Tag Archives: ideas

Lessons Learned From The Rise Of ETFs

For a large part of the 1980’s, 1990’s and the early 2000’s, hedge funds were equated with enormous financial success. Serving as investment vehicles primarily marketed towards the wealthy, hedge funds use a plethora of aggressive investing strategies in an effort to generate outsized returns. These strategies worked very well for the funds and for their clients for a short while. Yet, as the Securities and Exchange Commission (SEC) began to change the rules and monitor the actions of these funds more closely, the hedge fund game changed forever. In 2004, hedge fund managers were required to register their operation formally with the SEC and tie their name to that of their firm. This was mainly intended to keep portfolio managers accountable as fiduciaries. Then, after the global financial crisis in 2008, lawmakers in Washington D.C. took more decisive action to protect domestic financial markets. The Dodd-Frank Wall Street Reform Act of 2010 passed and brought with it more significant regulations to the United States’ financial sector. The restrictions on hedge funds were far more severe than what happened in 2004, such as extensive screening of investors and the presentation of sensitive data on trading positions. Because of the more stringent regulations, the risks that hedge funds once were able to take became almost impossible. Most notably, the Volcker rule has been placed into effect, which placed higher restrictions on speculative investments and proprietary trading that do not benefit the customers of funds. The success of the exchange-traded-fund (ETF) blossomed. ETFs are low-cost funds that track market indexes, asset classes, or commodities and are publicly traded like stocks. There is a stunning cost difference between ETFs and hedge funds. Hedge funds require a significant amount of active management and they usually charge a two percent annual management fee and a 20 percent fee on all profits (aka “two and twenty”). ETFs, however, charge anywhere between less than one and six percent on the basket of securities. Additionally, ETFs have the potential to attract the same clientele that hedge funds have traditionally won over: high net worth individuals. With high tax efficiency and low fees, ETFs are a no-brainer for high net worth portfolios. Understanding their advantageously low costs and taking into account the massive losses hedge funds incurred during the crisis, ETFs became a very desirable investment vehicle. Following 2008, total account balances in ETFs grew at an exponential rate and have continued to grow at an enormous annual rate of around fifteen percent compared to that of hedge funds’ annual rate of around nine percent. This past summer marked a big milestone for ETFs because total account balances for ETFs over took total account balances for hedge funds. (click to enlarge) Assets under management (The Economist) What this highlights above all is a shift in demand from active to passive investment management. In recent years, active investment managers have seen large fluctuations in their ability to beat passive funds. Ben Johnson, Morningstar’s director of global exchange-traded-fund research notes that “more than anything, fees matter” when seeking compounded capital gains. The theoretical debate on whether passive or active investing is truly more advantageous in the long run has been going on for quite some time at this point. First, we must discuss Modern Portfolio Theory (MPT). MPT dictates that investment diversification should play a complimentary role. Indeed, each investment in a given portfolio should play off the successes or failures of other investments to maximize return. MPT teaches us that there is a possible combination of assets that assumes very little risk and comparatively large return. This is all well and good, but one of the main assumptions of MPT is information efficiency and that is where the theory gets tricky. Given efficient markets, then all known factors will be priced into different stocks making it nearly impossible to beat the market in any case. Information asymmetry, the exact opposite as information efficiency, is actually the case, the effort, let alone the capital, necessary to achieve the proper asset diversification that mitigates a significant amount of risk and generates sizable returns. With the facets of MPT in mind, we can now begin to weigh in on active and passive investing aspects. Active investors assume more financial risk when trying to beat market indices, but passive investors take a significantly lower amount of risk when riding along with the successes or downfalls of markets. While the difference in returns of these two investing styles can be enormous, it is often enough that active investors, in fact, find themselves unable to generate returns that properly justify their assumed risk. (click to enlarge) Active vs passive performance (Forbes) What is so specifically important about the ETF versus hedge fund account balance trend is that when it comes to assuming financial risks, most investors don’t seem to really want to make double-digit returns when it means that their losses could be of equal magnitude. Kenneth French, Finance Professor at the Tuck School of Business at Dartmouth College, has commented extensively on the chance of investors doing better than indices. Indeed, Professor French’s Efficient Market Hypothesis (EMH) postulates that in the indefinite long run it is impossible to beat the market without acquiring high-risk investments. It would appear that the people are beginning, more so, to agree. Even if beating the market is possible in the short run, it takes effort. Stretching that effort into the long run and observing that beating the market is nearly impossible, it would seem that the effort is not worth it. ETFs are here to stay for the long-term. As more people want to find a cost and effort-effective way to participate in the markets and gather sizable returns, the more popular ETFs will continue to grow.

Concentration: The Age-Old Question

Summary I’ve made the case for concentration before, and while I still advocate concentration, my original “time” argument was misplaced because of diminishing marginal returns on time. Concentration is largely a function of risk tolerance, which makes it far easier to find an appropriate level for an individual investor than it is for a professional. There is a lot of value in thinking about position sizing in terms of “starter” and “core” positions. Concentration is a subject I’ve written on before. In one of my first SA articles , I made the radical argument for a form of hyper-concentrated investing termed “Focus Investing” whereby one holds 3-10 positions… or even just one. Concentration is still a topic I give an inordinate amount of thought too and I wanted to share some of those thoughts here. This post also follows my first post on stock screening in a series communicating my investment process and philosophy. On Time My thoughts on position sizing have definitely evolved since my first article, and in hindsight, some of my arguments, while nice in theory, don’t hold in reality and my use of them demonstrated my inexperience as an investor. For example: Time The responsible investor follows each and every one of his holdings. It takes a constant amount of time per week to stay up on a company. I would advise at least an hour per week. Again this time is constant, whether that company makes up 2% of your portfolio or 100%… He could own 10 companies and still diligently follow them, but he’d have to devote ten hours instead of one. But wait, if he was willing to devote 10 hours total to stock market research when he held 10 companies, why not spend the same time researching, but while only holding one company? He could spend 5 hours per week keeping up on Apple and another 5 researching potential investments, comparing them against Apple, only considering them if they seemed much more attractive. My argument that investments require a constant amount of time and that 50% of an investor’s research time spent on a single investment is a good strategy ignores one very important principle: diminishing marginal returns or, more practically, the 80/20 rule. See one of my favorite Seeking Alpha articles , which discusses this subject, before continuing. The first hour of research yields more information and more valuable information than the 100th hour. The other problem with the time argument is sunk costs. We all know that a sunk cost should not influence decisions, but that they often do and, sadly, this is true even for decisions that we (the same people who are aware of the phenomenon) make. When you spend weeks researching a company and preparing an extensive, tidy investment thesis and article on the stock, it’s just harder not to take a position, independent of the actual prospects of the investment. While my time argument was somewhat off the mark (though it does hold in extreme cases; time is a serious problem for an actively managed portfolio of hundreds of stocks), I’ve still been a proponent of concentration, to a lesser extent, recently. Professional Constraints Concentration is largely a function of risk tolerance. This is not that meaningful if you are only managing your own money. All it means is that you must discover your risk tolerance and volatility tolerance and find a commensurate concentration level. Thing get tricky, however, when you are managing money for others. Introducing clients means more than one brain and in turn, risk tolerance is involved. What is the appropriate level now? If you are a manager like me with one strategy and one portfolio, then you should stick to the concentration level that you think is best for total returns, but I don’t think the story ends there. There needs to be some consideration that you are a professional and are managing other people’s money. There is a higher standard. This is one good reason to find like-minded clients. If you can withstand volatility, are long-term oriented, and are okay with concentration, look for clients with the same approach. Good luck- they’re rare! My other insight is that adopting a concentrated strategy as a new manager is tough because it requires credibility, to some extent, to be very concentrated. The base rate in investing is market returns and those are derived from a market portfolio, which is very diversified (500 stocks if we assume S&P 500 = market). Naturally, the more concentrated your portfolio gets, the more different it gets from the market and the further