Ryan O’Connor is a featured instructor at Best Ideas 2017.

“While knowing how to value businesses is essential for investment success, the first and perhaps most important step in the investment process is knowing where to look for opportunities” –Seth Klarman

Warning reader! You are about to embark on a journey where your guide is a self-proclaimed non-expert.  It will entail diving into the “murky” (albeit exciting and alluring) world of interest rates and other such macro musings. Caveat emptor!

The “meta” argument

So why the warning?  Well, two reasons:

First, I’m attempting to introduce you to my firm, Crossroads Capital.  To be clear, I’m not a macro investor and do not, as a matter of principle, make market or macroeconomic forecasts.  On the contrary, I’m a concentrated, often event-driven, value investor with a long-term orientation.  This means the vast majority of my day is spent analyzing businesses at the micro level — thinking about competitive landscapes, business models, value creation runways, barriers to entry, management quality, etc. I think of myself primarily as a business analyst, not a securities analyst, and certainly not a market analyst.  That said, from time to time, I do emerge from my piles of 10Ks and earnings transcripts to do a bit of thinking about the macro environment.

Secondly and more importantly, I’m attempting to advocate a general approach to macro that has served me well and that I believe other value investors should follow, namely “don’t overdo it.”  Macro is hard.  The proper approach is one of limited, due consideration, particularly with regard to the level of certainty you ascribe to your own conclusions.  Ask John Cochrane, Greg Mankiw, Larry Summers, and Paul Krugman for their opinion on interest rates and you’ll get four very different answers, despite the fact that all four of these economists are in a much better position than you (or me) to fully understand the issues.  Ask Michael Porter about competitive dynamics at the industry level, on the other hand, and you’ll get a clear, common-sense, easy-to-understand response.

Since macro is “hard” and I’m advocating a cautious approach, why write about it and not about a specific company or industry?  Well, despite it’s difficulty, I strongly believe macro should play a role in any good value investor’s process.  Pre-financial crisis, this was a point of contention in the value investing community, but my guess is I no longer have to advocate that stepping back from 10Ks and 10Qs from time to time is a worthwhile endeavor.

At Crossroads Capital, we generally use macro for two very specific reasons.  First, we use macroeconomic thinking to “narrow our search,” by which I primarily mean identifying areas of the market to avoid (and only secondarily identifying areas of the market to focus on).  Secondly, we use it for risk-management, i.e. understanding how potential plausible macroeconomic scenarios might affect our portfolio.  Needless to say, we don’t use macro to make directional bets on interest rates or the price of oil.  If you take only one thing away from this article, hopefully it will be the value of this measured approach.

So with the introduction aside, the rest of this piece is about two “macro” observations that currently inform where I am looking (or more accurately where I am not looking) for investment opportunities.

“Reach for yield”

According to Sidney Homer’s “The History of Interest Rates,” we are now in the lowest nominal interest rate environment of the last 5,000 years. In many parts of the world, bondholders are paying sovereigns for the privilege of lending money.  Clearly rates are “too low” and central bankers are to blame for bad policy in this regard, right?.  Well … maybe.  Despite the introduction of this section, I don’t intend to take a position on the “correct” level of interest rates.  Don’t get me wrong, whether or not interest rates are “too low” is an important question; it’s just not one I believe has an easy answer (macro is hard, remember?).

Just to provide a taste of how this question is less straightforward than it may seem, a couple of observations: On a real basis, both ex-ante and ex-post, interest rates in the US are actually higher now than they were in the 1970’s.  Moreover, the incredible income growth in certain developed markets with high savings rates (e.g. China) has significantly increased the supply of real savings, putting downward pressure on real rates, while at the same time demand for capital investment has fallen due to the business cycle (low global growth) and, perhaps more importantly, due to changes in “production technology” (firms today require less capital to grow; think Facebook vs. General Motors).  That said, I’m sure you’re familiar with a number of arguments in the opposite direction.  My point is this: I’m unsure of where interest rates should be at the moment, but despite this fact there is something important and practical to say about the topic.

