospective long-term returns for any given stock will largely depend on whether the stock was bought at a discount to its intrinsic value and the underlying economics of the business itself. As a group, we believe the valuation risk for the large caps listed in the S&P500 is high. According to a recent report by Goldman Sachs, the prolonged bull market across stocks, bonds and credit has left a measure of average valuation at the highest since 1900. Strategist Christian Mueller-Glissman wrote, “It has seldom been the case that equities, bonds and credit have been similarly expensive at the same time, only in the Roaring ’20s and the Golden ’50s”. Price-to-value considerations are an important part of our investment process – we will buy a stock when we believe we will obtain more intrinsic value than we are paying for. Importantly, as a small and nimble investment firm with flexible mandates, we are not forced to look for our ideas in the S&P500 or the TSX. We are able to search for ideas outside the box. And in the absence of compelling investment ideas, we believe an investor’s default position should be cash (see Cash as a Strategic Asset Class).

In the third quarter, we purchased an initial stake in TripAdvisor, a founder-led firm. We see a disconnect between the fundamental value of the world’s largest travel platform and the near-term “monetization gap” of the franchise. TripAdvisor offers consumers a comprehensive travel platform to research and book hotels, attractions, and restaurants with enviable global reach that is unmatched by peers. In short, we believe either the current management team will be able to bridge this monetization gap, or the firm will be put up for sale and someone else will do it for them. Perhaps the world’s largest travel platform would be worth more to a strategic buyer with great monetization capabilities than to public investors?

As a result of these changes, many of the great entrepreneurial firms that create the most value have had their weighting in the index reduced by the amount of insider ownership. On the other hand, when a founder’s ownership declines, likely near the end of his or her career, and after much of the big returns have already been generated, the index is forced to buy more shares because the free float is increasing. That’s to say the S&P500 index is fundamentally structured to be biased against founder-led firms. All things being equal, investors who believe in the thesis that founder-led firms tend to outperform over time should make the opposite trade to the S&P500’s mechanical rule-based weighting mechanism. Buy stakes in firms when they are still founder-led and sell or lower weights when the founders move on. Again, similar to the iShares Value and Growth ETF discussion earlier, the S&P500 index is not necessarily constructed in a way that produces optimal results for investors, but rather oriented to make it more liquid and sellable.

Irrespective of the index’ shortcomings to weighting, the S&P500 may not be the best place to find tomorrow’s founder-led success stories. As a practical matter, newer firms that still trade outside of the mature larger indices are more likely to have young founders at the helm who still have many years of value creation ahead of them.

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