While some cook with a dash of this and a dash of that, the best chefs follow a recipe to a T. Without abiding by a set of instructions, you’re at risk of inconsistent results or worse, omitting steps altogether. Sugarless baked goods rank right up there with eating cardboard. And too much of even basic spices can ruin any dish. Overcooked foods can be dry or burnt. Undercooked foods can cause illness. Clearly, following a recipe precisely is essential.
Similarly, an oversight in investing can have ruinous results. Establishing the wrong asset mix can set an investor back many years. Overlooking operational issues, financial problems, overvaluation, or liquidity constraints, can result in poor security selections. A disciplined approach can assist in mitigating these risks.
Everyone’s Tastes Differ
Some prefer their meals bland whereas others desire spice. Some like dishes served hot while others prefer them cold. With food, people usually know what they want and how they want it. Investments are much trickier. Choices are often more complex. Not to mention that investing environments can differ widely depending on things such as economic outlook, inflation levels, interest rates, valuations, or tax rates. Many investors are even unsure of what they want or need. And market movements often wrongly influence investor psychology. They’re fearful when they should be greedy and vice versa.
As one should, we always begin the investment process with an asset mix discussion. All else being equal, stocks should be emphasized. Stocks provide the highest returns over time and their after-tax returns are more favourable. But, many investors have income requirements, low thresholds for volatility or short-term needs which drive objectives toward income investments.
Though a winter tomato certainly doesn’t taste like a summer tomato, preparing for a meal starts with a specified list of ingredients. The investment analogy is the securities held in one’s portfolio. The choices are ever-changing though, depending on the opportunities presented in the marketplace. And much like shopping for produce, we must be discerning—examining companies which are often blemished to ensure they aren’t rotten to the core.
Recipes have been likened to culinary road maps. At Generation, we have our own defined processes, including specifically designed tools such as TECTM, TRIMTM, TRACTM and TVMTM, to guide us. And like recipes that get handed down from generation to generation, we’d like nothing better than to pass along our processes to future generations—both ours and yours. 2
Not Eclectic Nor Continental
Though they sound made up, ‘eclectic’ and ‘continental’ are used by reviewers to describe restaurant fare that can’t be slotted into a specific type of cuisine. Conversely, at Generation we have a very specific style—value investing. Like a memorable dining experience we look for good value—getting our money’s worth. That’s why we seek bargains—stocks or bonds that trade at prices below our estimate of Fair Market Value (FMV)—a wide discrepancy between price and FMV because it can provide potential for both a margin of safety and upside. And good value isn’t just about cheapness. We look for higher quality businesses, those that tend to be more predictable, in order to have fewer losers and to minimize the size of the losses.
We wish to avoid the lure of attractiveness based on price alone. Buying companies that appear to be cheap can pay off but it can also lead to value traps—businesses whose valuations are deteriorating and therefore fall to meet already depressed prices. We’d rather wait for the caviar to go on sale than purchase day-old sushi. Our philosophy requires not just an attractive valuation but also a high quality business, determined by enduring competitive advantages and more predictability, so we can more easily estimate the value with confidence.
A Watched Pot Never Boils
Well that’s not true. But it surely doesn’t happen any faster if you’re watching. Investing also requires patience, to ride out the ebbs and flows of individual securities as each reacts to daily changes in market sentiment. To suffer through market turbulence or bear markets. To avoid capitulating at the bottom or throwing in the proverbial towel because it appears to be taking too long to achieve expected results. It’s our job to assess short-term disappointments, industry concerns, or news (or rumours) which often lead to uncertainty, in turn depressing security prices. And one usually has to allow sufficient time for the uncertainty to dissipate so the gap between price and FMV can be closed.
And there’s a fine line. Because we clearly don’t want to overstay our welcome when deterioration is occurring, otherwise there’s a risk of permanent rather than the temporary impairment we seek out to exploit opportunities. So we constantly monitor to ensure situations remain analyzable, that the story has not changed, and that we are still relying on the mere passage of time for misperceptions to correct themselves.
We also reinforce that volatility should be used in our favour. Undervalued securities run up to fair value and then become susceptible to declines on any negative changes in sentiment. Which means that we need to part with our positions once they approximate our appraised values and be ready to pounce once they fall back to where they are sufficiently undervalued. For perspective, even the largest companies in the world have intra-year average declines of about 17%, nearly each and every year.
That’s also the reason bigger is better, i.e. holding larger companies. Not just for liquidity purposes so we can realign portfolios on a moment’s notice if we’ve erred in judgment or wish to react to our macro alerts. But also because their staying power is likely increased by cost advantages, dominant networks, or significant brands and/or patented technology. And while large companies tend to be less volatile than small ones, the large ones are more widely followed and typically rise back to their FMVs on a more timely basis, which helps in the patience department too.
The Key Ingredients
As noted above, it all starts with an appropriate asset mix. Then we add in high quality undervalued companies. We conduct in-depth analysis to make those choices—by both determining values and assessing risks. And in calculating FMVs, which most do not do, we have an advantage—a reference point for establishing the discount relative to price, to assist with loss mitigation and return potential as well as for approximating where to sell. This framework also provides comfort and the conviction to continue to own positions under adverse conditions. It also lets us average down, buy more of a position that’s fallen further in price from our cost, when we believe the risk-reward opportunity is even more favourable.
