<November 3, 2022>
A long time ago, in a city far, far away, I was attending a company Christmas dinner. Employees were randomly seated at large round tables. I was fortunate and found myself at a table with lively conversations. Topics included the markets, sports, and movies. Our movies discussion was particularly enlightening as one of my colleagues was from California and a movie enthusiast. We had a lot in common, including our distaste for predictable mainstream movies. As movie contrarians, we preferred creative plots that would twist and turn in unexpected ways. My colleague was intrigued by my cinematic tastes and began to recommend some of her favorite independent films. Curious as to the depth of my knowledge and vast movie library, she asked, “So, what’s your favorite movie?” “Oh, that’s easy,” I said without hesitation, “Star Wars!” She laughed, rolled her eyes, and moved on to a more meaningful conversation across the table.
Released in 1977, Star Wars (later titled A New Hope) was the first of eleven Star Wars films. Throughout the series, the forces of good and evil battle for control of the galaxy. Leading the fight for good are the Jedi. Through their discipline and extensive training, the Jedi use the Force to protect, serve, and seek justice. George Lucas described the Jedi as “warrior-monks who keep peace in the universe.” Leading the evil are the Sith, who attempt to rule the galaxy through intimidation, oppression, and violence. The Sith tap into the dark side of the Force to fuel their powers.
For the Sith to achieve their goal of ruling over the galaxy, the Jedi needed to be eliminated. In the Star Wars movie The Revenge of the Sith, a Sith Lord, Palpatine, uses his clone army to seek and destroy the Jedi. The directive, called Order 66, succeeded in killing most of the Jedi, with the few surviving forced into hiding.
In a recent Bloomberg interview, David Einhorn was asked when value investing would make a comeback. He responded, “I don’t know if it ever comes back. There have been serious changes to the market structure and most of the value investors have been put out of business.” He concluded, “There are just very few of us left.”
We’ve often compared the remaining value investors to the Jedi in Star Wars—a once powerful presence in the markets forced into hiding! What happened? While Einhorn points to the growth in passive investing, we believe the spread of passive investing was a result, not the cause, of value’s demise. In our opinion, the near extinction of active value investing can be traced directly to the Federal Reserve and their overuse of unconventional monetary policy.
In November 2008, the Federal Reserve slashed interest rates and implemented its first round of quantitative easing (QE). Its experiment in digital money creation was a direct response to tightening credit and the collapse in asset prices. Additional rounds of significant quantitative easing were implemented in 2010, 2012, and 2020. As a result, the Federal Reserve’s balance sheet and the number of dollars in existence boomed.
With short-term rates pegged at 0% and the Federal Reserve aggressively buying Treasuries and mortgages, interest rates remained artificially low for over a decade. As rates remained suppressed, investors scrambled for yield and alternative sources of return. Asset prices soared, while market declines were brief and were often met with threats of additional policy response. Higher risk equities, such as growth stocks, did particularly well as investors took advantage of the Fed’s newly created liquidity and unspoken promise to backstop markets.
In our opinion, passive investing did not kill value investing. It was the prolonged period of artificially low interest rates and the unimaginable creation of money. In effect, it was an Order 66 equivalent implemented by the monetary Sith Lord, Darth Bernanke, followed by future orders from Darth Yellen and Darth Powell. Instead of cloning an army to fight the Trade Federation (Attack of the Clones), the monetary Sith Lords cloned trillions of dollars, flooding the financial markets, and destroying the value investor’s natural habitat (capitalism and free markets).
Without the cyclical ebbs and flows of the business and market cycle, the need for the discipline and skillset of the value investor was significantly diminished. Why hire a value manager when you can simply buy a low-cost passive fund and ride the wave of easy money? In such an environment, it shouldn’t be surprising that passive investing has put many active value managers out of business. The Investment Company Institute (ICI) detailed these trends, stating, “From 2012 through 2021, index domestic equity mutual funds and ETFs received $2.2 trillion in net new cash…while actively managed domestic equity mutual funds experienced net outflows of $2.1 trillion.”
As passive investing has grown, so has the career risk for the remaining active value managers. Keep up or else! While many value investors have called it quits, we believe others have capitulated to become growth managers or closet indexers just to stay in business. In effect, we believe many of the remaining active managers feel they must conform and buy stocks that are “working” or lose their jobs. And we’re not being critical. We understand deciding between maintaining your investment discipline and providing for your family isn’t easy!
Jeremy Grantham has long discussed career risk and its influence on portfolio managers and asset allocators. In his 2012 Q1 quarterly letter, Grantham wrote, “The central truth of the investment business is that investment behavior is driven by career risk. The prime directive…is first and last to keep your job.”
Grantham also discusses the career risk associated with holding cash. He writes, “Picking cash or conservatism against a roaring bull market probably lies beyond the pain threshold of any publicly traded enterprise.” In a January 2022 Bloomberg interview, Grantham was asked about holding cash after claiming U.S. stocks were in a “super bubble.” While Grantham said investors would “do pretty well by selling,” when asked about his firm going to cash, he had a different response. The interviewer asked, “Why doesn’t getting out mean, for GMO included, mean liquidating and going to cash?” Grantham replied, “I think commercially it’s too extreme to be brutally honest.”
Even Grantham, who believes U.S. stocks are in a super bubble, acknowledges that selling and going to cash is not commercially viable for most professional investors. We respect his understanding of financial history and his honesty.
Some investors believe a more viable solution to holding cash or hiring an active value manager is to invest in passive value strategies. While passive value funds typically have lower fees, we believe many currently carry underappreciated risk. Passive value strategies often use current earnings and book value to determine security selection. However, they do not consider the quality of earnings or net assets. Further, they do not analyze the profit cycle to determine if earnings are sustainable or inflated.
We believe normalizing earnings is extremely important at this stage of the profit cycle given our view that twelve-month trailing earnings for most companies are inflated. In our opinion, concluding a low P/E stock is a value can be very misleading, especially after a period of extraordinary profit growth, such as we’ve seen over the past 12-18 months. If, as we expect over the next year, the profit cycle transitions from an earnings boom to an earnings recession, many of today’s quantitatively-labeled value stocks will look much more expensive.
As the monetary Sith Lords have increased their control over the financial universe (markets), the population of value investors and portfolio managers willing to hold cash has been devastated. In such an environment, what are we doing? We are actively managing a portfolio of value stocks and holding cash. Instead of going into hiding, we are fighting central banks, passive funds, and the pressure to conform. We will not give into the dark side of overpaying and deviating from our discipline. Actively managed value and absolute return investing must survive the Sith Lords' Order 66. There is simply too much at risk and too much to fight for.
Eric Cinnamond
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Definitions:
Quantitative easing (QE): QE refers to monetary policies that expand, or increase, the Federal Reserve System (Fed) balance sheet.
S&P 600: The S&P 600 is an index of small-cap stocks managed by Standard & Poor's.
Russell 3000 Growth: The Russell 3000 Growth Index is a market capitalization-weighted index based on the Russell 3000 index that includes companies that display signs of above-average growth.
Russell 3000 Value: Russell 3000 Value Index is a market-capitalization weighted equity index maintained by the Russell Investment Group which measures performance of U.S. stocks in the equity value segment.