May 2019 IssueLong scroll reading

Asymmetric Investing

By Edward A. Studzinski

“If more than ten percent of the population likes a painting it should be burned, for it must be bad.” George Bernard Shaw

Where are we with one third of the year gone? Many domestic and international funds are showing year-to-date positive total return performance ranging from the low teens to just into the twenty percent range. The more instructive number is the total return performance looking back over one year. There many funds are still showing negative numbers, not having earned back the losses suffered in last year’s market debacles.

1442 mutual funds have trailing 12-month returns of zero or below, as of 4/30/2019.

Twelve funds, mostly in energy-related fields, have lost between 25-50% of their investors’ money over the past 12 months.

82 funds remain miraculously alive despite losing money over the entire past decade.

I must confess to feeling a good bit of schizophrenia currently. If you look back over the last twenty years of investing, from 12/31/1999 to 3/31/2019, the Vanguard S&P 500 ETF has returned annualized slightly more than 5.5%, with volatility in excess of 14.5%. While the numbers look slightly better through 4/30/2019, they are not barn-burners. Horizon Kinetics, an investment firm that is one of the better groups of asymmetric investment thinkers, posits an interesting question in their Q1/2019 Market Commentary piece. Specifically, if you knew then what you know how, would you have committed to that ETF investment? They point out that at year-end 1999 you could have purchased a twenty-year U.S. Treasury that would have produced a 6.8% yield to maturity. Or alternatively, you could have purchased a high quality closed-end municipal bond fund, exempt from Federal taxes, at a 7.3% distribution yield.

But that was then, and we are where we are now, which presents us with a very different picture. Through yesterday’s close, the metrics on Vanguard’s S&P 500 Index Fund (Admiral Class) show a trailing p/e of 19.9X, trading at 3.2X book value, and have a 1.98% SEC yield. Those are historically lofty valuations. If one is looking to retire in the next five years, do you want to assume that those valuation levels will remain intact? The argument for staying the course in equities is that the alternatives at present, although more attractive than in the recent past, are starting to back off from levels that one could find acceptable. Two-year certificate of deposit yields have dropped from 3% to the 2.8% area, intermediate U.S. Treasury yields are in the 2.3% range, and money market funds are also in the 2.3% range (as we hover around the possibility of an inverted yield curve).

Alternatively, one can construct a portfolio of dividend paying stocks that will throw off dividend income close to 4% and have some potential of increasing both the dividend income and intrinsic value per share over the next five years. It all comes down to time horizon, and not so much your tolerance for risk as it does your tolerance for not confusing the intrinsic value of a security with its market price. Those may most likely be two very different things.

Which brings us to the question of asymmetric investing. Much of what we see in funds today involves portfolios that frankly, look alike. The ten largest positions in the Vanguard 500 Index (VFIAX) are: Microsoft, Apple, Amazon, Alphabet, Facebook, Berkshire Hathaway, Johnson & Johnson, Exxon Mobil, JP Morgan Chase, and Visa, Inc., for which Vanguard charges 4 basis points as a management fee. Go to the effort, dear investor, of looking at your various funds and their reports to see what the top ten positions are in those. For instance, in the Vanguard Growth & Income Fund (VGIAX), which charges 23 basis points and is an actively-managed fund with three sub-managers, the top ten largest positions are: Microsoft, Apple, Alphabet, Amazon, Facebook, Johnson & Johnson, JP Morgan Chase, Merck, Home Depot, and Visa. Making this effort will give you some sense as to whether you are paying higher fees than you need to for what is in effect a closet index fund.

10-year correlation of VGIAX to VFIAX: 100

Alternatively, making this effort will allow you to identify those firms that are still trying to distinguish themselves from an index. For example, a review of the top ten holdings of the Dodge & Cox Stock Fund (DODGX) will show a very different listing and emphasis from what you see above.

And then of course, we still have Mr. Buffett. He was asked in a recent interview with the Financial Times of London (last weekend) how he expected the returns to differ going forward for Berkshire Hathaway, his investment holding company, with an investment in the Vanguard S&P 500 Index Fund, which he has suggested would be appropriate for most people. His answer was that he expected both to perform pretty much in line with each other. One suspects that represents a certain amount of false modesty on Buffett’s part. While Berkshire, from a market return perspective, has underperformed in recent years, the composition of its investments and operating businesses makes it the very example of an asymmetric investment now. And if its returns should end up approximating the S&P 500, how it gets there should be very different.

I am going to conclude by saying – look for funds or investments that are uncorrelated (not sitting on top of) to an index. Often there will be other similarities – firms with a relatively small amount of assets under management, firms with a nimble investment selection process, firms that are doing their own legwork rather than depending on either Wall Street research or what other investment firms are doing. Recognize that what the indices and recent bull market returns have told us is that things are pretty much priced in a such a fashion that perfection must occur going forward for these recent returns to be sustained.

“Valar Morghulis”

I heard the other day that Wintergreen Fund (WGRNX), under David Winters, is liquidating. To date I have not heard a definitive explanation. But a good guess would be lagging performance, asset redemptions, coupled with the illiquidity of the investment in Consolidated Tomoka, a Florida-based real estate company, which apparently ended up representing more than 42% of the fund’s assets at year-end 2018. Those of us in the Chicago investment community have long been familiar with Consolidated Tomoka, as it was a holding of a Chicago closed-end investment fund, Baker Fentress, that liquidated some years ago. The shareholder-owners of Consolidated appear to have been happy over the years with how it was managed. They were and are apparently resistant to change for the sake of change. The other noteworthy issue for Wintergreen was a well-publicized disagreement where David Winters raised some governance issues regarding Coca-Cola and one of its major shareholders, Warren Buffett. Here one saw a violation of the well-known dictum, “Don’t sword fight with Zorro.” It will be interesting as more comes out about this shuttering to see whether it becomes a learning event. Winters of course had his start as a manager of Mutual Discovery at the Mutual Shares group, under Michael Price. Winters was quite successful at managing what started as a small cap global value fund.

“Valar Dohaeris”

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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.