“Meh”, Again

Here are a couple updated charts courtesy of Aswath Damodaran’s latest data:

201901_Impl_Stdy_PE
Data Source: Aswath Damodaran
201901_Impl_Stdy_vs_FWD_PE
Data Source: Aswath Damodaran

I’ve posted similar charts before. These are a bit different in that I switched them over to use an implied equity risk premium and cost of equity derived from discounted free cash flows instead of dividends. The result is some moderation in the steady state multiple. However, the general trends in the data hold.

My reaction to the broad US market’s valuation continues to be “meh.”

Near as I can tell, at these levels you’re being roundabout fairly compensated for owning US equity risk. Yes, a near-term recession would send the market lower. But I’m not a recession forecaster, and I don’t adjust asset allocation on the basis of near-term economic data reads. The lower equities go, the more attractive the forward returns will become.

That said, if you pick individual stocks there are most definitely pockets of opportunity out there. It’s a great time to go bargain hunting if you were prudent about taking off some risk in the last couple years. Cash can be used to play offense as well as defense.

A World Of “Meh”

Right now, a lot of people are sitting out there trying to decide whether to dip-buy this market. They want to tick the bottom. Perhaps you are one of these people. In my own humble opinion, they are fools–fools engaged in a foolish game. Most will ultimately do more harm to their net worth than good, whipsawing themselves based on “sentiment” (a.k.a what they are seeing and hearing from the financial media).

For some perspective, I want to revisit forward-looking return expectations from a couple of different sources.

The chart below looks at prospective 10-year S&P 500 returns as a function of the equity share of US financial assets (a mouthful, I know). This is similar to the Buffett Indicator of stock market capitalization/GDP. The data runs through 3Q18, which is the most recent Z1 release from the Federa l Reserve.

(As far as I know, Jesse Livermore at Philosophical Economics was the first to do a deep dive into the efficacy of this model. David Merkel at Aleph Blog used to update it quarterly. Since David seems to have abandoned the project, I’ve decided to pick this up on my own)

SP_500_Proj_Return
Data Sources: Federal Reserve, Morningtsar

The predicted forward return bottomed in 1Q18, below 5% nominal. Since then, the proportion of equities to total assets has decreased a few points. This corresponds to a modest increase in predicted return over the next 10 years, to approximately 7%.

The second chart is an updated expected return bar chart from Research Affiliates:

201812_RAFI_10YR_ERs
Source: Research Affiliates

RAFI’s methodology is the simple model discussed in my post on investment return expectations. RAFI’s estimates are even less inspiring than the equity allocation model. Here US Large Cap is expected to return about 2.7% nominal over the next 10 years.

If we weight each forecast 50/50 to account for the inevitable errors and uncertainty, we get something like 4.8% as an expected return for US Large Cap Stocks over the next 10 years.

To which I say: “meh.”

This is neither a “run for the hills” number nor a “go all-in” number for someone whose investment strategy is oriented around asset allocation over a long time horizon. In fact, it’s rare to arrive at either of those conclusions from an exercise like this. Which is the whole point. For most of us, our reaction to most market moves should be “meh.”

Now, this certainly isn’t the only lens through which you can view financial markets. A trader or trend follower can safely ignore everything I’ve written here. Traders and trend followers are playing an entirely different game. Same for pure, bottom-up stock pickers.

However, most of us building portfolios for institutions and individuals are not traders, trend followers or pure, bottom-up stock pickers. We’re asset allocators who merely need to be directionally correct about the performance of a handful of different asset classes over a couple of decades.

How does a fundamentally-oriented allocator invest in a world of “meh?” 

I’d suggest the following core principles:

Balance. Never make “all-in” or “all-out” calls. Investing is an exercise in decision-making under uncertainty. It’s a probabilistic exercise, except we don’t know the “true” probabilities of the various outcomes. Only fools make all-in, all-out calls when making decisions under uncertainty. And yes, gunslinging hedge fund guys, fools who make all-in, all-out calls can become billionaires.

Prudence. Don’t reach for yield or return. Our world is overrun with yield pigs, but they’re generally not being well-compensated for the incremental risks they’re running to juice their returns. And yes, middle market private credit investors, that’s directed at you.

Flexibility. As Henri Poincaré famously said, “geometry is not true, it is advantageous.” Asset allocation is similar. You become overly attached to particular asset classes, strategies and their historical performance at your peril. And yes, “VOO for the long run” investors, that’s directed at you.

