Dear Fellow Investors:
Harry Markopolos was working for a hedge fund of funds and attempting to put a portfolio together that would “smooth” long-term returns. In the process of marketing what his company was doing, he ran into a client who already had a money manager doing that for him. The money manager the client used was Bernie Madoff. When Markopolous looked at the long-term track record of Madoff’s client, he instantly knew that it was mathematically impossible to have a return that high with as little year-to-year variance in the return. We at Smead Capital Management would like to ask a few questions. How do you legally “smooth” investment returns? What price do you pay to “smooth” returns? Why do we as long-duration common stock owners not care about “smooth” returns?
Over the last 12 years, we have observed that the primary means of smoothing returns has been diversification via wide asset allocation. By balancing your investments among US equity (small, mid, and large-cap), US bonds (Treasury, corporate and junk), foreign equity (large-cap and emerging market), foreign bonds (sovereign developed and emerging market), commodities (gold, oil, commodity indexes, etc.), and a wide variety of alternatives (private equity, hedge funds, timberland, farmland, commercial real estate, etc.) institutional and high net worth individual investors have attempted to smooth returns.
Stock picking organizations attempt to “smooth” returns via hedging, market timing, and excessive activity. Hedging can come through the use of derivatives, where put options are purchased or call options are written against existing long positions. Holding large cash balances during a decline can reduce volatility to the downside and retard rewards on the upside. High activity in equity portfolios occur as managers seek to avoid declines in existing holdings and seek “undervalued” securities outside their current holdings. The theory is that managers want to avoid large percentage corrections in their holdings by swapping into something which will be less volatile and/or perform better.
It seems apparent to us that the main price of smoothing returns is lower long-term performance. We believe that wide asset allocation mutes horrendous return possibilities while significantly lowering results. The idea behind wide asset allocation is to own non-correlated assets. We like to think of it as betting on all nine horses in a nine-horse race. You are sure of cashing a winning ticket, but whether you make money is determined by how much of a long shot your winning horse was. While you are muting the downside and inhibiting the upside potential, you are feeding many more people via the investment process. The asset allocator must be paid; each organization which provides an investment vehicle for participation in each asset class must get paid. One of our enduring theories is that the more humans between you and your money, the more returns are eaten in the process. Ironically, one of the most successful firms in wide asset allocation, GMO, has admitted recently that the success of wide asset allocation has damaged the benefit of the practice in a quarterly newsletter called, “We have met the enemy, and he is us”!
The cost of smoothing returns for stock pickers is high trading costs, no definable record of successful market timing, and big time sins of omission. The Boston College Center for Retirement Research study on mutual funds in 401k plans showed that the average large-cap equity fund used 1.44% of its annual return in trading costs. This comes directly out of reported returns and is separate from fund operating expenses. I personally have been in this industry for nearly 33 years and the supposed market-timing genius of the day changed every five years. It took me only ten of those years to conclude that nobody successfully times the stock market.
Lastly, high turnover and market timing lead to the most damaging cost of impatience and smoothed returns. The sale of what turn out to be your best performing stocks exacts a huge price on long-term performance. Warren Buffett explained this to students at the University of North Carolina on a YouTube video in 1996. When asked what his biggest mistake was in his career he said, “I sold Disney (DIS) in 1966 with a one-year gain of 50%”. He went on to tell the students that he “missed a 250-bagger” and the mistake has only become larger today. He owned 5% of Disney which he paid $4 million for in 1965. Today, a 5% stake is Disney is worth $4.75 billion. Just ask Steve Job’s estate attorney. Job’s was Disney’s largest shareholder via the sale of Pixar to Disney and his widow owns 7.25% of the company. Upon retirement from running T. Rowe Price’s “New Horizon” fund, lead manager Jack Laporte explained why he believed his fund had outperformed his competitors. “We just held our winners a lot longer than our competition”, Laporte said.
At Smead Capital Management, we believe that much higher returns are available to common stock owners over ten-year time periods by making no effort to “smooth” returns. The theoretical basis of the above average return offered by long-term common stock ownership is the fact that the historical returns weren’t provided in anything looking like a straight line. WE CONTINUE TO ASSERT THAT COMMON STOCKS EARN THE HIGHEST RETURNS AMONG LIQUID ASSET CHOICES BECAUSE OF THE VARIABILILTY AND VOLATILITY OF THEIR RETURNS. Anything reducing the difficulty in the process detracts from the wealth creation of the underlying businesses. The earnings, free-cash flow, dividends and smart capital allocation of the companies we own provides the wealth creation within time frames which are available to nearly all of us.
We view our job as focusing on three main tenets. One, valuation matters dearly when you purchase a common stock. Two, we want to own the business for a long time. Three, to do this we have to own a high quality group of companies to survive the volatility and variance which come with owning common stocks. Our goal is not “smooth”; our goal is to use the ownership of high quality common stocks to get wealthy over the next ten to twenty years.
The information contained in this missive represents SCM’s opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.
This Missive and others are available at smeadcap.com