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Iron Capital Insights

  • Iron Capital Insights
  • September 30, 2014
  • Chuck Osborne

Rear-View Mirror?

While the market just keeps churning and not really moving in either direction, there have been a few significant newsworthy happenings of late. The California Public Employees’ Retirement System, better known as CalPERS, has exited hedge funds; legendary bond manager Bill Gross was shown the door at the firm he helped create, Pimco; and the citizens of Hong Kong are protesting for the right to vote their leaders into office. What does all of this mean?

It is somewhat refreshing to see that CalPERS still has their rear-view mirror firmly attached and that they are still driving one of the nation’s largest pension funds steadily forward with their eyes focused steadily backward. Our longer-term clients may recall that hedge funds and other so-called alternative investments were a topic of one of our “Quarterly Report” articles  in 2011, “There is No ‘Alternative'”.

At that time CalPERS and other large institutional clients were moving earth and sky to get out of stocks and into anything that claimed to be alternative. They saw in the rear-view mirror that stocks, as defined solely by the stock of large companies headquartered inside the United States, had provided basically no return from 2000 to 2010. In the meantime endowment investors, such as David Swensen from Yale, had made solid returns investing in other types of investments.  So they copied him, except he said they were not copying him, at least not correctly.

Swensen’s genius was not that he just invested in things other than stocks. He invests looking ahead, out of the windshield. In 1999 stocks were extremely expensive, and therefore not likely to fare well going forward. The stocks of small companies did look attractive, as did international companies and real estate, among other things. These investments looked attractive largely because they were being ignored by the rear-view mirror crowd who, in 1999, thought it was a new world where valuations no longer mattered…or at least that was true until March of 2000. That same mentality saw the same suspects crowding onto hedge funds a decade later as if bull markets were never going to return. Of course, by that time those U.S. large company stocks had been ignored for a decade and now looked very attractive.

Almost five years into their big hedge fund experiment, CalPERS is admitting a mistake. The question is, are they making another? The time to hedge may be coming very soon.

It is hard to know if Pimco is one of the world’s largest and most sophisticated money managers or if it is a new reality TV show. Bill, I am sorry to inform you that you have been voted off the island. Yes, we know you are primarily responsible for building the island, and we all appreciate that, but please leave.

I know it must seem strange to those who have followed this story and who do not track managers the way we do. Star portfolio managers usually have large egos. They often are difficult to work with, and believe it or not their departures are often this ugly; but not often this public. I am reminded of when Jeffrey Gundlach left TCW to form Doubleline. That episode involved law suits, alleged pornography and drug use. It makes the Bill Gross episode seem somewhat tame.

Gundlach has gone on to do well as has his old firm, and I’d wager the same will be true for Bill Gross and Pimco. It does illustrate the difficulty of making prudent investment decisions. To do that one must learn to decipher what is important data from what is hyped-up noise. For example, The Wall Street Journal reported that $10 billion had already left Pimco. Think about this: The news broke on Friday morning and by the time The Wall Street Journal went to print Monday morning the infamous “person familiar with the situation” supposedly told The Wall Street Journal that Pimco has seen clients withdraw $10 billion. Pimco manages approximately $2 trillion, and much of that is in income-producing strategies. Frankly it would not surprise me if Pimco saw that much paid out on any given Friday. The same article said one of Pimco’s competitors estimated the total loss of Gross’ departure in a “research report.”  Perhaps research means something else to twenty-something-year-old beat reporters; either that, or the reporter’s editors know that “wild guess” is not going to sell as well as “research report.”

This is noise. It is good to learn to recognize it. We will treat Gross’ departure with the same seriousness we do all manager departures. No overnight “research,” no knee-jerk reactions and no spreading rumors that have no real bearing (and probably are either greatly exaggerated or just not true). This is what prudent investors do.

I always cringe when I see anti-capitalist protests. I cringe because in the vast majority of cases they know not what they do. I remember seeing interviews of the “occupy Wall Street” movement a few years ago in which some of the protesters were asked what they would replace capitalism with, and they stared blankly. They had no idea. Capitalism is the name economists gave to an economy based on freedom. The alternative is a command economy; an economy controlled by central powers. In the real world no economy has ever been completely free – with no rules whatsoever – and not even the Soviet Union could wipe out all voluntary trade, as black markets find their way in when rules get too tight. We live on a continuum either moving closer to freedom or closer to command.

Hong Kong has edged closer to freedom than just about anywhere else. This was especially true before the turnover of authority from Great Britain back to China, but China promised to keep things much the same. China may have a real problem:  Human history shows that economic freedom usually precedes political freedom. People able to control their economic destiny ultimately will want to control their political destiny. Just ask King George about the trouble he had with those New World colonies.

Students now swarm the streets of Hong Kong demanding the right to vote, since they go hand in hand – capitalism and democracy. Unlike those who protested on Wall Street, these students know what they want. They want democracy. This could be the start of something big; or it may not. It may just go away, but this is likely news. We could be talking about these events in Hong Kong long after Bill Gross has been forgotten, and while it may turn out well in the long haul, in the short term CalPERS may want to call back some of those hedge fund guys.

Prudence seems simple, but simple and easy are not always the same thing. It can be difficult to look ahead instead of at the past. It can be difficult to not get swept up in sensationalism. It can be hard to recognize what really matters, and that is what we strive to do every day at Iron Capital.

Chuck Osborne, CFA
Managing Director