“And one other thing: you have to be willing to look wrong for a while.” -Howard Marks, Oaktree Capital
By now, most of you know when it comes to investing, we generally prefer active fund managers as opposed to passive, or index investing. Sometimes index funds work very well, such as the phenomenon of low volatility investing. And then there is the argument that index funds, usually in the form of exchange traded funds (ETFs), are less expensive and more tax efficient.
But as allocators of risk capital, yours and our own, it makes sense to study long term, high performing investment managers (or better yet, management teams) and compare them over time to their respective index. Markets usually move on three things: 1) global economic conditions, 2) corporate valuations and 3) investor psychology. It is at market tops and bottoms, when the “greed and fear” factors of investor psychology are at their greatest, that we see the most value being added by active managers. As markets go up, well, let the good times roll! And as they fall, well, things are bad and will never get any better. Indices mirror this human behavior, but good managers usually don’t.
It’s not news to any of you that the U.S. markets have been on an incredible bull run, both last year and through the first quarter of this year. This is despite a lackluster U.S. economy, which generally has been the best performing in the developed world. Our research leads us to conclude that our market has gotten ahead of itself, overbought, so to speak, and needs to rest. As I write this on April 5th, the jobs report widely missed the economic consensus forecast, so we are seeing the beginning of a pullback and the return of some volatility.
Some of the managers we employ stay fully invested during a downturn and use the volatility to either add to existing positions at lower prices or to pick up new bargains. But some, like the management team of First Eagle Global, slowly raise their cash position as the markets climb. The primary reason for this is that as the markets get more expensive, the higher prices conflict with their discipline and they can find nothing to buy that meets their value criteria. It is not unusual to see their cash allocation at 20 -25% of their asset base at a market top. This strategy of being disciplined buyers slows their returns slightly as markets reach for a top, but it also gives them a natural cushion as markets retreat. It also gives them plenty of “dry powder” to use as bargains become available in a lower market. This strategy is one that has worked well for them for over thirty years, and is most “un – index” like, but tends to smooth the jagged tops and bottoms of the market.
We know that index funds, whether they cover a broad market index or a tiny sliver of an individual market sector, are a daily reflection of the markets’ progress. This must be correct because it presents a summation of not only global economic health and individual corporate health, but also a snapshot of the underlying investor sentiment that day. Yet we also know that our active managers have choices: they can choose to hold what they consider are the best stocks or bonds, or can hold abundant cash if need be. Because of these choices, good active managers tend to outperform over long periods of time, and often do so with much less market risk.
In closing, if we go back to Howard Marks’ quote about “looking wrong”, we often do. We are willingly to “look wrong” sometimes in order to achieve good long term results with less risk. As always, thank you for being clients and for your continued confidence in the Longview team.
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