from the base rate its returns. You are going further out on a limb. It’s tough to do that with no professional track record. The logical next step is that if you’re a new manager you should be very diversified, but that’s a dangerous path I don’t want to take because it eliminates my positive optionality of earning extremely good returns and I’m in the investing industry for more than just money. Intellectual stimulation and an interesting, meaningful career is the most important thing I seek and the use of money as a means of keeping score and creating value is a big part of the financial aspect. In short, if I’m to succeed, I want to do so on my own terms and that rules out heavy diversification. If that means a slower ramp for my firm, so be it. “Starter” and “Core” I’m at a point now where my view on concentration is somewhat nuanced. Because I employ both deep research and empirical, systematic methods in my portfolio, not all positions will be sized equally – far from it. Right now, I have some positions that are 15-20% of my portfolio and some that are less than 1%. I think this dual concept of “starter” and “core” positions has been very helpful and is worth discussing. For me a starter position is 1% and a core position is much more than that, but the numbers don’t matter as much as the way of thinking about position sizing it represents. A starter position represents something that should, based on empirical evidence, outperform. That is a firm requirement. I talked about this extensively in a previous post . A starter position is also something I’ve done some research on, find interesting, and can model a good expected return with little to no downside on in an adverse case. But for some reason, it’s not fit to be a core position yet. The most common reasons are: I’m not sure I understand it, i.e. it may not be within my circle of competence The expected return I model is not high enough to exceed my absolute return hurdle, i.e. it’s not quite juicy enough I’ve not done enough research or thinking yet, i.e. I need more time Starter positions are crucial to my investment process because they allow me to slow down. Doing research needs to be a treasure hunt for me. I’m only interested in learning about companies when there is the possibility of it being in my portfolio and making me and my clients money. During the research process, it’s so tempting to act on research and invest. It’s hard to delay gratification. The problem is that good long-term investment decisions are made slowly. Gratification must be delayed. However, I’ve found that taking a small starter position up front helps to hold me over. Of course, I don’t do this for everything I research, but obviously far more than I end up taking core positions in as the chart above shows. It also provides an extra incentive to continue to dig deeper in the research. As Tom Gaynor says : When I buy some of something, I’m buying a library card. One of the reasons I buy some of something is to make myself think more deeply about it, read the reports and be more aware of it. It’s hard to overstate the positive impact starter positions have had for me. Not only have they performed well in aggregate, which is how I look at their performance, but they’ve rejuvenated me as an analyst. There was a rough patch where I only published four articles and made four investment decisions, not all of which were good ones, over a period of almost 8 months. (click to enlarge) I researched more than just four companies over this period, but not at as high a rate as I am now and not as effectively. The lack of gratification in the research process demotivated me. There’s no rule saying research needs to be fun for you to be a good investor, but for me I think it does need to be or I won’t find anything to invest in. It needs to be a treasure hunt and starter positions help a lot on that front. At the same time, when my research does, on rare occasions, generate what I think is a really good idea, I’m not going to only put 1% in it. There are times when the level of conviction and opportunity costs make anything but a big position a bad decision and that is when I am willing to take a core position. That is where concentration is needed. And in aggregate, you still end up with a pretty concentrated portfolio. More than half of my portfolio is in 6 stocks despite the large cash position. So I still advocate concentration, but clearly have a more nuanced view now and recognize that position sizing is a far more difficult issue than I initially had thought.

