"If you never change your mind, why have one?" - Edward De Bono
If you are like me, you don't like to argue. This is somewhat ironic, however, as my main job as an active valuation-driven investor is to find those selective opportunities when I DISAGREE with the stock market. Disagreeing with the market is certainly not a task to be taken lightly, as it requires careful balance between confidence and humility. You must have the confidence to patiently wait for a stock's price to converge to its fair value, and the humility to change your mind when new information and/or analysis invalidate your investment case. This letter will walk through how we try to achieve that balance in a world that seems extremely polarized and uncertain in many ways, yet where the crowd is increasingly embracing the consensus when it comes to financial markets.
A critical first step is to frame the argument, and essentially reverse-engineer the set of expectations that the market has embedded in the price of a given security. This set of expectations forms the core of the market's argument, and we measure market expectations against a full range of possible outcomes: from the downside nightmare scenario to the ultimate upside dream scenario. Our valuation-driven process allows us to value a security across this range, and we frame our own set of expectations by assigning subjective probabilities to the full set of scenarios. A subjective probability simply measures our degrees of belief about what could happen, and a security is only mispriced if we disagree sufficiently with what the market believes. If the gap between our narrative and the market's expectations is narrow, we don't bet. We also will not risk capital unless the expected upside if we win the argument outweighs the downside if the realized outcome is even worse than what we and the market expected.
Most of the time, the market is good at framing expectations and exploitable expectations gaps are quite rare. Accordingly, picking too many fights with the market is a fool's errand. As importantly, our degrees of belief are not set in stone, but rather dynamically change as we gather new information, continually analyze data and observe events over time that influence our estimate of a company's fair value. This is a representation of Bayes' theorem, which systematically updates our existing or prior beliefs based on a set of observed data and conditions. The Bayesian framework is a critical tool for our process, as our assigned probability of a stock being mispriced is always dramatically less than 100%, and conditional shifts in probability are essential in fine-tuning our judgment. A key takeaway from Bayes' theorem is that if you assign a 0% or 100% prior probability to an event, no amount of evidence will change your mind: you are blind to data! Unfortunately, a fundamental driver of human behavior is to try and reduce uncertainty, and we are all naturally drawn to the seductive black-and-white clarity of a 0% or 100% probability. In markets and life, however, there is no room for certainty, and the probabilistic nature of markets is what makes overconfidence such a prevalent danger in investing. Bayes helps us navigate the grey middle, as we continually update our degrees of belief in a stock's value relative to a constantly changing market price.
Beyond a core process discipline in assessing individual stocks, a Bayesian framework can provide interesting observations of the broader world; including U.S. politics and the ongoing debates around record-low market interest rates and the popularity of passive investing.
Many Americans are frustrated by the polarized state of U.S. politics, and yet cannot comprehend how people in the other camp can believe what they believe. Ironically, this lack of comprehension is what is driving the polarity, and I'm also not sure the current state of politics is that historically extreme: this country did fight a Civil War and used to occasionally settle political rivalries through duels. The key here is that people with polarized political views, by definition, have degrees of political belief that are pretty close to the 0% and 100% probability extremes. In addition, when updating those already high degrees of belief, the Internet serves up an endless supply of confirming evidence that further drives belief divergence. This process is consistent with Bayes' theorem, but it highlights that Bayes does not make you right. Rather, the Bayesian framework simply calibrates your belief updates based on your prior beliefs and the new information you choose to observe. Beyond mandating that opponents must exclusively read each other's Facebook (NASDAQ:FB) feeds to expand the scope of new information, I'm not sure what would reverse the polarizing loop. The only bright spot is that expectations for the next administration are extremely low, but the risk is that low expectations are realized, while policy dysfunction continues to grow.
Despite policy dysfunction, a rolling series of sovereign crises and record levels of outstanding government debt, it has never been cheaper for sovereign governments to fund themselves. Before we provide a few narratives of how this could be, it's always good to look at historical data. Exhibit 1 shows the 10-Year U.S. Treasury yield since 1871. At the current 1.63% yield, Treasury yields have been higher more than 99% of the preceding 145 years! This extreme reading in the bottom 1% of observations holds true for all the major developed countries' 10-year government yields, which now include $9.3 trillion, or roughly 35%, of outstanding government debt in negative-yield territory.
Exhibit 1: U.S. 10-Year Treasury Yield (1871 to September 2016)
Extreme readings of this nature are often associated with asset bubbles, which are typically inflated by the collective madness of the crowd, excess capital and exuberance. Much of this holds true in the current environment, with the odd exception that this extreme reading is driven by pessimism. Mathematically, mean reversion argues for a bet on higher yields, but there are current beliefs and mechanisms that must be challenged for this bet to pay off. The risk of this bet is that valuation alone is never a good timing mechanism, and this is especially true when prices are unanchored from past norms. A good Bayesian must try to understand the current arguments and match them against observations. From a broad perspective, two major narratives are generally utilized to explain current yields and both capture deeply embedded investor pessimism despite U.S. equity markets near all-time highs:
- Central Bank Manipulation: Central bank buying and monetary experimentation have overwhelmed market fundamentals and pushed yields down to record levels. These policies may have kept us out of an economic depression following the Great Financial Crisis, but the result has been asset price inflation that is not sustainable and has driven populist anger through increasing wealth disparity. This anger will dominate policy agendas going forward, driving fiscal policy expansion and ultimately major market dislocations.