Regardless of whether nominal interest rates are “too low” or “too high”, I believe their sustained low level is having a profound impact on investor behavior and is distorting markets.  Investors call this phenomenon “reaching for yield”, a term that likely requires little explanation for this crowd.

For the technically inclined, a few ways to get to the idea that (a) the level of interest rates might be “correct” yet at the same time (b) low nominal rates are causing distortions in relative asset prices are (1) “money illusion” (the average person poorly distinguishes between nominal and real values), (2) “debt overhang” (increases in nominal liabilities lead to more risk taking by borrowers), (3) “principal / agent problems” (a fancy way to say career risk and misaligned incentives amongst institutional investors), and/or (4) the complicated mechanism related to bank capital requirements mentioned in this article (a little too complicated to summarize here.).  In any case, despite not taking a hard stance on where interest rates should be, I believe sustained low rates have led to risk seeking behavior among a certain class of investors (“reach for yield”) and areas where this behavior most fully plays itself out are less likely than others to include great low risk, high-return investment opportunities.

Assuming you take the idea of “reach for yield” seriously, what does it mean concretely for a value investor?  My view, simply stated, is that the worldwide hunt for yield has led to an irrationally large increase in the demand for stable, income generating assets. This demand shock has resulted in the “bond proxy” category of stocks attracting a level of capital inflows that has far surpassed the level that could have otherwise been attractively invested in the space. In other words, I’m not spending a lot of time looking for value in large-cap, income-generating assets.  This phenomenon is particularly evident in defensive, dividend-orientated blue chips like Exxon (XOM) or Coke (KO) and other classic darlings of the yield crowd, e.g. utilities and REITs, but it applies more broadly to most “high quality” businesses with hefty dividends.

Given that sustained low nominal interest rates are my hypothesis for the cause of abnormally low risk premia in the category of assets described above, their relative overvaluation is likely to persist until nominal interest rates “normalize.”  I don’t know when interest rates will “normalize,” but I’m convinced these areas are not the best places to be spending time doing work right now.  Other areas of the market provide a higher probability of unearthing compelling value, assuming, of course, that your time horizon is long enough to realize that value via internal compounding in the underlying businesses but I digress.

The key takeaway is this: In a world where many “high-quality,” dividend-oriented “bond substitutes” have been bid up to levels that all but guarantee low future returns, the bargain hunting investor must learn to fish elsewhere if their aim is to add value in the long run.  This view doesn’t require holding a view on the “correct” level of interest rates.  It merely requires a view that “reaching for yield” is indeed, a real phenomenon.

Passive money

Now I would like to turn to another salient feature of today’s “macro” environment that is informing my search radius, namely the secular “mega trend” of passive investing.  Like persistently low nominal interest rates, I believe this development is leading to significant distortions in today’s equity markets.

According to the Investment Company Institute, index-like strategies have managed to attract a whopping $1.1 trillion in additional assets since 2007 alone. And as you may have guessed, this blistering growth in AUM has largely come at the expense of actively managed investment vehicles like traditional mutual funds, which have lost upwards of $835 billion in AUM over the same period.  To make the same point with slightly different data, passive ETFs and passive mutual funds have grown to a 38% share of total US equity market AUM in 2016, up from 12% in 1999 (based on CRSP data analyzed by these economists). Some investors, like Murray Stahl put the true share of passive management around two thirds of AUM, with the delta explained by a number of factors, including differences in disclosure and other reporting requirements, amongst others.  Regardless, the point is that essentially all of this share gain is coming at the expense of actively managed equity funds.

As an active manager myself, I should probably make clear that I believe passively managed indices are a good thing for most investors – if not always in practice, certainly in principle. The truth is that it’s extraordinarily difficult to find active managers capable of consistently outperforming the market.  It’s even more difficult to stick with them should you actually succeed.  Moreover, I’d be the first to point out that most professionally managed investment vehicles destroy value.  My advice to the average investor unwilling to put the work in to manage their own capital is nearly always: (1) buy a low cost index fund and (2) find a good psychologist (or “investment advisor”) to keep you from doing what 90% of retail investors do: enter late and exit early.