Creativity. If the financial markets are giving you “meh”, consider changing the way you play the game. For individuals, that could mean saving more, or starting a business to generate wealth through “real world” economic activity. For institutions, it’s tougher to make those kinds of changes, but mostly for political reasons.

It is a frustrating thing, to be stuck in a word of “meh.” But recognizing it and acting accordingly is a hell of a lot more productive than staring at your E-Trade account trying to tick the bottom for SPY.

Reaching For Yield

Are you a high net worth individual investor?

Are you feeling left out of the institutional yield chase?

Do you wish you could access the same esoteric, illiquid credits as pension funds and endowments?

If so, we may just have an investment opportunity for you.

Interval funds offer you, the high net worth individual, the full institutional investing experience. Not only do you get the high management fees and carried interest associated with traditional private equity investments, but as an added bonus you will invest through a seemingly liquid, mutual-fund like structure that is in fact subject to the vagaries of market conditions and the fund sponsor’s judgement.

That’s basically the pitch for interval funds. Interval funds are part of a larger growth trend for private credit and direct lending funds. Remember all the risky loans banks used to make prior to the financial crisis? Well, banks don’t make those loans anymore. They have regulation to thank for that. The risky loans didn’t go away, though. They just moved from bank balance sheets to private credit vehicles–unregulated hedge fund and private equity-like structures.

Up until recently private credit has remained out of reach of most individual investors. Interval funds are now being marketed as a way for a wider array of individuals to access private credit and even private equity. The idea is that a sponsor with expertise in these areas (like Carlyle) can sub-advise on a strategy that can be sold through a large asset manager with established retail distribution channels (like Oppenheimer Funds).

As you might guess I have several issues with interval funds. Here are the main ones:

  • You have know way of knowing whether the sponsor actually cares about performance or is just dropping mediocre deals into the structure to gather assets in a high fee product. I struggle to believe these sponsors are saving their choice deals for interval funds when they have longtime relationships with large, institutional investors to look after.
  • Illiquid things are being held in what is being marketed as an open-ended structure. This works right up until it doesn’t. In the event of a severe market dislocation these funds will suspend their repurchase programs and investors will be stuck.
  • In my view, you’re not being compensated particularly well for the risks you’re taking. Don’t take my word for it. Read the financials. Maybe you think 500-ish bps of spread is fair compensation for this kind of risk. Fair enough. But consider that JNK will give you nearly 400 bps of spread over 10-year Treasuries these days.

Here’s what the portfolio valuation disclosure for the Carlyle/Oppenheimer vehicle I’ve been linking to above looks like:

OPCIX_ASC_820
Source: OFI Carlyle Private Credit Fund Semi-Annual Report

This would be pretty typical for a private fund playing in credit such as a credit hedge fund. I have a mental rule of thumb for these things which goes like this: in a dislocated market, assume the fund will turn completely illiquid. Do not invest unless you’re prepared to live with the consequences.

The sales pitch for interval funds is straightforward. It’s yield!

There’s a pejorative term in the business for investors who chase yield without regard to risk. We call them yield pigs. And yield pigs almost always end up getting slaughtered.

We Need To Talk About Multiple Contraction

In light of recent market moves I wanted to revisit this post about discount rates and how they might impact valuation multiples (spoiler: it’s an inverse relationship). I think the post holds up pretty well. The key feature was this chart:

118_Implied_Cost_Equity_SP
Data & Calculation Sources: Professor Aswath Damodaran & Michael Mauboussin

Recall that there’s an inverse relationship between the discount rate and the multiple you should pay for an earnings stream. The discount rate has two components:

1) a riskfree interest rate representing the time value of money (usually proxied by a long-term government bond yield), and

2) a “risk premium” meant to account for things like economic sensitivity, corporate leverage and the inherent uncertainty surrounding the future.

Back in January I wrote:

By way of anecdotal evidence, sentiment is getting more and more bullish. Every day I am reading articles about the possibility of a market “melt-up.” If the market melts up it may narrow the implied risk premium and further reduce the implied discount rate. If this occurs, it leaves investors even more exposed to a double whammy: simultaneous spikes in both the riskfree interest rate and the risk premium. The years 1961 to 1980 on the chart give you an idea of how destructive a sustained increase in the discount rate can be to equity valuations.

I am reminded of this as I read this post from Josh Brown, featuring the below chart:

daily-shot-sp-attribution
Source: Bloomberg via WSJ Daily Shot & Reformed Broker

Taken together, this is a fairly vivid illustration of why the current level of corporate earnings matters far less than long-run expectations for margins, growth, and (perhaps most importantly) the discount rate.

