February 2018 IssueLong scroll reading

What You See …

By Edward A. Studzinski

“If you can’t annoy somebody, there’s little point in writing.”

       Kingsley Amis

These days, given the continuing march of new highs in the market indices, coupled with the ongoing extremes of most valuation metrics on individual securities, there is not a lot for a conservative investor to say that hasn’t been said before. What is different this time is the continuing flight from higher fee investment vehicles by both retail and institutional investors. And that money is flowing either into exchange-traded funds or passive index products (the popularity of which provides additional juice to the rising markets). I have said before that we know how this movie ends. It will not have a happy ending. I don’t know when, and I don’t know by how much. I just know it will not end well. And yes, I am fully prepared to admit that I have been too conservative over the last five years. But that ultimately is the difference between investment and speculation. And in the fund world, it is the difference between asset gatherers and investment managers.

What I would like to cover briefly are some of Byron Wien’s Ten Surprises for 2018. This past year in December, shortly before the list was released, I had the pleasure of sitting next to Byron Wien at a small dinner party in New York. He would not and did not discuss his list with me. But, he was willing to discuss the methodology that went into researching and constructing it every year. Wien for many years was the Chief Investment Strategist at Morgan Stanley. Wien left Morgan Stanley in 2009 and joined Blackstone as a senior advisor in its Private Wealth Solutions Group. Interestingly, Wien’s successor at Morgan Stanley had no interest in continuing the Ten Surprises franchise, so Wien was able to secure the use of the name for effectively nothing (another example of children wanting to kill their parents).

What is a surprise? Wien believes a surprise happens when the average investor ascribes a one in three chance of an event taking place. Wien however believes the surprises have more than a 50% chance of happening. There are also the small group of Also-rans, which have either a lower probability in Wien’s mind of occurring or, are less germane to the investor. In total, we have the Ten Surprises and Six Also-rans. I am not going to discuss all sixteen items, but only those I find most intriguing.

The first one that strikes me as important is Wien’s Also-ran #15. The FANG stocks continue to make new highs, while many other companies stand still. There is a lot of discussion about creative destruction, especially with hundreds of companies spending billions of dollars on r & d. Remember, creative destruction used to be the two guys in the garage in Silicon Valley. Now it is corporate America. What I find of major interest (and concern) as an investor, is that the rapid growth of Amazon and Google to name a few, could come to a screeching halt if only the regulators decided to enforce the antirust and anti-competitive laws on the books. We see a lot of enforcement coming out of the European Union. We would see more if BREXIT were not a front and center issue there. And here, a change in the administration or control of Congress could also result in more targeted enforcement.

Wien’s Surprise #6 is the prospect of rising inflation. We have seen it for some time now, particularly in the shopping basket. The combination of shrinking packaging and shrinking contents has been obvious to anyone whose grocery budget has been static for the last couple of years. Rising inflation means higher interest rates. And higher interest rates mean that bonds and certificates of deposit become decent competition for the dividend yield available on the S&P 500. That produces disintermediation from stocks, slowing and then reversing the rise of the markets.

Wien’s Surprise #5 is that oil hits $80 a barrel, and stays there. At this point, we are increasingly capable of supplying our own needs with domestic production. Could that come to an end, especially with increased demand from developing economies (read “China”), as well as disruptions in the supply chain. Conflict in the Middle East or terrorist acts in various energy producing areas around the world could throw a monkey wrench into the prospects of global economic growth. Those who blocked the completion of pipelines running down from Canada for environmental concerns may find themselves in an unpopular and untenable position.

Wien’s Surprise #4 is a real barn burner. The markets, given increased speculation, suffer a 10% correction, with the S&P 500 falling to 2300 but rebounding strongly by year-end. This is one I like myself. Since the beginning of the year, we have been seeing a melt-up in securities prices, extending the extremes in valuation. And yet, there are now increasing signs that not all is right. Many companies are selling out to foreign bidders. Managements continue to cash out as huge sellers of stock – the fleeing of the insiders.

What I am going to leave you with is this. In New York, excepting hotel room rates which seem to have come down thirty per cent from the end of last year, everything else is up. A year ago my restaurant tab for dinner would have been about 60% of what it was this December. And yet, the restaurants I was in were not full. I also saw lots of shuttered locations, because the rentals for those locations had reached a point where the fundamentals of the businesses could no longer support them. If our markets are this rubber band which is stretching out further and further, at what point does the rubber band snap, as in the dot.com craze?

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About Edward A. Studzinski

Ed Studzinski has more than 30 years of institutional investment experience. He was a partner at Harris Associates in Chicago, Illinois. Harris is known for its value-oriented, bottom-up investment approach that frames the investment process as owning a piece of the business relative to the business value of the whole, ideally forever. At Harris, Ed was co-manager of the Oakmark Equity & Income Fund (OAKBX). During the nearly twelve years that he was in that role, the fund in 2006 won the Lipper Award in the balanced category for "Best Fund Over Five Years." Additionally, in 2011 the fund won the Lipper Award in the mixed-asset allocation moderate funds category as "Best Fund Over Ten Years. Concurrently Ed was also an equity research analyst, providing many of the ideas that contributed to the fund’s success. He has specialist knowledge in the defense, property-casualty insurance, and real estate industries, having followed and owned companies as diverse as Catellus Development, General Dynamics, Legacy Hotels, L-3, PartnerRe, Progressive Insurance, Renaissance Reinsurance, Rockwell Collins, SAFECO, St. Joe Corporation, Teledyne, and Textron. Before joining Harris Associates, over a period of more than 10 years, Ed was the Chief Investment Officer at the Mercantile National Bank of Indiana, and also served on their Executive and Asset-Liability Committees. Prior to Mercantile, Ed practiced law. A native of Peabody, Massachusetts, he received his A.B. in history (magna cum laude) from Boston College, where he was a Scholar of the College. He has a J.D. from Duke University and an M.B.A. in marketing and finance, as well as a Professional Accounting Program Certificate, from Northwestern University. Ed has earned the Chartered Financial Analyst credential. Ed belongs to the Investment Analyst Societies of Boston, Chicago, and New York City. He is admitted to the Bar in the District of Columbia, Illinois, and North Carolina.