That said, the point of this section is neither to bemoan nor to encourage the shrinking of the active asset management industry, just as the point of the last was not to bemoan the Fed for keeping interest rates “too low.”  Rather, it is to understand how the reality of these secular trends is impacting valuations of significant categories of equities. Plain and simple.

After all, as all of this money has poured out of actively managed funds, active managers have been forced to sell down their investments in kind. Likewise, with upwards of $1.2 trillion finding its way into various passively managed investment vehicles over the last decade, the managers of index funds must follow a similar process, just in reverse. Active managers in the aggregate become forced sellers and passive managers in the aggregate become forced buyers.  As an aside, whenever you hear the terms “forced sellers” or “forced buyers,” you should get excited.

Note this buying is being done irrespective of valuation or other fundamental considerations, the very considerations that will ultimately determine the long-term returns of the securities in question. Even more pernicious, the buying is based on, in the case of the S&P 500 index, primarily market cap and float-related considerations.  In other words, assuming you believe markets aren’t always and everywhere efficient, index funds are by design overweight overvalued components and underweight undervalued components.

With that, let’s zoom out for a second and discuss two high level points worthy of consideration. First, putting over a trillion dollars to work in this fashion is no easy feat, if only because the number of big, liquid stocks capable of absorbing such a staggering amount of capital is limited. Naturally, this introduces the potential for rather large distortions in individual securities pricing, as trillions of dollars gets mindlessly allocated towards a narrow band of large, liquid stocks, continuously pushing prices up along the way. Second, any active manager that has avoided the securities attracting asset flows over the last few years has faced enormous performance headwinds.

The bottom line then is this: Since the financial crisis, the market’s structure has rapidly evolved, resulting in a dynamic where massive AUM flows into passive and yield orientated strategies are increasingly responsible for driving movements in securities pricing, thereby weakening the link between prices and fundamentals, which, given a long enough time horizon, can only be a temporary phenomenon.

Like sustained low nominal interest rates, it’s impossible (and perhaps foolhardy) to forecast when this trend will end, i.e. at what point the market share breakdown of passive vs. active management stabilizes; so I’m afraid I don’t have much useful advice for short-term oriented investors in this respect.  If you’re a long-term, high active share investor, however, — a rare breed among professional money managers these days — returns will ultimately be determined by fundamentals, not trends related to recent market dynamics.  Take advantage of that by searching where you’re more likely to find value for the long-run, i.e. in areas other than large, liquid, high yielding index components.

Conclusion

So what does all this mean, assuming you’re still with me?

For one, it means that one of the best things the risk averse investor can do in today’s climate is avoid a conventional investment profile.  When strategies become popular they rarely remain safe, and what’s popular today has been popular for nearly eight years running. So unless you are willing to bet on this bull market continuing indefinitely, beware. As always, it appears that achieving superior investing results in the current environment will almost certainly require the strength to diverge from the herd.

It also means securities benefiting from the recent rate- and index-related tailwinds should probably be avoided. These dynamics aren’t likely to end well over the long-run. In the case of index components in particular, given the magnitude of asset flows in relation to the small and finite universe of stocks capable of absorbing them, no one should be surprised by the potential fallout here.

Moreover, although I can’t predict the timing of these “forecasts” (timing is even harder than macro), I see a number of storm clouds on the horizon.  In fact, there is a decent chance that today’s various yield and index related distortions may already be in the process of unwinding. With interest rates rising ~1% point in past few months and a record $97.6 billion getting pumped into ETF’s alone since November (an indicator of the peak?), perhaps these trends will begin to reverse sooner rather than later.

Regardless, I think many of the most attractive opportunities in today’s markets will be found among smaller, less liquid, more volatile, non-dividend-paying names. Anything and everything that tends to be of no interest to either yield chasers or passive managers strikes us as a pretty darn good place to fish for great investments over the next 3 to 5 years. After all, superior investors go where the competition is not, and if that means anything in today’s environment, it means avoiding securities associated with two of the most crowded trades around.

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Meet Ryan O’Connor, Portfolio Manager of Crossroads Capital.