“Golf is deceptively simple and endlessly complicated; it satisfies the soul and frustrates the intellect. It is at the same time rewarding and maddening – and it is without doubt the greatest game mankind has ever invented.” – Arnold Palmer, 1929 – 2016
Yesterday was a sad day for golfers and a sad day for the Wake Forest Demon Deacons, and since I am both, I’m sad. Arnold Palmer passed away on Sunday, and the legendary golfer and Demon Deacon will be deeply missed by both communities.
Golf, like most sports, can teach a lot of life lessons. If one were to take the quote above and replace the word golf with investing, and the word game with pursuit, then he would have pretty well summed up what it is like to be a professional investor. Simple yet complicated, rewarding yet frustrating…yep, that pretty much sums it up.
Just last week I welcomed a visit from the Chief Investment Officer of a New York-based investment firm that has a stellar long-term record but has been struggling in the recent environment. They are by no means alone. He was telling me that they have been losing clients and that the majority of them have been going to so-called passive index-based fund options. Of course this appears to be happening just as their results are improving. In fact, quarter to-date their flagship fund was well ahead of the index returns, but so many times decisions are made looking in the rear view mirror.
He and I lamented that we live in a world where few seem to ever slow down and ask the simple question, “Why?” For the last year and a half if not longer, the stock indexes have been delivering better investment results than the vast majority of quality investment managers. To be clear, I’m not talking about the average investment managers. Index true believers will tell you all the time that the index beats average. In other words, the index is usually a solid C+ student. However, lately the index has been getting an A+. Most people just look at this and say, “Those other managers are just too dumb to beat their benchmark.” We on the other hand want to ask, Why?
Why all of a sudden is the index beating the good managers? During Iron Capital’s 13-year existence, on average two thirds of the managers we use beat their benchmark for any given three-year period. Quality managers do exist, and they can be identified. So if they are smart when they succeed, did they all just simultaneously become dumb? I don’t believe that.
To get to the real answer one has to understand how an index return differs from that of an active manager. The return of a whole portfolio is simply the returns of the stocks of all the companies in that portfolio. If two portfolios differ in their returns, it is usually because they own different stocks. So, if the index is delivering better results this means that the stocks that are doing the best are stocks that no quality manager wishes to own.
That to me is a signal that something is wrong. The last time this happened was the internet bubble – that time when stock prices were being driven up by the excitement around the internet. Anything internet-related did well, while the stocks of other companies were ignored. Quality managers don’t typically chase pipedreams, so they didn’t keep up with the index. We remember how that ended. For a decade after the bursting of the bubble, almost every active manager (even the C students) beat the index.
Today it is all about the Fed. The Federal Reserve just met and decided to leave interest rates unchanged for now. That means record-low interest rates, and not just here in the U.S. Both Germany and Japan currently have negative interest rates – meaning that they are promising those who loan them money to pay back less than what they borrowed.
There are two beneficiaries of this policy. The most obvious is the dividend-paying stock. Retirees and other investors who need to produce income would normally invest in bonds. However, when bond yields are so low, they cannot produce adequate income to meet the needs of most retirees. This causes investors to abandon bonds for typical income-producing stocks, such as the stocks of utility companies. Many utilities are now selling for prices usually reserved for the fastest-growing technology companies.
The other area that has benefitted from recent Fed policy is the so-called FANG stocks. FANG stands for Facebook, Amazon, Netflix, and Google, but the phenomenon is not limited just to these four. Basically any company whose future is tied to either your mobile device and/or social media has seen its stock price rise. This is less obvious to many, but this is a result of low interest rates. Long-term interest rates are an indication of what investors believe about future growth. When our ten-year Treasuries are paying less than two percent, it indicates that investors believe growth will be less than two percent. In that environment investors look for companies they believe can grow regardless of economic conditions. The FANG stocks match that criteria.
Just like the late 1990’s, today all the stocks not meeting the criteria du jour have been ignored and that is where the quality managers find opportunities. Those opportunities can be rewarding, but it takes patience. In the meantime, the markets can be frustrating. There are signs that patience is beginning to be rewarded. My visitor last week informed me that I was the last stop on a three-day tour in Atlanta and I was the only one they met who was optimistic, which of course made me even more optimistic.
Arnold Palmer drew people to golf and to himself largely because of his optimism. There was never a spot on the course where he couldn’t see a way out. Sometimes this led to frustration, but it often led to reward. It was certainly part of what made him the King. We have been in a frustrating market, but the reward looks like it is coming. Mr. Palmer may have been talking about golf, but it could have been just as easily about investing, or for that matter life. Rewarding and maddening all at the same time, that just about sums it up.
Chuck Osborne, CFA