<January 11, 2023>
One of my favorite routines is going out to breakfast with my son. We go once a week and usually arrive before 8 a.m. so we can get the early bird special! In addition to receiving a good value, I look forward to supporting one of Palm Valley’s holdings—WH Group Limited (WHGLY). Through its Smithfield Foods division, WH Group is a market leading producer of bacon.
There are few things in the world that baffle me as much as bacon. Of course, I think most of us can agree, it’s delicious. It’s how bacon is usually served that I have trouble comprehending. If you had to pick between soggy or crispy, how would you like your bacon served? Hands down crispy, right? And maybe I’m way off on this, but for me it’s not even up for debate. However, most bacon, whether on a club sandwich or next to scrambled eggs, is served undercooked, fatty, and limp.
My thoughts on bacon are similar to how we view investment philosophies. While there are many philosophies and strategies to choose from, most are served up in a relative fashion. In other words, they attempt to outperform “relative” to a benchmark. In the relative world, losses are considered a success as long as they're not as bad as the benchmark! In contrast, absolute return investing—how we define it—attempts to generate an attractive absolute return over a full market cycle. While we admit to being extremely biased, the difference between the two investment philosophies is equivalent to crispy and soggy bacon!
Compensation packages for relative return portfolio managers are often tied to relative performance. Beat your benchmark and receive a higher year-end bonus. Trail your benchmark and prepare yourself for possible outflows and lower revenue. And whatever you do, don’t look too different from the benchmark, as you may risk falling too far behind! Consequences for significant relative underperformance can even lead to termination. For instance, in 1999 if a manager was benchmarked to the S&P 500 and refused to overpay for technology and large cap growth stocks, relative performance suffered considerably, likely resulting in elevated career risk.
I knew several portfolio managers in 1999 that refused to overpay and allocate capital into what they believed was an out-of-control asset bubble. Many were fired and replaced with managers that would play along and invest with the crowd. For refusing to chase overvalued growth and technology stocks, disciplined value managers often found themselves in the unemployment line! Unfortunately for clients, many of the growth managers that took over eventually lost significant amounts of capital as their tech holdings crashed. All in the name of relative return investing, or soggy bacon.
The stock market bubble in the late 1990s was an intense but concentrated asset bubble. For the most part, it was contained to technology and large cap growth stocks. In fact, there were tremendous bargains in beaten-down “old economy” value stocks. When the bubble collapsed in 2000-2002, many of the remaining value managers actually generated positive returns even as the NASDAQ collapsed 78% from its high.
Unlike the late 1990s, we believe the current stock market bubble is much more broad-based. In fact, during the current bubble’s peak in 2021, most asset classes appeared significantly overvalued. In a world with extraordinarily expensive normalized valuations (the Shiller P/E reached 39x in 2021) and artificially suppressed yields (10-year U.S. Treasury note began 2021 yielding 0.93%), there were few suitable places for absolute return investors to allocate capital. During periods of unjustified asset valuations and undercompensated risk, we believe flexible and independent positioning is necessary. And most important, patience.
Whether it’s due to the risk of underperforming or the requirement to remain fully invested, many relative return managers (includes passive managers) lack the ability or incentive to invest patiently. This is true even during asset bubbles when patience is needed most. We’ve often wondered how fully invested relative return managers can uphold their fiduciary duty during asset bubbles. Even if a manager believes prices are significantly overvalued and the risk to capital is elevated, the pressure to keep up with a benchmark, or requirement to remain fully invested, may override the manager’s duty to invest in the best interests of clients. More soggy bacon.
Instead of defining risk as the potential loss of capital, relative return investors often view risk as the volatility of the price of an asset. The higher the volatility, the greater the risk. Viewing risk as volatility, in our opinion, does not properly capture the underlying risk of an investment, or in the case of equities, the underlying business. Throughout our careers we’ve identified many businesses that had stocks with below average volatility but above average risk. Remember Fannie Mae? It was one of the steadiest stocks around leading up to the Great Financial Crisis. Based on volatility, it was considered a low-risk investment.
