February 24, 2017
Volatility Is the Price You Pay for Returns
We recently had an exchange with an investor who asked us to tell him why he should continue to invest in Opportunity Equity. As our long-time followers know, 2016 was one of our worst relative performance years. The Strategy was roughly flat in a market up close to 12%, as measured by the S&P 500. Similar to previous periods of underperformance, many investors question whether they should continue to stay invested during these times. We consistently see that sell-offs like this are amazing buying opportunities; a point we emphasize to investors on the fence. In addition, despite our poor 2016, Opportunity Equity outpaced its benchmark, the S&P 500, 21.62% (net of fees)1 versus 14.66% for the five year period ending December 31, 2016.
This dichotomy between poor short-term performance and strong long-term performance bears noting for two reasons. First, we believe changes in market structure make it easier to construct portfolios that should do well over the long term, but also increase volatility in how excess returns will be earned (e.g. more extremes in under- and outperformance in the shorter term). Second, these performance patterns demonstrate important lessons on how to invest to maximize your chances of earning excess returns over the long-term. The short answer: buy high quality investments after periods of significant underperformance.
We’ve written extensively regarding changes in market structure. After the financial crisis, risk management exploded. New systems and structures for limiting downside volatility popped up everywhere. Risk parity traders, who target a set amount of “risk”, dynamically adjust their portfolios to market conditions. As prices fall and volatility increases, the measured “risk” increases so they sell. Other investors implemented other rules, such as stop losses (sell at a designated, lower price), designed to limit losses. The similarity between these different “risk mitigation” strategies is that declining prices alone force holders to sell. Since we know that market prices fluctuate more than the underlying value of assets, prices often decline far more than intrinsic business value, creating buying opportunities. As selling based purely on price, absent any fundamental inputs, has proliferated, the chance of inefficiencies has increased in our opinion.
At the same time, market participants who historically traded against the trend have been disappearing. Dodd Frank eliminated bank proprietary trading desks who had previously been able to profitably step into liquidity gaps stabilizing markets. Specialists on the floor of the stock exchange previously served a similar role, but they have been replaced with technology firms, widely known as high-frequency traders. Rather than providing liquidity, these firms employ pattern recognition software and small bid sizes to determine other market participants’ activity and trade against them. This behavior exacerbates rather than offsets trends.
Moreover, investors have shifted funds towards passive managers and away from active managers. Active managers buy assets because of some perceived market mispricing, whereas passive managers buy broad baskets of assets on the assumption of market efficiency. Active managers serve as price makers, while passive managers are price takers. As marginal capital flows away from players who attempt to exploit inefficiencies, overall market efficiency will eventually be impacted.
Anatole Kaletsky at GaveKal research recently wrote about how the combination of a shift towards passive management and the increase in strategies based on historical pattern recognition algorithms may be creating a market that’s less efficient at anticipating change.
Algorithms that are based on past market behaviour or economic correlations cannot, by definition, anticipate structural regime changes…. The more markets are dominated by passive trading that reacts to surprises in backward-looking economic and corporate data, the harder it becomes for forward-looking investors to hold large positions that try to anticipate policy changes whose impact may not show up in economic data and corporate results for months or even years. And the more these forward-looking investors are overwhelmed by passive strategies and algorithmic trading, the more reactive, as opposed to predictive, markets become.
All of these changes combine to make the market hyper efficient when it comes to the short-term trends. Markets price on trends and news instantaneously. Prices then mostly continue in the same direction as long as the trend remains intact. This also means that prices can tend to go too far in either direction. Reversals can be sudden and dramatic.
Take the performance of the big banks in the latter half of 2016. Banks lagged for years while it was clear that unless we entered a deflationary spiral, interest rates would eventually rise. We witnessed that in the second half of 2016, along with prospects for a better regulatory environment. An efficient market would have priced in some odds of this occurring in advance, especially as those odds increased in 2016. But it did not. Prices didn’t start improving until the trend reversed, reflecting what we call the “just-in-time” market. The largest six banks’ (JP Morgan, Bank of America, Wells Fargo, Citigroup, Goldman Sachs and Morgan Stanley) market values increased a whopping 48%, or $374 Billion, from Brexit through the end of 2016. That’s greater than the entire size of Exxon Mobil! This stunning move illustrates a reactive market, not an anticipatory one.
We believe this dynamic creates opportunities over the long-term. We find plenty of investments where ugly near-term trends have created a dearth of buyers and market prices significantly below our assessment of the intrinsic values. The challenge: poor price trends can continue much longer than expected and they correct only when trends reverse. Valuations provide no support. For truly long-term investors, this creates an amazing opportunity to build positions at attractive prices, but it pressures shorter-term performance.
My colleague, Bill Miller, has said that in his 35 years in the business, it is easier now to construct portfolios you have confidence will do well over the next 5 years, but more challenging to do the same for a 6-month horizon. In other words, volatility is the price you pay for returns in this market.
This is a trade-off we like and attempt to use to our advantage. We believe a patient, long-term, contrarian value mindset helps. We remain disciplined about evaluating the intrinsic value of businesses. Then we use price weakness to build positions. We believe this enables us to construct portfolios that have high odds of delivering strong performance over the long-term (5 years), as we did recently.
It’s clear that you achieve better results by buying at lower prices, yet people refuse to do it. After we had one of the worst months in our history in January 2016, we looked at other times the Strategy was down more than 15% in one month and what happened subsequently. In almost every case, it was a great time to buy for the next 1, 3, and 5 years. The average 12-month return after these months was a whopping 47%. We published a piece detailing these results and advocating using the weakness to buy rather than sell. Did people listen? Of course not. Our net redemptions continued. Yet, over the 12-month period ending January 31, 2017, Opportunity is up 20.6% (net of fees)1 versus the S&P 500’s 20.0%. When you find a good manager with a high quality process who has outperformed over the long term, it makes sense to add after periods of underperformance if the process remains intact.
We will continue to use these market conditions to create portfolios we expect to do well over the long-term. We think the market served us one of these opportunities last year in healthcare. We ramped the weight from 13.7% at the end of the third quarter to 17.3% at year end. Healthcare was the worst performing sector in 2016 as fears about regulatory pressure on pricing hurt the stocks. It screens as the only sector that trades below average historical valuations (so it’s no surprise we got interested). We added a number of new names, which are working out well so far. We also believe our airline, builder, tech and other holdings offer significant upside.
We are excited about the investment opportunities offered by this market and we will continue to work hard to capitalize on those for our investors.
1For important additional information on Opportunity Equity strategy performance, please click on the Opportunity Equity GIPS Composite Disclosure. This additional information applies to such performance for all time periods. Past performance is no guarantee of future results.
The views expressed in this report reflect those of the Miller Value Partners strategy’s portfolio manager(s) as of the date of publication, the date of the call. Any views are subject to change at any time based on market or other conditions, and Miller Value Partners disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.
©2017 Miller Value Partners