At Smead Capital Management, we believe that everyone who invests has faith in someone or something. We also believe that who and what you put your faith into is greatly influenced by the time period involved. As we look out into the rest of 2014 and beyond, we would like to consider the kind of faith required by the largest pools of investment dollars in the US. This includes looking at who they are trusting, what they are trusting in, and what time frames they are operating under.
Institutional investors are pretty easy to track because of the NACUBO study of the common fund of college endowments. Also, endowments are not adverse to the kind of long holding periods conducive to investment success. The NACUBO study includes the largest endowments like Harvard and Yale and totals over $1 trillion of institutional investment dollars. At the end of 2002, 52% of their dollar-weighted portfolios were in long-only US equities despite the fact that we were at the end of a 40% decline in the S&P 500 Index. This dwarfed fixed-income investments and the total of every other asset class in which they participated. They trusted the US stock market to meet their long-term investment goals.
Since the prior years had been dominated by large-cap outperformance, we assume that more than 70% of the 52% was in large-cap equity. This would mean that north of 36.4% of all the money held in college endowments was in large-cap US long-only investments. Passive investments have been reported to be 13% of total equity investments back then, so we can assume that 87% of the large-cap money was with active managers. We interpret this to mean that institutions trusted active managers and what they trusted was the historical outperformance of US long-only common stock ownership.
In the most recent NACUBO study, those same institutions had 15% of their portfolio in US long-only equity. Since small and mid-cap indexes have dramatically outperformed the large-cap S&P 500 index over the last 14 years, we assume that large-cap is the smallest part of their US long-only portfolio in the history of modern US institutional investing! We assume it is somewhere between 5 to 7% of their portfolios. Perhaps, ironically, small and mid-cap strategies make up a smaller portion of these institutional investors’ portfolios than they did before they had outperformed. We take this to mean that these institutions don’t have faith in the ability of US long-only common stock portfolios to meet their long-term investment needs. Secondly, indexing in the large-cap space makes up as much as 40% of the 5 to 7% total. It appears then that active managers are only trusted with 3 to 4% of the portfolios of the largest pools of money in the US. Our view: they don’t have faith in large-cap stocks and don’t have faith in active large-cap managers.
We think high-net-worth individual investors in the US have made a similar adjustment in where they place their faith and what they trust. At the end of 1999, US investors had never been more exposed or concentrated with their investments. They not only owned more in US common stocks as a percentage of their net worth as they had ever had, but most of that was concentrated in the 50 largest technology stocks. They trusted a “new era” of technological innovation and acted on it via large-cap growth stock investing. The spillover created a drowning waterfall of cash into large growth funds and even inflated the P/E ratios of other non-tech growth stocks. As Warren Buffett pointed out in Sun Valley in 1999, the Fortune 500 companies looked frothy. You only had to look at price of the S&P 500 Index, which was trading at a record setting 31 P/E.
The brutal clobbering that was handed out to institutional and individual investors in the 2000-2002 bear market was especially hard on technology and growth stocks. Between the end of 2002 and the end of 2008, these two largest investment pools reacted by morphing into wide- asset-allocation investors. Individual investors in the US went from as concentrated in one sector of the S&P 500 index and as concentrated in one asset class as they had ever been at the end of 1999, to being as widely spread out among assets classes as ever. This included major introductions to commodity indexes, emerging market equities and bonds, gold, and alternative strategies like hedge funds and private equity. We view this as proof that they decided to trust asset allocation strategists and what they decided to trust was diversification.
Warren Buffett likes to say, “What the wise man does in the beginning, the fool does at the end.” We think the investment business is no different than any other industry. When too many people are participating in the same industry, profit margins are damaged. By the summer of 2011, it seemed to us that asset allocation strategists were treated like gods because of the trust placed in them and diversification became an end in itself, because of the faith placed in it. Many of these newly popular asset classes are not of the same size and scope of the largest companies in the US and quickly became crowded trades. From our view, most emerging markets are a pimple on the face of American humanity from a size standpoint, and there are only so many companies out there at valuations worthy of being taken private by LBO firms drowning in institutional capital. Here is how the CIO, Jane Mendillo, of Harvard’s endowment explained today’s private equity climate in Barron’s recently:
Private equity is a much more crowded place than it was 10 or 20 years ago. So you need to be choosy and pick the right managers and opportunities. It has been estimated there is a trillion dollars of dry powder in the private-equity industry today.
Experience has taught us that at the peak of popularity of every asset class, those who are over-committed to it claim to avoid the risk by having the best managers. We remember “smart” investors in the tech sector back in the late 1990’s, who avoided the most outlandish dot-com’s and stuck to what they called the “pick-ax” companies like Cisco (CSCO) and Microsoft (MSFT). It kept their losses down to 50-80% in the 2000-2002 bear market, while the most egregious stocks disappeared completely.
Thanks to the largest pools of money in the world avoiding large-cap US stocks like the plague and the massive exodus of talented investment managers to the hedge fund industry, the competition in the stock picking division of the mutual fund industry dropped immensely. Like any other industry, the lack of competition has fattened profit margins for effective active managers. Why would someone talented in stock picking do it in a vehicle which charges .75% annually, when they can work for a hedge fund which charges investors 2% and gets 20% of the profits? We like to say that the hedge fund world is a compensation system looking for a client. It put a premium on well-compensated talent and caused folks in the hedge fund world to be in a hurry to get rich from what we call OPM (other people’s money).
Who does Smead Capital Management ask people to put their faith in and what do we trust to meet the long-term investment needs of institutional and high-net-worth investors? First, we assume that US large-cap stocks will offer some of the highest returns among liquid asset classes, as they have in the past. We also assume these returns come with the most tolerable ride for risk investors throughout the years. Near the end of 2008, we didn’t know much, but we did know that all the government’s efforts to turn things around were going to require the federal taxes paid by our companies. If they didn’t survive and prosper, deposit insurance for a CD wouldn’t have mattered.
Second, we ask investors to share our belief that valuation matters dearly, that owning businesses for a long time is beneficial and that to own them for a long time you need a high quality set of companies. Numerous academic studies that we’ve seen agree that cheaper stocks outperform average or expensive ones. Owning the same stocks for a long time cuts frictional trading costs significantly and takes away one of the passive indexes biggest advantages. Lastly, quality aspects like strong balance sheet and earnings consistency have proven to add alpha over the decades.
Third, we ask investors to have faith in the execution in our discipline of screening companies through our eight criteria for stock selection. We believe these criteria identify quality and search for bargains.
In ten years, we expect our investors to be really excited about the businesses we have owned. Who we trust currently are names like Gannett (GCI), Wells Fargo (WFC) and Merck (MRK). What we trust is that our relatively uninterrupted ownership of these businesses will produce returns exceeding the S&P 500 index and the Russell 1000 Value index. We also trust that our success will meet the long-term investment needs of the institutional and individual investors we serve.
We are comforted by knowing that our view is a minority opinion, because only the lonely can play.
The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. Bill Smead, CIO and CEO, wrote this article. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.