Of course, Fannie Mae’s business had tremendous risk, and its stable stock eventually crashed as plunging home values and rising mortgage defaults did not mix well with its leveraged balance sheet. As Fannie Mae illustrated, we believe risk measurements such as beta, standard deviation, and tracking error are inadequate and often spike after losses have already been incurred. More strips of soggy bacon.
Volatility measurements, in our opinion, also fall short in measuring one of the largest and most overlooked forms of risk influencing capital allocation decisions—career risk. If relative return investing has an advantage, it’s that it carries lower career risk. By investing like everyone else, or a benchmark, it’s difficult to be proven wrong relatively. And if you’re rarely wrong relatively, it’s difficult to lose your job as a relative return manager. While some may consider it job security, we view it as self-serving conformity and a disincentive to think independently. Another serving of soggy bacon.
Career risk can be reduced further by investment mandates that limit the portfolio manager’s ability to invest differently. Mandates include limits on cash and the amount sector weights can deviate from a portfolio’s benchmark. While mandates may reduce career risk, they can make it difficult for managers to avoid the risks associated with significantly overvalued markets and sectors. For example, in 2006, the largest sector in the S&P 500 was financials. And what was the most expensive and riskiest sector in the stock market in 2006? You guessed it, financials! If a manager had a mandate limiting how much they could deviate from benchmark sector weights, financials were likely their largest holding heading into the Great Financial Crisis.
The risks of sector mandates were also exposed during the tech bubble. Given the largest sector in the S&P 500 in 1999 was technology, managers required to mirror benchmark sector weights were forced into the most expensive and highest risk part of the market. Of course, the timing couldn’t have been worse as technology stocks crashed the following year. Soggy bacon, indeed!
Investment mandates can also reduce a portfolio manager’s ability to act opportunistically when volatility in the market or certain sectors create value. For example, in 2020, we felt one of the most undervalued sectors was energy (Locking It In). However, it was the lowest weight in the S&P 500 (2% down from a 10% weight in 2006). If a manager had sector weight requirements, or limitations on how much cash they could hold, it was likely difficult to take advantage of the tremendous value in energy in 2020. We view the restrictions that inhibit relative return managers from acting opportunistically as another serving of soggy bacon.
Being wedded to a benchmark by relative return fears, career risk, and investment mandates, in our opinion, practically guarantees a highly correlated and ordinary outcome. If the objective is to achieve higher returns with less risk, we do not believe looking like everyone else, or serving soggy bacon, is the answer. Bacon, in our opinion, should be served crispy. From an investment perspective, we believe crispy bacon is best prepared when using a mixture of independence, flexibility, patience, and decisiveness. Crispy bacon may take more time and discipline, but when it comes time to enjoy your meal, we believe it is well worth the effort!*
*The views and opinions expressed on bacon are those of the author and do not necessarily reflect the official policy or position of Palm Valley Capital (Jayme prefers his bacon on the fatty side!).
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S&P 500: The S&P 500 Index, or Standard & Poor's 500 Index, is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S.
Nasdaq: The Nasdaq Composite Index is a market capitalization-weighted index of more than 3,700 stocks listed on the Nasdaq stock exchange.
S&P 500 Financials Index: comprises those companies included in the S&P 500 that are classified as members of the GICS financials sector.
S&P 500 Information Technology: comprises those companies included in the S&P 500 that are classified as members of the GICS information technology sector.
S&P 500 Energy Index: comprises those companies included in the S&P 500 that are classified as members of the GICS energy sector.
Shiller P/E: A valuation measure that uses real earnings per share over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle.
Beta: A measure of the volatility of a security or portfolio compared to the market as a whole. Stocks with betas higher than 1.0 can be interpreted as more volatile than the compared to index.
Tracking error: The divergence between the price behavior of a position or a portfolio and the price behavior of a benchmark.
Standard Deviation: A statistic used as a measure of the dispersion or variation in a distribution or set of data, equal to the square root of the arithmetic mean of the squares of the deviations from the arithmetic mean.