(You do remember what’s happening with interest rates, don’t you?)

Assuming no growth, a perpetual earnings stream of $1 is worth $20 discounted at 5%.

Raise that discount rate to 10% and the same earnings stream is worth $10.

Raise it to 15% and the value falls below $7.

And so on.

Now, there’s no way to reliably predict what the discount rate will look like over time. The real world is not as simple as my stylized example. On top of that the discount rate is not something we can observe directly. The best we can do is try to back into some estimate based on current market prices and consensus expectations for corporate earnings.

So, what’s the point of the exercise?

First, I don’t think it’s unreasonable to expect some mean reversion when the estimated discount rate seems to lie at an extreme value. And yes, I counted short-term rates at zero percent as “extreme.” As the above attribution chart clearly demonstrates, multiple contraction can be quite painful.

Second, this should explicitly inform your forward-looking return expectations. Generally speaking, the higher the implied discount rate, the higher your implied future returns. There is good economic sense behind this. “Discount rate” in this context is synonymous with “implied IRR.” To look at a 5% implied IRR and expect a 20% compound return as your base case makes no economic sense. Assuming the implied IRR is reasonably accurate, the only way that happens is if you sell the earnings stream to a greater fool at a stupidly inflated price.

Do fools buy things at irrationally high prices?

Yes. Indisputably. All the time.

Does that make price speculation a sound investment strategy?

No, it does not.

“Multiple expansion” is just a fancy way of saying “speculative price increase.”

Likewise, “multiple contraction” is a fancy was of saying “speculative price decline.”

Private Credit Stats

Sometimes I hear people say we “deleveraged” following the 2008 financial crisis. Sure, the consumer may have deleveraged, but I can assure you there’s plenty of debt left sloshing around in the system. A bunch of it has moved from bank balance sheets to what can loosely be thought of as the hedge fund space.

We call this private credit or direct lending. It’s huge right now in the institutional investing world. Sometimes it feels like every scrappy hedge fund guy in the world is launching a private credit vehicle.

Today, I came across a great paper by Shawn Munday, Wendy Hu, Tobias True and Jian Zhang providing an overview of the space. If, like me, you’ve been inundated with pitch decks from private credit funds over the past couple years, you won’t find much in the way of new information. But the stats are worth perusing.

private_credit_aum
Source: Munday, et al
private_credit_Commits
Source: Munday, et al
pooled_MOICs_IRRs
Source: Munday, et al
IRR_by_vintage_year
Source: Munday, et al

If you are an allocator this is nice base rate data for the space. According to the pitch decks everyone is targeting a net IRR in the mid-teens. It doesn’t surprise me that the median IRR for the post-crisis era is closer to 10% than mid-teens.

Personally, I’m inclined think median returns over the next decade will look more like the 2006 and 2007 vintages. Anecdotally, I can tell you there are middle market deals getting done out there with six turns of leverage and 7% yields. Unless you’ve got warrant coverage, you’re not getting anywhere near 15% IRR on a deal like that.

That kind of behavior reeks of yield chasing.

And we all know what happens to yield hogs.

Eventually, they get turned into bacon.

3Q18 US Factor Returns

Below are my factor return charts, updated for 3Q18. As always, this data lags by one month, so it is technically through August 31. Note also that the more recent bout of market volatility lies outside this date range. It will fall inside the next update.

This one features more of the same. Returns to Market and Momentum continue to grind higher, leaving the more value-oriented factors in the dust.

At bottom I’ve added a snap of Research Affiliates’ latest factor valuations. They’re about what you’d expect given the return data, with Illiqudity (think VC and private equity) and Momentum at the high end of their historical ranges. Value remains at the low end.

It’s worth asking: what’s the point of this exercise?

To better understand and contextualize the following (thanks Rusty Guinn):

[T]here is no good or bad environment for active management. There are good or bad environments for the relatively static biases that are almost universal among the pools of capital that benchmark themselves to various indices.

For a diversified portfolio, the variation in returns is explained almost entirely by the aggregate factor exposures. You’d be surprised how many professionals are ignorant of this.

Now, some of that ignorance is deliberate. There’s a reason investment managers don’t often show clients factor-based attribution analyses. The data typically supports the idea that a significant portion of their returns come from the relatively static biases (“tilts”) mentioned above.

As an allocator of capital, it behooves you to be intentional about how your portfolios tilt, and how those tilts manifest themselves in your realized performance. This self awareness lies at the heart of a disciplined and intentional portfolio management process.

3Q18_rolling_avg_factor_returns
Source: Ken French’s Data Library & Demonetized Calculations
3Q18mkt
Source: Ken French’s Data Library & Demonetized Calculations
3q18size
Source: Ken French’s Data Library & Demonetized Calculations
3q18val
Source: Ken French’s Data Library & Demonetized Calculations
3q18mo
Source: Ken French’s Data Library & Demonetized Calculations
3q18_op_profit
Source: Ken French’s Data Library & Demonetized Calculations
3q18inv
Source: Ken French’s Data Library & Demonetized Calculations
201810_RAFI_Factor_Valuations
Source: Research Affiliates

Shenanigans! “Index Investing Distorts Valuations” Edition

Here is an oft-repeated meme that has begun to grind my gears. Here it is again, from the FT’s Megan Greene:

Passive investments, such as exchange traded funds (ETFs) and index funds, similarly ignore fundamentals. Often set up to mimic an index, ETFs have to buy more of equities rising in price, sending those stock prices even higher. This creates a piling-on effect as funds buy more of these increasingly expensive stocks and less of the cheaper ones in their indices — the polar opposite of the adage “buy low, sell high”. Risks of a bubble rise when there is no regard for underlying fundamentals or price. It is reasonable to assume a sustained market correction would lead to stocks that were disproportionately bought because of ETFs and index funds being disproportionately sold.

The idea that index investors cause valuation disparities within indices is a myth. It is mainly trotted out in difficult client conversations about investment performance. For the purposes of this discussion, let’s restrict the definition of “passive” to “investing in a market capitalization weighted index,” like the Russell 2000 or S&P 500. There is a simple reason everyone who makes this argument is categorically, demonstrably wrong:

INDEX FUNDS DON’T SET THE RELATIVE WEIGHTS OF THE SECURITIES INSIDE THE INDEX. 

It is correct to say things like, “S&P 500 stocks are more expensive than Russell 2000 stocks because investors are chasing performance in US large caps by piling into index funds.”

It is correct to say things like, “S&P 500 stocks are more expensive than OTC microcaps outside of the index because investors are chasing performance in US large caps by piling into index funds.”

It is demonstrably false to say, “NFLX trades at a ridiculous valuation relative to the rest of the S&P 500 because investors are chasing performance in US large caps by piling into index funds.”

Index funds buy each security in the index in proportion to everything else. Their buying doesn’t change the relative valuations within the index.

Here is how index investing works:

1. Active investors buy and sell stocks based on their view of fundamentals, supply and demand for various securities, whatever. They do this because they think they are smart enough to earn excess returns, which will make them fabulously wealthy, The Greatest Investor Of All Time, whatever. As a result, security prices move up and down. Some stuff gets more expensive than other stuff.

2. Regardless, the markets are not Lake Wobegon. All of the active investors can’t be above average. For every buyer there is a seller. If you average the performance of all the active investors, you get the average return of the market.

3. Index investors look at the active investing rat race and think, “gee, the market is pretty efficient thanks to all these folks trying to outsmart each other in securities markets. Let’s just buy everything in the weights they set. We are content to get the average return, and we will get it very cheaply.”

4. Index investors do this.

Despite what we in investment management like to tell ourselves, index investors are rather clever. They are trying to earn a free lunch. They let the active investors spend time, money and energy providing liquidity and (to a much lesser extent) allocating capital for real investment in primary market. They just try to piggyback on market efficiency as cheaply as possible.

In my experience, some index investors like to think of themselves as somehow acting in opposition to active managers. This, too, is demonstrably and categorically false. Index investors’ results are directly and inextricably tied to the activity of active investors setting the relative weights of securities within the indices. That activity is what determines the composition of the index portfolio.

It’s a symbiotic relationship. Index investing only “works” to the extent the active investors setting the relative weights within the index are “doing their jobs.” When the active managers screw up, bad companies grow in market capitalization and become larger and larger weights in the index. At extremes, the index investor ends up overexposed to overvalued, value-destroying businesses. This happened with the S&P 500 during the dot-com era.

Now, flows of passive money certainly can distort relative valuations across indices, and, by association, across asset classes. When it comes to asset allocation, almost everyone is an active investor. Even you, Bogleheads. Otherwise you would own something like ACWI for your equity exposure.

A running theme of this blog is that there are no free lunches. Someone is always paying for lunch. These days, it’s the active managers. But that doesn’t mean the passive folks will always enjoy their meal.