This is the tenth piece in Seeking Alpha's Positioning for 2013 series. This year we have taken a slightly different approach, asking experts on a range of different asset classes and investing strategies to offer their vision for the coming year and beyond. As always, the focus is on an overall approach to portfolio construction.
Arne Alsin has been an investment manager since 1990. He received his law degree from the University of Oregon in 1984, worked as an accountant for the international accounting firm KPMG Peat Marwick, then got involved in investing. He is currently Lead Portfolio Manager at San Diego-based Alsin Capital Management.
Seeking Alpha's Jonathan Liss recently spoke with Arne to gain insight into his unique approach to stock picking.
Jonathan Liss (JL): How would you describe your investing style/philosophy?
Arne Alsin (AA): I call it Buffettology meets game theory. It starts with a comparison of price to value in the Ben Graham tradition. I figure out what NCR and Amazon (AMZN) and General Electric (GE) are worth, then I compare those calculations to what the stock market says they are worth. If intrinsic value exceeds price by a wide margin, I’m interested in buying. Needless to say, my investment performance is wholly dependent on my ability to properly identify mispriced stocks.
Beyond that, in 2009, I decided to get away from my earlier focus on turnaround stocks. I was a dolt for not figuring it out before: It’s far easier to outperform when you have the entire universe of stocks to choose from.
I first wrote in 2009 (PDF) that this was a “once-in-a-lifetime market,” about being able to crush the market averages (PDF), to “run circles around the S&P 500” (PDF). I’m sure it sounded like just so much chutzpah back then, but now I have the numbers to back it up. 10 of 10 of my picks for 2012 have beaten the S&P return by a wide margin, with four of ten up over 100%. I don’t know what the odds of that are, but my guess is it's quite remote. And I expect to beat the market again in 2013.
Another thing that’s really helped my performance has been the incorporation of game theory into my analytical process. I’ve changed quite a bit, from thinking that players in the market were often irrational, to the other extreme: Now I always consider my opponent to be fully rational, even clever. The stock market is not a zero-sum game, but at the level it really matters, at the point of transaction, whether it’s buying or selling, investing is a zero-sum game. That’s the way I look at it, a one-on-one contest, in which either the buyer or the seller is making a mistake. When I recommended buying NCR at $23 in my Top Ten column, if you acted on that tip and bought the stock, either you or the seller was making a mistake. In other words, if each of you were clairvoyant and could see the future of NCR, one of you would not make the deal.
This is why investing is an endlessly fascinating game: It’s a battle of wits between buyer and seller – one of whom is making a mistake – and it’s a game of incomplete information. It’s like we’re playing chess and we can see only half the pieces, so we have to make inferences and calculated guesses as to where the other pieces are.
Now, I’ll give you the secret to outperformance in the stock market: You’re engaging in a battle of wits, a one-on-one contest in a zero-sum game, and get this: You get to pick the battlefield. Investors don’t realize what an enormous advantage this is. I don’t have to be smarter than my opponent on Netflix (NFLX) because I don’t have to fight that battle. All I have to do is glance at the Netflix operating model and say, whoa, a middleman aggregator and distributor of content, I’m not going there. There’s too much uncertainty in how distribution is going to shake out, which means I can’t get enough of an edge on my opponent to justify risking my capital.
But there are a few battles where I’m quite sure I’m going to win, such as my Amazon pick in November. It’s a good example of how game theory can help your investing game. Not only do I know I’m smarter than my opponent when it comes to Amazon – as in most cases, my edge in Amazon involves opacity in the financials – but my opponents do not respect my position. If the bears respected my position, if they said, wait a minute, there are some sophisticated investors taking the other side, what exactly are they seeing? It could save them, but they don’t even bother asking the question. It’s just, you’re stupid, it’s selling at 1,000 times earnings. And all I’m saying is no, there’s more to it than that.
JL: As we approach 2013, are you bullish or bearish?
AA: I’m bullish for the next several years, to 2020 and beyond. I don’t think the market will put in a significant top until enthusiasm returns for stocks and complacency takes hold. We’re not even close to that yet, which is surprising, given how far the market has come from the 2009 lows. Investors are leery of stocks and I have to say, I can’t blame them. Scars from 2000’s Nasdaq meltdown still run deep, and when you layer on 2008-2009’s decline, in which numerous high quality stocks fell by 60% or more, it’s just too much for the average investor to absorb. It’s like the aftermath of the Great Depression, from which we lost an entire generation of investors who swore off stocks.
Funny thing is, it’s never been easier to make market-beating returns, but that doesn’t mean the average investor is interested. This is how much investors loathe stocks: They’d rather earn zero on their money than risk their capital in a company like General Electric, with its 3.25% yield. Remember, in the aftermath of the 1987 Crash, at least investors could get 7% money markets. Today, you get zippola. Value in the fixed income market is embarrassing – a bond market rout is highly likely to occur in the next few years – and yet money continues to pour into bonds and out of stocks.