- Deflationary Debt Trap: The world experienced several decades of above-trend growth fueled by a massive debt cycle. The resulting buildup of excess credit has led to a series of economic crises, and the weight of outstanding debt has reached a level where marginal credit can no longer drive economic growth. The low resulting nominal growth combined with excess outstanding debt has boxed the world into a deflationary debt trap. Essentially, the model for the world is Japan, and we must endure structurally low growth and resulting yields for decades to come.
The reason why macro forecasting is almost always wrong is that these simple and linear causal narratives, like the 0% or 100% belief state, comfort us with a seeming clarity and understanding, but they fail to capture the true complexity of market and economic dynamics. In 1981, the embedded inflation narratives of the day sure didn't support a 35-year bond bull market, but change-events like Volcker do happen. All we can know is that yields are at extreme levels, and extreme levels ultimately get replaced by something closer to average. As the narratives inevitably change, the transition will not be fun for most investors, and we have to prepare for a wide range of possible outcomes, including the risks of both lower AND higher rates.
Popularity of Passive Investment Vehicles
What is really striking to us is that despite the uncertain nature of global politics, the extreme level of yields and resulting pockets of inflated assets, most capital is being allocated in full agreement with what the market currently believes. How so? Passive investing by its nature is "agreement capital." Passive investors do not quibble with what expectations are embedded in prices; on the contrary, they accept on the surface that the degrees of belief embedded in market prices are broadly correct. Given that the stock market goes up roughly two-thirds of the time and we have enjoyed a 35-year bond bull market, a passive strategy has had lots of merit. However, the market collectively loses its head with some regularity, as evidenced in recent history by the 1990s equity bubble and the Great Financial Crisis. In addition, capital flows to passive impact the very prices that are taken as an efficiently priced given: the 1990s equity bubble was aided and abetted by the first big wave of capital to indexing. We see similar risks today, with the proliferation of passive vehicles facilitating potential misallocation of capital. This is especially prevalent when the crowd chases past performance and floods increasingly narrow market niches, directly dislocating underlying security prices.
These dynamics make selectively disagreeing with the market more challenging than ever, and active managers must balance standing apart from the crowd with not getting overwhelmed by the flood to passive. However, if an active manager can balance these challenges through a disciplined process, the potential long-term rewards are mounting. In many ways, this active-to-passive shift is following a classic capital cycle: returns go up as capital flees a sector and competitive capacity is shuttered. To reverse this trend, surviving active managers must demonstrate a differentiated edge in driving returns, and crowding risk in passive must lead to disappointing outcomes. This potential is building, and we continue to find expectations gaps that lead to compelling disagreements with the market.
If So, So What?
The most prevalent opportunity for "disagreement capital" remains in the financial sector. The market's strongly-held belief in "lower-for-longer" on interest rates has kept many U.S. financials at attractive absolute valuation levels. The key part of our strategy is to own financials that have fortress balance sheets, are returning excess capital to shareholders that support dividend and buyback yields well in excess of the market, and are collectively earning returns on equity well above their cost-of-capital. During the quarter, we returned to a previously owned insurance name, Hartford Financial Services (NYSE:HIG), which sold down to levels below business value due to missteps in its auto insurance pricing. These pricing mistakes are fixable, and Hartford meets all the financial criteria we mentioned above, along with a nice upside kicker if we ever get higher rates. Many analysts consider the insurance stocks to be "unownable" in the current interest rate environment. To be sure, lower-for-longer is a real risk, but if rates ever do go higher, this argument will turn against many currently popular stocks, and what is shunned in financials will be prized.
We fully realize that a great attraction of a passive strategy is that as "agreement capital" it allows investors to win and, more importantly, lose with the crowd, which certainly lowers career risk for institutional investors. However, in a world of record low yields and mounting policy risks, the opportunities for capital that can stand apart from the crowd and exploit valuation opportunities is incredibly compelling. As always, having a different set of beliefs than the market requires an active investor to be disciplined in their approach, humble enough to acknowledge and manage inevitable mistakes and yet stand ready to seize great long-term opportunities when these are available.
Disclosure: I am/we are long HIG.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: All opinions and data included in this commentary are as of September 30, 2016 and are subject to change. The opinions and views expressed herein are of the portfolio management team named above and may differ from other managers, or the firm as a whole, and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Neither ClearBridge Investments nor its information providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.