Tracking The Sequoia Fund: Q3 2015 Update

Summary Year-to-date, the fund is up 1.97%, versus -5.29% for the S&P 500. Top 10 holdings (65.2% of the fund): Valeant Pharmaceuticals, Berkshire Hathaway, TJX Companies, O’Reilly Automotive, Fastenal, Precision Castparts, MasterCard, Idexx Laboratories, Mohawk Industries, and Google. During the third quarter, the fund was adding to its positions in Rolls-Royce, Constellation Software, and Jacobs Engineering. An update on Valeant Pharmaceuticals. Since its inception on 7/15/1970 an investment in the Sequoia Fund (MUTF: SEQUX ) has returned 14.34% annually versus 10.65% for the S&P 500. The fund is noted for its long-term value investing style, portfolio concentration, and outperforming in down years. For more background on the fund you can check out my original article here . The big news for the Sequoia Fund is the Valeant Pharmaceuticals controversy. The fund started accumulating shares in the second quarter of 2010 and by the end of the year held 11.3 million shares. The stock price during this period ranged from $14 to $30. You can find the fund’s reasoning for getting into the company in the 2010 annual report, which you can find here . Valeant quickly became the fund’s largest position. It said at the time: Valeant and Biovail merged during the year, and on December 31 the combined company, called Valeant, was our second largest holding. In recent weeks, rapid appreciation in Valeant shares caused it to surpass Berkshire and become Sequoia’s largest holding. It is the first time in nearly 20 years that Berkshire has not been the largest investment in the Fund. Speaking of Berkshire, it was Charlie Munger that first sounded the alarm that all might not be up to snuff. Munger is Chairman of the Daily Journal Corporation and was asked about Valeant at the last annual meeting. He responded: Valeant is like ITT and Harold Geneen come back to life, only the guy is worse this time. For those unfamiliar with the ITT story you can check out this article , which gives a nice summary. Basically, like Valeant, ITT was built up on acquisitions and debt. And what was once a growth story turned into a mish mash of debt laden businesses. Despite Munger’s warnings Valeant’s stock continued its upward trajectory, reaching a high of $263.81 on August 6th. Munger wasn’t the only one suspicious of the stock. On August 13 blog AZ Value Investing published an article on Valeant, calling it a dangerous story told well. You can find the article here . Trouble for Valeant was just around the corner. On September 17th infectious disease website Healio reported that Turing Pharmaceuticals raised the price of its Daraprim drug from $13.50 per tablet to $750. The USA Today followed up with its own article the next day and did the math for us, noting the price hike was 5,000%. Then Hillary Clinton jumped on board, tweeting on September 21st: Price gouging like this in the specialty drug market is outrageous. Tomorrow I’ll lay out a plan to take it on. That put all specialty pharma companies in the crosshairs, including Valeant. In a week the stock dropped from $245 to $155. But the pain wasn’t over. On September 28 Citron Research, a specialist in unearthing frauds and terminal business models, published a report saying a congressional subpoena to Valeant on price gouging should be granted. Plus it gave a short term price target of $130 with the stock in the $170-$180 range at the time. The initial report didn’t move the stock much. But sure enough on October 14 subpoenas were issued. And then Citron wrote another report detailing the whole Philidor RX issue. By the time the dust had settled Valeant had dropped 50%, from $180 to $90, in just a few days. On October 28 the Sequoia Fund addressed the issue in a letter to shareholders which you can find here . Key comments: The short seller Andrew Left (of Citron Research), writing as Citron Research, exploited the negative sentiment surrounding Valeant. Our consultations with lawyers who specialize in the pharmaceutical industry lead us to believe there is no legal reason Valeant can’t advise, control or own Philidor. We work hard to understand Valeant and its business model. Our belief has always been that Pearson is honest and extremely driven. He does everything legally permissible to maximize Valeant’s earnings. At a recent price of $110, Valeant trades for about seven times the consensus estimate of 2016 cash earnings, which does not strike us as a rational price for a company with a diverse collection of product lines and strong earnings growth. So it appears the