2019 Half Year Commentary

by | Jul 9, 2019 | Market Commentary

Investment management attracts some of the smartest people in our society. This produces high levels of competition (with the potential of fame and glory) for those able to forecast the next crash or pick the next Apple. These very smart experts, however, have a very spotty track record.

In fact, the Wall Street Journal recently published an interesting article showing how wrong the average economist was in predicting the 10-year treasury yield (read it here). In January, 2019 the average expectation was 2.96%. As of June 20, 2019, the actual yield was 1.98%. The difference between forecast and actual may look bad, but it’s fairly normal. Most of the expert prognosticators we see on TV tend to do worse than random over time. That means they are right less than 50% of the time!

Don’t hold the poor forecasting results against the experts.  The game they are playing is very hard to win. It’s played by some incredibly smart people all using the same basic models with the same data sources.  And it is very short-term. Most difficult of all, economic and market outcomes depend on many factors and unless they are properly weighted it’s hard to produce a good answer.

With increasing levels of complexity and stiffer competition, winning the forecast game is hard.  And every stock or bond selection comes with a forecast. As we build portfolios, we look for what we call “edge”. Edge is the potential to be better than average.

We think there are four main sources of edge.  They are:

  1. Informational.  This is having better information than average. Possessing unique or undiscovered data can yield excellent returns.
  2. Analytical. This is using information better than average. That means understanding the world in new and better ways.
  3. Behavioral.  This is behaving better than average. It is selling when others are greedy and buying when others are fearful.
  4. Structural. This is the ability to take advantage of other investor’s constraints.

To paraphrase Warren Buffett, whether it’s an investment or a business, think of edge as going to a parade and in order to see better you stand on your tiptoes. In only a few seconds, everyone else is on their tiptoes.  Whatever better view you had was immediately taken away. Edge is being able to stand on your tiptoes and not have anyone notice you.

Doing something profitable and having no one else notice is elusive. So, we take extra care to look for investments that may have above average potential.

That means uncovering lots of rocks.  It also means watching and inspecting potential investments closely.  Here is an example of a manager we’ve been watching for several years.

This manager has assets under management just over $20 billion and nearly 60 employees. They operate several strategies and the one that had our interest was their emerging markets fund. We first interviewed the portfolio manager and firm owner in 2016 before its launch.

The fund fit all our initial criteria: small size for structural flexibility, a long-term approach, co-investment from managers, concentration of holdings, and contrarian thinking. On the surface, this manager had the qualities we believe result in edge. Then, in 2017 they began to talk about how sometimes the market consensus is right and China Tech companies were worth owning. As the chart below describes, they plowed in as the stocks rose.  It looked right for a while.  Then it turned.  Worse, they did what we don’t like to see, they sold as the stock prices dropped.

At a review meeting, we asked them what happened.  They said the data changed and they changed their mind.  Maybe.  Despite the price drop, China Tech companies continued to grow rapidly and improve their market dominance.  At lower prices it would seem an even better deal, something to buy not to sell.

As shown in the previous chart they were completely out by October 31, 2018.  It may not be obvious, but this is the same date most mutual funds close their books for the year.  The technique to get losers out of the portfolio before reporting is called “window dressing”.  It’s a game manager’s play to avoid answering tough questions from investment committees. It also helps them keep assets.

Having watched this particular manager for a while, it seems to us they don’t always do as they say.  Now, at over $20 billion in assets under management they’ve likely lost the structural edge of being small and have shown to behave badly, negating any behavioral edge. It’s hard to make the case for investment, so we don’t.

Understanding how portfolios should be structured as well as the worth and potential value of individual elements of the portfolio is a requirement for long-term success.  We perform our analysis carefully and steadfastly so that, over time, the goals of all clients are met.  There are too many investments in the marketplace that are sold and not bought.  It’s our job to filter the noise and apply the principles necessary to achieve desired outcomes.

We are working on new ideas every day and we are regularly sharing our thinking through our email blog. Be sure to check your inboxes, we try to publish something new every two weeks.  If you’re not getting them, then we encourage you to sign up for the mailing list on the bottom of our website: www.kswrightassociates.com.

Here’s to a wonderful second half of 2019!


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