Don’t get me wrong, I’m not complaining. This is an ideal environment for a money manager like me. It’s clearly a stock-picker’s market cycle, and for a reason: The competitive landscape is changing at warp speed and even the rate change is accelerating. Operating models are going from elite status to functional obsolescence almost overnight – at Best Buy (BBY) it happened over just seven quarters. Change is happening faster than the stock market’s discounting mechanism can adjust, creating lots of terrific opportunities.
JL: What do you feel are the major catalysts for the market in 2013 and beyond?
AA: First of all, I think we’re in a secular bull market, a bull move that started in March 2009, and will last into the 2020s. We have different catalysts now, of course, than we did in the 80s, but I think this cycle will be similar to the 80s in one respect: Like the 80s and 90s there will be intermittent, relatively innocuous bear cycles (down 20%), just scary enough to keep the masses from believing. Sentiment continues to be wary of stocks going into 2013. This pessimism will take years to unwind, which supports my case for a secular bull market.
My catalysts for a secular bull market lasting into the 2020s are as follows:
1. The infrastructure build-out in emerging economies is a powerful trend that will last a decade or more. In China, for example, they’re in the midst of the largest urban migration in the history of mankind - from 200 million people living in urban areas in 2002 to a projected 800 million by 2020.
2. America is becoming an energy powerhouse, which is about to be reflected in a lot more job creation and economic growth in 2013 and beyond. We will not only be energy independent in a few years, we’ll be exporting our energy abroad.
3. A rebound in housing. About 1.6 million homes need to be built every year for the next 10 years in order to meet demand, according to a recent Harvard study. We’re not even back to 1 million new homes per year yet, but the momentum’s clearly beginning to build, and when things return to normal, we’ll see surprisingly strong economic and job growth.
4. Efficiency and productivity gains that inure from technology. Understand what lies at the heart of wealth-building, and you’ll understand why business assets (stocks) are going to be a lot more valuable in the coming years; that is, wealth-building results from gains in productivity and efficiency – the ability to make a widget using fewer man-hours. It’s hard to see unless you step back from all the noise, but gains in efficiency are accelerating across the board. Like a forest fire, the credit crisis cleared out a lot of the growth-choking, nonproductive, speculative “debris” from the economic landscape. What is emerging is a healthier foundation for growth than we had before.
5. Valuation is a catalyst, too. Today you can buy many of the best businesses in the world for 10 to 12 times earnings – this is normal for the early years of a secular bull market. As the secular bull matures, you’ll see values migrate toward their long-term norm, or 14.5 times earnings. In the final years, PEs typically drift up to the high teens, as investors become more and more confident that there is no end in sight for the bull move.
JL: To which index or fund do you benchmark your performance? Has this changed recently, and if so, why?
AA: All of the indices are easy to beat in this cycle. I use the S&P 500 with dividends included (total return) for my personal yardstick.
JL: The data would seem to indicate otherwise. See this piece for example. In the recent 12 month period for example, “90 percent of all U.S. equities funds failed to beat their benchmarks in the rolling 12 months ended June 30.” Is it possible you’re matching up your picks with the wrong benchmarks from a risk perspective? How do you explain the persistent underperformance of actively managed funds?
AA: Most money managers are around average, which is what you’d expect, and because of slippage and costs, they’re going to underperform, on average. But that doesn’t mean there isn’t an anomaly out there. I expect to outperform in a meaningful way over the next several years, so maybe I’m a freak, I don’t know. I’ll put up the numbers, and let someone else figure out which benchmarks and all that.
JL: As a stock picker, you are assuming you can regularly beat the collective wisdom of Wall Street and outperform basic market benchmarks. With the widespread availability and rapid movement of information and ease with which individuals can now trade, how do you remain confident you can continue to offer clients value above just putting their money in low cost index funds?
AA: You’re right, I assume – or rather, I expect – to beat the market. Index funds are a great idea if you don’t have an analytical edge. If you have a definable and sizable edge, though, there is quite a lot of money to be made over and above market returns.
JL: How many stocks is too many to hold in a portfolio? How many is too few to be properly diversified?
AA: There’s not a hard and fast rule for me. I’m comfortable owning 10-12 stocks. When I get bearish, I add to cash, spread out my holdings to 18-20, though I don’t anticipate such a move anytime soon.
JL: What is your highest conviction pick heading into the new year and why?
AA: I have two: NCR and Amazon. Both opportunities are a result of complexity in their respective operating models as well as their financials, which is cool. The more complex the story, the better; it’s where I generally can get an advantage over my opponents.
JL: Finally, what advice would you offer a ‘do-it-yourself’ value investor in the present investing environment?
For investors, this environment is the polar opposite of the 80s, when you could invest in just about anything and you would have made money: stocks, bonds, real estate all did well - even cash paid 7% yields and higher during the first half of the 80s. Fast forward to today, and we’re looking at a completely different picture. I can’t make this any simpler: You should not invest in bonds. Period. Cash is an awful investment, too. There are two great investment opportunities right now: Stocks and real estate. And since I don’t have an analytical edge with respect to real estate, I’ll be playing the stock market game. Whatever your inclination, there’s a lot of money to be made in both asset classes over the next several years.
To read other pieces from Seeking Alpha's Positioning for 2013 series, click here.
Disclosure: Arne Alsin is long NCR, AMZN and GE.