Sequoia Fund is sticking with Valeant. As of 6/30/15 Valeant was a $2.5 billion position in the fund, and its largest, accounting for 28.7% of the fund. As of 9/30/15 Valeant was a $2.0 billion position in the fund, and its largest, accounting for 24.8% of the fund. Based on my numbers, assuming the fund didn’t sell any shares, the position is now worth about $1 billion at a price of $90. It will be interesting, to say the least, to see the fund’s activity in Valeant during the fourth quarter of 2015. Here’s the fund activity for the third quarter of 2015. New Stakes: None. Stake Disposals: None. Stake Increases: Rolls-Royce ( OTCPK:RYCEY ) designs, develops, manufactures, and services integrated power systems worldwide. The company is known for its expertise in making engines for wide body jets. The fund has been in Rolls-Royce since 2007. It built up the position to over 12 million shares by the end of 2008. Since then it’s held, save very minor selling. Despite continuing to hold, the fund is very concerned over the position. While it admires its jet engine business, it questions the board of directors recent decisions to diversify into marine engine and power generation businesses. It’s also concerned the company is abandoning its Total Care service contract selling model which was very successful under the former CEO. As for the current CEO, John Rishton, the fund says, “… in our meetings with him, has shown minimal awareness of the returns on capital his acquisitions have generated.” The fund was selling in the second quarter of 2015, trimming the position by 437k shares when prices traded between $13.75 and $16.00. Rolls Royce announced in April that John Rishton was retiring and be replaced by John Rishton. The fund must like East’s plan as they did an about face in the third quarter of 2015, adding just over 7 million shares as prices ranged from $9.75 to $13. Constellation Software ( OTCPK:CNSWF ): Constellation Software, based out of Toronto, acquires, manages, and builds vertical market software (VMS) businesses. The fund likes the company because the software they provide tend to be essential to the customers’ operations. It also likes Constellation for being an adept acquirer and then increasing the cash flow of acquisitions. During the fourth quarter of 2014 the fund acquired 257k shares for a 1.09% position. Prices for the fourth quarter of 2014ranged from $240 to $300 for the ADR. During the third quarter of 2015 the fund added another 165k shares boosting its position by 64%. Prices ranged from $380 to $460. This is now a 2.19% position in the portfolio. Jacob’s Engineering (NYSE: JEC ) provides technical, professional, and construction services to industrial and government clients. The fund first established a position in the fourth quarter of 2013, picking up 743k shares when prices ranged from $56 to $64. That turned out to be near the high point for the stock which has been falling since January of 2014. The fund added another 716k shares in the second quarter of 2014 when prices traded between $53 and $65. This past quarter the fund added another 764k shares. Prices traded between $36.50 and $44.50. This stock is a 1% position in the portfolio. Stake Decreases: None. Kept Steady : Omnicom (NYSE: OMC ), Precision Castparts (NYSE: PCP ), Compaignie Financiere Richemont SA ( OTCPK:CFRUY ), O’Reilly Automotive (NASDAQ: ORLY ), Canadian Natural Resources (NYSE: CNQ ), Sirona Dental Systems (SRIO), Berkshire Hathaway (BRK.A & BRK.B), Danaher (NYSE: DHR ), EMCOR Group (NYSE: EME ), Trimble Navigation (NASDAQ: TRMB ), Mohawk Industries (NYSE: MHK ), Expeditors International (NASDAQ: EXPD ), Perrigo Company (NYSE: PRGO ), Valeant Pharmaceuticals (NYSE: VRX ), West Pharmaceuticals (NYSE: WST ), Zoetis (NYSE: ZTS ), Fastenal Company (NASDAQ: FAST ), Praxair (NYSE: PX ), IMI plc ( OTCQX:IMIAY ), MasterCard (NYSE: MA ), Brown & Brown (NYSE: BRO ), Google (NASDAQ: GOOGL ) and (NASDAQ: GOOG ), Goldman Sachs (NYSE: GS ), International Business Machines (NYSE: IBM ), Waters Corporation (NYSE: WAT ), Admiral Group ( OTCPK:AMIGY ), Hiscox Ltd. ( OTC:HCXLY ), Verisk Analytics (NASDAQ: VRSK ), Costco Wholesale (NASDAQ: COST ), Tiffany & Co. (NYSE: TIF ), TJX Companies (NYSE: TJX ), Walmart (NYSE: WMT ), Croda International ( OTCPK:COIHY ), Cabela’s (NYSE: CAB ), and Idexx Laboratories (NASDAQ: IDXX ) saw no changes from the second quarter of 2015 to third quarter of 2015. Here’s a snapshot of the activity from the second quarter of 2015 to the third quarter of 2015: (click to enlarge) Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.