High Valuations
Sector that trades at out of whack multiples
Hot IPOs
Retail Frenzy
Of these four factors, retail frenzy is missing!
Going forward, we will seek to focus on low risk investments while emphasizing capital preservation.
Although emerging markets are bargain priced by historical standards, we will maintain a
much more limited exposure to them in the future, including, as much as possible, an emphasis on
situations with catalysts for the realization of underlying value. Until the developed stock markets
retreat from record levels of valuation, we expect to have less portfolio exposure to equities going
forward and more exposure to event driven situations such as liquidations and reorganizations that
are not so dependent on the vicissitudes of the stock market for their investment return. Also, we will demand more compelling undervaluation than before to incur market risk. In the absence of appropriate
opportunities, we will hold increased levels of cash. Finally, while we still expect to hedge
against extreme conditions, the aforementioned combination of greater undervaluation, catalysts,
potentially higher cash balances, and hopefully better aligned hedges should result in much improved
performance.
It is evident that we are in the midst of a stock market mania, with the usual accoutrements: hot
IPO's, a market sector attracting enormous speculative activity (internet stocks), rising margin debt, (redux in 2014)
and the late 1990's innovation: at home trading via the internet. Most significantly, the prevailing
bullish arguments focus on momentum, money flows, and inevitability; valuation underpinnings are
not mentioned as part of the bull case.
Just as in the early 1970's, but perhaps even more pronounced, there has been a stampede to
own a "nifty-fifty", several dozen widely admired companies seeming to promise an investment utopia
of safety, stability, steady growth, and liquidity.
Finally, we do not believe the current market mania will end without the ending of its twin, the
mutual fund mania. U.S. equity mutual fund assets have surged tenfold since 1990, helping to fuel
the market boom. Overconfident individual investors, projecting the stock market's recent performance
indefinitely into the future, have developed a blind faith in the merits of equity investing, the
fundamentals notwithstanding. They have also developed supreme confidence in their own willingness
to remain invested in the face of unfavorable developments, a confidence reinforced by their
successful buying of the market's dips for the past 16 years (did not understand, is he saying don't buy market dips?). When the tide goes out, as it has in Japan
for the past eight years, money will flow out of the market and out of mutual funds (as it has in Japan);
buying the dips will significantly exacerbate the pain.
------------------------------------
We prefer to invest with a catalyst present to facilitate the partial or complete realization of underlying
value. There is, however, significant competition for these sorts of opportunities from other
investors, rendering many of them unattractive for investment; by contrast, uncatalyzed value situations
today attract few buyers. Seemingly, it would make sense to increase our commitment to the
deeply depressed uncatalyzed investments that are much more undervalued and where there is considerably
less competition. Our concern is that we cannot know when the current love affair with large
capitalization growth stocks will end, and what sort of havoc this will wreak on smaller stocks, however
inexpensive. As we have explained before, the only logical way to hedge against this risk is to protect an
investment in these undervalued smaller stocks with a put option on or short sale of more expensive
stocks. We have ruled out short selling for a number of reasons, including the unlimited downside risk
that short selling poses. With puts, at least, your cost is limited to the up-front premium. Such a hedge,
however, is historically quite expensive and, as we learned last year, far from perfect.
Our resolution to this dilemma is to position the Fund's portfolio in three parts.
A major component
is cash (held in U.S. Treasury bills and/or in a U.S. Government securities money market fund), at
around 42% of the Fund's portfolio at April 30. This asset is available to take advantage of bargains,
but represents important dry powder until some of today's market extremes resolve themselves.
Another segment, about 25% of the Fund's portfolio, involves numerous public and private investments
with catalysts for the partial or complete realization of underlying value. This includes
corporate bankruptcies, restructurings and workouts, liquidations, breakups, asset sales and the like.
These situations are generally purchased at expected annual returns of 15% to 20% or more. The
success of these investments depends primarily on the outcome of each situation rather than on the
level of the stock market. There can, however, be month by month fluctuations in the market prices
of these positions.
At April 30, we held about 32% of the portfolio in deeply undervalued securities with no strong
catalyst for value realization. Values in this portion of the portfolio are particularly compelling, with
prices at discounts of 30% to 50% or more from our estimate of underlying asset values. A number of
these positions are former spinoffs, ignored and abandoned in a market not oriented toward smaller
companies. Most of these situations involve partial catalysts for value realization such as ongoing share
repurchase programs and/or insider buying, but these limited catalysts offer only modest protection
from the short-term volatility of the financial markets. This category represents the lion's share of our
market exposure; this is generally the portion of the portfolio that we attempt to hedge. Frequently,
but unpredictably, investments in this category develop a stronger catalyst and move to the previous
category; indeed, the undervaluation itself often attracts such a catalyst. Less often, an investment from
the previous category loses its catalyst and either moves into this category or is sold.