We have a global opportunity set which provides a wide universe of industries and companies to choose from and offers the benefits of diversification too. We screen often, utilizing technology, in a structured fashion, to uncover investment opportunities.
We have also developed proprietary tools over the years to assist us. We use TVMTM (our valuation model) to screen for opportunities that may be trading at a discount. And TRACTM provides us with potential entry and exit points as we try to maximize gains and minimize losses.
Our macro tools—TECTM and TRIMTM—were designed to alert us to recessions and market panics, so we can better time our hedging activities (where authorized by client accounts) to potentially offset the impact from overall market declines.
If You Can’t Stand the Heat, Get Out of the Kitchen
As value investors we are contrarian by nature—buying when others are disinterested and selling when others are captivated. And if investors become euphoric, it’s likely an indicator that the overall market is susceptible to a swoon, particularly if the economy is peaking.
When the economy peaks the markets usually suffer from 2-year rolling losses in excess of 20%; therefore, we wish to get out of the way best we can. Though, even with the macro tools we’ve designed, it’s still difficult to pinpoint when a recession will begin or end. Unlike at previous market highs, the market currently does not appear overvalued to us. Since there’s an absence of distinct economic excesses, growth is anemic and stimulus is already underway in the U.S. and elsewhere, the rollover of this already record-long cycle could take even longer.
While we suffered in the Great Recession, in the dot-com decline we defied the expression “you can’t have your cake and eat it too” as our long positions rose and our shorts declined. The current environment, while less pronounced, certainly rhymes with that period. Market participants have prized growth stocks—the last 10 years being the worst relative performance for value vs. growth in history. This has likely been caused by those chasing growth during this low growth, low interest rate period and the passive investment craze where ETFs indiscriminately buy the same mega-cap positions, regardless of fundamentals.
We’ve also witnessed a bubble in cannabis stocks and Unicorns—startup companies that have valuations above $1 billion—e.g., Uber, Lyft and Slack. Companies in these segments have had unjustifiably high levels of overvaluation and little to no profits. Some who were adept enough to sell at the top may have gotten wealthy but most get left holding the bag, not even a doggie bag which at least has something in it. Moreover, for the last 2 years, 80% of all IPOs have been companies with no profits. The last time these figures were this high was 1999 and 2000, during the dot-com frenzy which obviously did not end well.
Also indicative of a top, the last time investors were as bullish as they are now, for such an extended period, was 1999. This optimism is likely why average equity allocations in the U.S. are at heights only exceeded in the last 50 years during the dot-com bubble. There are certainly reasons to expect less robust markets in the near term. But it hasn’t been easy on anybody with a bearish stance.
Since risks are elevated, we intend to begin hedging soon via shorting ETFs (for accounts that have authorized short selling) or buying inverse long ETFs which mimic short selling. Because the business cycle peak may still be months away we will move slowly. We are trying to best time our hedges and are pleased that we have yet to initiate any given the markets are higher than when our TECTM triggered its U.S. recession alert in March.
This indicator, designed following the Great Recession to alert us to business cycle peaks, would have warned us about the past 7 recessions about 290 days in advance. Though that would place the peak of the cycle early next year, there are a number of forces at work that could prolong this cycle’s peak. However, the market also appears to be at its FMV, and a ceiling in our TRACTM work, thus market upside from here appears somewhat limited over the short term.
And since fundamentals can erode quickly once the business cycle peaks, which would likely result in markets being overvalued, we want to at least be partially hedged against a bear market. The intent is to offset some of the impact from declining prices which is exacerbated during bear markets from the combination of declining FMVs and negative sentiment.
This cycle has had the slowest global economic growth rate in post-war history. And now, the data is showing further softening. The PCE, the broadest inflation measure, has dipped to 1.5%, well below the Fed’s 2% target. Therefore, the central bank will continue to be highly accommodative. After raising rates 7 times over '17 and '18, which culminated in the market sell-off into last December, the Fed has lowered rates 3 times this year. Because inflation is trending down and interest rates are so low, the Fed is looking for new means to ease and stimulate.
U.S. 10-year Treasuries remain low at 1.9%. And U.S. unemployment at only 3.5%, with outstanding job additions still taking place, continues to amaze. Wage pressures are beginning to creep in which needs to be watched because that could impact hiring. In all of the last several recessions, not only did the yield curve invert but the real Fed funds rate rose above 3%. Inversion occurred this year between March and October but the real Fed Funds rate has remained extremely low.
For a host of reasons disinflation is the secular trend and since few excesses are in place today we remain optimistic that the next recession could be relatively shallow. Especially since we simply aren’t experiencing the excesses we generally have at the end of cycles. This bodes well for a potential soft landing. While there are meaningful signs that the economy is slowing, there could be a lift from the 40-month inventory cycle which may have just troughed. This could provide a boost to manufacturers in the U.S. and elsewhere.
Meanwhile, the markets appear to be sluffing off issues such as fallout from Brexit, trade tensions with China, pro-democracy protests in Hong Kong, Chile, Lebanon and Iran, lacklustre retail earnings, impeachment proceedings, the left-leaning U.S. democratic nominees, record government debt and deficits and negative interest rates. So the stock market powers higher, bolstered by the prolonged economic cycle—twice as long as typical—and ultra-low interest rates.
© Trapeze Asset Management