November 25, 2019 | François Sicart
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I recently looked back, and reviewed the performance of some of my longest managed portfolios that date back to the 1970s. I noticed that the accounts grew net of fees only slightly better than the S&P 500 index, though the returns, and the performance versus the index varied year to year. But that small outperformance through over more than 40 years of compounding did make a big difference to the owner families’ ending wealth.

My first observation is that while there obviously was an influence of the general market behavior on the performance of the accounts, there was no clear cycle correlation between the two. To some extent, this could be expected from a “contrarian” investment style, which often causes portfolios to underperform when markets are ebullient or in bubble-inflating mode, and to overperform in a pessimistic cycle or/and in the immediate aftermath of such an episode.

The second observation is that two distinct periods could be identified: the first twenty years, and the next twenty plus years. The returns were good over both periods, but the first period was clearly better while in the second period they started to resemble the index more. In that second period, we decided to involve a larger number of managers, while in the first, it was just me and one partner making all investment choices. As we added more (in-house) managers, the performance actually began to slightly fall behind that of the S&P 500 index.

I should mention that our decision to diversify the management team seemed logical in view of the size attained by the account, and I fully agreed with my partners on this. However, upon subsequent reflection, my intuition is that multiplying the number of managers tended to make the management team behave more like a “crowd,” and thus blunted the contrarian edge of the team.

The third observation is that the nature of our value/contrarian investment philosophy evolved progressively over the years.

In the ancient days before cheap computing power and widely available databases of corporate financial statements, value investing was predominantly a simple accounting exercise. Assuming you had ascertained that the reported earnings and asset values of companies were truthful (by carefully reading the footnotes to the financial reports first, as Ben Graham and Warren Buffett advise), you could calculate various ratios of value and liquidity with relatively little effort.

At that time, generally speaking, value investing and contrarian investing were nearly synonymous: a “value price” tended to be low in relation to fundamental statistics, reflecting the lack of enthusiasm of the investment crowd. This changed after the widespread adoption of personal computers and large, relatively inexpensive databases. For example, one of the most successful approaches used by Ben Graham, the Net Net Working Capital ratio, consisted of buying a stock trading for less than its current assets minus all liabilities. It became too easy to find those opportunities as a mere personal computer and access to a cheap database of balance-sheet statistics proliferated. The Internet further accelerated that transformation.

The fourth observation became apparent in the mid-1980s. Japanese companies were conquering market share from their U.S. competitors at a rapid and seemingly inexorable pace and were widely seen as destined to conquer the world. At the time, Japanese stock prices were in a major bubble as a result, and we did not own any. But this was in contrast with the cultural changes we were observing on our visits to U.S. companies.

We enlisted professors at leading universities to investigate this apparent contradiction. In particular, Prof. Robert Kaplan of Harvard University, a leading expert in management accounting, argued that the problem was that we were still using 19th-century accounting to measure the 20th-century performance and results of American companies.

A hundred years earlier, materials and direct labor represented the bulk of corporate costs. Accounting practice developed to allocate all other costs, or overhead, in proportion to these direct costs. But by the mid-1980s, materials and direct labor often represented only 10% or less of total costs in new and globally-competitive industries such as electronics. Because important competitive factors such as the costs of time or quality were totally ignored, our accounting tools assessed increasingly irrelevant measures.

This was an early sign that a novel way was needed to assess the corporate performance and profits of modern companies. Today, we label this type of company as “asset-light.” Such entities can often raise money at zero cost or reach astronomical stock valuations in spite of having no GAAP (Generally Accepted Accounting Principles) earnings. In addition, results can be massaged through various adjustments (EBITDA, or “Earnings Before Bad Stuff”). Not being able to ascertain the truthfulness of financial figures makes comparing market prices with estimated or calculated value much more challenging than in the past.

The fifth observation was that, whereas value investing had traditionally been a bottom-up exercise, the 2007-2008 sub-prime lending crisis and the ensuing Great Recession indiscriminately engulfed most financial markets into a cyclone-like turmoil. This made it clear that “macro” considerations should not be neglected altogether.

However, one problem in including macro considerations into our market work was that the past record of economists in anticipating recessions had been and remains dismal. In addition, there really is no clear correlation between GDP fluctuations and stock market behavior. Nor are we convinced by the long-term results of “technical” analyses – charts or others — of financial markets.

We had long been seduced by Hyman Minsky’s falsely simplistic financial instability hypothesis that crises are part of the normal life cycle of an economy. In other words, financial crises (and the often-associated recessions) need not be triggered by external events or influences: long periods of stability naturally breed instability by encouraging greater risk (debt) acceptance, which eventually leads to investment bubbles. The 2007-2008 crisis and its aftermath confirmed this intuitive attraction and the need for a contrarian macro approach to investing.

To heed our long-standing belief that “you cannot forecast but you can prepare,” the only discipline we could use to add macro considerations to our traditional bottom-up approach was to try and assess the psychological cycles of financial markets – an approach based more on observation than on measurement.

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In today’s environment, it could be argued that developed financial markets are generally high and overpriced. But they are not uniformly so.

There have been some examples of speculative, bubble-like moves like the FANGs (Facebook Apple, Netflix, Google) in 2018 and early 2019. Some of those were reporting very fast revenue and — sometimes — profit growth, but most of their popularity with investors derived more from momentum-following and extrapolation. It therefore tended to lose touch with fundamental values.

There also has been a plethora of cash available to venture capital and private equity, resulting in so-called unicorns (start-up companies valued at $1 billion or more while often still profitless). Until very recently, many of the resulting IPOs (Initial Public Offerings) were snapped up by investors as well – sometimes at even higher valuations.

The background for all recent speculative moves has been the global decline of interest rates to near zero or, in a growing number of cases, into negative territory! This has probably constituted the bubbliest area of financial markets, but many institutional investors (for regulatory reasons) and some individual investors as well (for whatever reasons) feel like TINA (There Is No Alternative) and desperately keep searching for the promise of some return.

Among the stocks which — although not outrageously overpriced in relation to prevailing interest rates — comprise a near-bubble of their own are shares of companies offering good dividend yields. If or when interest rates should recover to more attractive yields, this segment of the market will necessarily face headwinds.

In spite of these examples, we do find stocks that are currently selling 40% to 50% below their previous highs — a level that traditionally, subject to balance-sheet strength, is where one should start watching for a bottom. Financial history books are full of anecdotes about investors who made fortunes investing at major stock market bottoms. Most readers forget to ask where they found the cash to invest. The answer is: they sold well before the bottom (perhaps near the top?) and kept the cash until irresistible opportunities arose.

In summary, our traditional value/contrarian approach has gradually evolved into a contrarian approach with a value filter boosted by ample cash reserves to prepare for irresistible opportunities. That is how we are approaching investment these days.

François Sicart


This article is not intended to be a clientspecific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon. This report is for general informational purposes only and is not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally.