March 5, 2019
The financial markets have been extraordinarily generous over the past ten years. From the cycle’s trough in 2009 to its peak in 2018, the S&P 500 and Russell 2000 increased 425% and 477%, respectively. Business results, on average, have also been robust with profits and margins improving considerably since the 2008-2009 recession. While it can be argued many of the variables contributing to the current environment are unsustainable – such as artificially low interest rates and ongoing debt accumulation – it’s been an undeniably impressive profit and market cycle.
In an environment with limited volatility and rising equity prices, many investors have decided to forgo active management in favor of a more hands-off passive approach. Passive investing, or simply keeping up with the benchmarks, has been rewarded and has grown considerably in popularity. Given that it’s been the longest and one of the smoothest market cycles in history, many investors have been questioning and even dismissing the benefits of active management.
Based on the success and popularity of passive investing over the past decade, it’s difficult to find a time when active management has been so out of favor. Possibly out of favor even more than active managers are absolute return investors who believe asset prices are overvalued and are patiently waiting for their opportunity sets to improve.
Given the current trends in asset flows, along with the past ten years of rising markets, some would argue it has never been more challenging to launch an asset management firm focused on absolute returns. But here we are, doing just that.
Brought together by our shared beliefs and passion for absolute return investing, we founded Palm Valley Capital Management to provide investors with an alternative to the growing number of strategies focused exclusively on relative returns. Unlike relative return managers mirroring a benchmark, style box, or peer group, we view investing, along with risk and reward, in absolute terms. Put simply, we love making money and hate losing it. We do not view relative outperformance as a success if significant client capital was lost. Conversely, we do not view performance that lags a benchmark a failure as long as we remain disciplined and are on track to meet our investment objective.
Our investment goal is simple. We are attempting to provide our clients with an attractive absolute return over a complete market cycle. As we seek to achieve this goal, we follow several important guiding principles. First, we will never deliberately overpay. Limiting large mistakes and permanent losses to capital (our definition of risk) is essential to generating attractive full-cycle returns. Buying assets priced above calculated fair value, in our opinion, is one of the most common and preventable investment mistakes that can lead to permanent losses to capital.
Refusing to overpay may seem simple, but in a world dominated by relative return investing, it’s not as easy as it sounds. For professional investors, the pressure to conform and participate in groupthink can be immense. During periods of consistently rising asset prices and expensive valuations, avoiding overvalued securities can cause a portfolio manager’s returns to lag his or her peers. The consequences of poor relative performance can be severe, including lost clients, declining assets under management, and even unemployment. We have experienced all three!
While the consequences of investing differently are real, we believe incurring risk to one’s career is preferable to placing an overvalued security in a client’s portfolio. Furthermore, as an independently-owned absolute return asset manager, we believe Palm Valley Capital Management is uniquely positioned to manage the business risk associated with investing differently and remaining disciplined throughout an entire market cycle.
In addition to having the discipline to invest independently, investment mandates must provide the necessary flexibility. We believe strict investment mandates requiring managers to remain fully-invested throughout a market cycle make it difficult to successfully navigate through periods of excessive overvaluation. Palm Valley is not required to maintain a fully-invested portfolio. Our investment mandate permits us to hold cash and invest patiently when we believe valuations are expensive and risks elevated.
Other portfolio constraints, such as requiring certain industry weights, can also restrict a manager’s ability to invest flexibly and avoid concentrated pockets of overvaluation. Palm Valley’s investment guidelines provide us with the necessary discretion to avoid sectors we perceive as overvalued during periods of industry euphoria. Past examples include technology stocks in 1999, financial stocks in 2007, and multiple sectors in 2018.
In addition to remaining patient and flexible during periods when we believe market and/or sectors are overvalued, our equity selection process is essential to helping us meet our absolute return goal. Over many years, we’ve developed a possible buy list of businesses that we believe are high in quality and can be valued with a high degree of confidence. Based on our experience, high-quality businesses that can be valued more accurately are less likely to incur large losses relative to our calculated valuations.
Maintaining a strict valuation discipline is critical to our investment process, contributing to our effort to limit valuation mistakes and permanent losses to capital. We believe the use of realistic valuation variables – sufficient required rates of return, normalized cash flows, and achievable growth rates – can reduce the risk of calculating an inaccurate business valuation. In our opinion, a rigorous valuation discipline is especially important during periods of overvaluation, when the temptation to manufacture opportunity by lowering investment standards is most elevated.
In our attempt to avoid large losses and permanent losses to capital, we also exclude companies from our opportunity set that possess both operating and financial risk. Examples include highly cyclical businesses with uncertain cash flows and over-leveraged balance sheets. By avoiding firms with both operating and financial risk, we believe we’re less likely to invest in businesses that will become distressed or enter bankruptcy. As one would expect, investments with an above-average chance of going to zero have no place in an absolute return portfolio.
As we seek to achieve our investment objective, it is important to have the ability and willingness to act opportunistically. When valuations become attractive to us and we think we’re being adequately paid to assume risk, we should. While we believe investing patiently is often required, we do not expect our portfolio’s cash levels to remain elevated throughout an entire market cycle. When we see attractive absolute return opportunities materialize, we expect to allocate cash and assume risk.
And finally, and most important, we are committed to managing money as fiduciaries. As fiduciaries, we have never – and never will – manage money with the sole purpose of getting hired and raising assets under management. Given our determination to achieve our investment objective, we will strive to defend client capital when necessary, even if it results in relative underperformance and fewer clients.
Our commitment to our clients and investment objective is well documented. Jayme Wiggins was released by his previous firm in September 2018 while remaining dedicated to an absolute return process and discipline. Eric Cinnamond returned capital in 2016 after the valuations within his opportunity set became so expensive that he did not believe clients would be appropriately compensated for risk assumed. And finally, Frank Martin has taken considerable business risk this cycle, as he attempts to defend client capital from the risk associated with what he believes to be a broadly overvalued equity market.
In summary, we are absolute return investors dedicated to seeking attractive absolute returns over a full market cycle. We are guided by our principles and beliefs, which include acting as fiduciaries, investing independently, and demanding an adequate return relative to risk assumed. We believe our ability to invest in a flexible manner (patiently and opportunistically), along with our emphasis on avoiding permanent losses to capital, place us in a favorable position as we seek to meet our absolute return goal.
Definitions:
S&P 500: The Standard & Poor's 500 Index is an American stock market index based on the market capitalizations of 500 large companies.
Russell 2000: The Russell 2000 Index is an American small-cap stock market index based on the market capitalizations of the bottom 2,000 companies in the Russell 3000 Index.
It is not possible to invest directly in an index.