Sector that trades at out of whack multiples
Hot IPOs
Retail Frenzy
Of these four factors, retail frenzy is missing!
Going forward, we will seek to focus on low risk investments while emphasizing capital preservation.
Although emerging markets are bargain priced by historical standards, we will maintain a
much more limited exposure to them in the future, including, as much as possible, an emphasis on
situations with catalysts for the realization of underlying value. Until the developed stock markets
retreat from record levels of valuation, we expect to have less portfolio exposure to equities going
forward and more exposure to event driven situations such as liquidations and reorganizations that
are not so dependent on the vicissitudes of the stock market for their investment return. Also, we will demand more compelling undervaluation than before to incur market risk. In the absence of appropriate
opportunities, we will hold increased levels of cash. Finally, while we still expect to hedge
against extreme conditions, the aforementioned combination of greater undervaluation, catalysts,
potentially higher cash balances, and hopefully better aligned hedges should result in much improved
performance.
It is evident that we are in the midst of a stock market mania, with the usual accoutrements: hot
IPO's, a market sector attracting enormous speculative activity (internet stocks), rising margin debt, (redux in 2014)
and the late 1990's innovation: at home trading via the internet. Most significantly, the prevailing
bullish arguments focus on momentum, money flows, and inevitability; valuation underpinnings are
not mentioned as part of the bull case.
Just as in the early 1970's, but perhaps even more pronounced, there has been a stampede to
own a "nifty-fifty", several dozen widely admired companies seeming to promise an investment utopia
of safety, stability, steady growth, and liquidity.
Finally, we do not believe the current market mania will end without the ending of its twin, the
mutual fund mania. U.S. equity mutual fund assets have surged tenfold since 1990, helping to fuel
the market boom. Overconfident individual investors, projecting the stock market's recent performance
indefinitely into the future, have developed a blind faith in the merits of equity investing, the
fundamentals notwithstanding. They have also developed supreme confidence in their own willingness
to remain invested in the face of unfavorable developments, a confidence reinforced by their
successful buying of the market's dips for the past 16 years (did not understand, is he saying don't buy market dips?). When the tide goes out, as it has in Japan
for the past eight years, money will flow out of the market and out of mutual funds (as it has in Japan);
buying the dips will significantly exacerbate the pain.
------------------------------------
We prefer to invest with a catalyst present to facilitate the partial or complete realization of underlying
value. There is, however, significant competition for these sorts of opportunities from other
investors, rendering many of them unattractive for investment; by contrast, uncatalyzed value situations
today attract few buyers. Seemingly, it would make sense to increase our commitment to the
deeply depressed uncatalyzed investments that are much more undervalued and where there is considerably
less competition. Our concern is that we cannot know when the current love affair with large
capitalization growth stocks will end, and what sort of havoc this will wreak on smaller stocks, however
inexpensive. As we have explained before, the only logical way to hedge against this risk is to protect an
investment in these undervalued smaller stocks with a put option on or short sale of more expensive
stocks. We have ruled out short selling for a number of reasons, including the unlimited downside risk
that short selling poses. With puts, at least, your cost is limited to the up-front premium. Such a hedge,
however, is historically quite expensive and, as we learned last year, far from perfect.
Our resolution to this dilemma is to position the Fund's portfolio in three parts.
A major component
is cash (held in U.S. Treasury bills and/or in a U.S. Government securities money market fund), at
around 42% of the Fund's portfolio at April 30. This asset is available to take advantage of bargains,
but represents important dry powder until some of today's market extremes resolve themselves.
Another segment, about 25% of the Fund's portfolio, involves numerous public and private investments
with catalysts for the partial or complete realization of underlying value. This includes
corporate bankruptcies, restructurings and workouts, liquidations, breakups, asset sales and the like.
These situations are generally purchased at expected annual returns of 15% to 20% or more. The
success of these investments depends primarily on the outcome of each situation rather than on the
level of the stock market. There can, however, be month by month fluctuations in the market prices
of these positions.
At April 30, we held about 32% of the portfolio in deeply undervalued securities with no strong
catalyst for value realization. Values in this portion of the portfolio are particularly compelling, with
prices at discounts of 30% to 50% or more from our estimate of underlying asset values. A number of
these positions are former spinoffs, ignored and abandoned in a market not oriented toward smaller
companies. Most of these situations involve partial catalysts for value realization such as ongoing share
repurchase programs and/or insider buying, but these limited catalysts offer only modest protection
from the short-term volatility of the financial markets. This category represents the lion's share of our
market exposure; this is generally the portion of the portfolio that we attempt to hedge. Frequently,
but unpredictably, investments in this category develop a stronger catalyst and move to the previous
category; indeed, the undervaluation itself often attracts such a catalyst. Less often, an investment from
the previous category loses its catalyst and either moves into this category or is sold.
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