What follows is a section from the “Thoughts & Analysis” portion of my monthly letter to investors at T11 Capital.
Learning To Love Lumpy
Generally speaking, markets are sadistic tools for separating capital from those who are both emotionally and intellectually unprepared for the challenge at hand. As emotional individuals we are inherently unprepared for the primary challenge of inverting greed and fear instead of falling victim to the burdensome exertion of their influence during the most inopportune moments.
Secondarily, as individuals in an ever fast paced society, we are unprepared to remain patient in the face of constantly shifting value equations reflected in green and red ticks on a minute to minute basis five days per week.
Equity investors would be much better off, if like the real estate market, values were only available through expert appraisal which would only take place on occasion of a sale or borrowing on the asset. This type of structure would eliminate the need to obsess over price, which for the most part is inconsequential except for a few times per year.
The liquidity afforded by the equity markets, while being one of its most attractive attributes is also its greatest force for manipulation and the ultimate failure of the investor who dreams of Buffett like riches.
Buffett is famous for saying, "the stock market is a device for transferring money from the impatient to the patient."
Patience takes on a different meaning based on which sector you are invested in. For example, in large cap, widely traded equity names, patience means that you are subject to price manipulation on a much more frequent basis than the thinly traded, deserted names that I happen to favor. When the markets swoon as they recently did, large cap investors take on correlation risk as securities are largely lumped in same basket with the classic dumping of the baby with the bathwater taking place.
This correlation risk is a much less prominent feature of the micro/small-cap marketplace. The more off the run the security, the less an investor has to worry about correlation to the broad market indices. There is a trade off, however.
The lack of influence created by the broad market creates long periods of relative inactivity in small company names. And when the gains do come, they show up in lumps that total a few weeks of movement per year. The rest of their time is spent effectively grazing on a pasture waiting for a regrettable trip to abattoir or preferably, a blue ribbon at the state fair.
This tendency towards lumpy gains is as much a form of manipulation running counter-intuitive to prevailing human emotional and psychological tendency as volatility in a name like Google or Facebook. When an investor is faced with an asset that simply lacks activity all together, while surrounded by rapid increases and decreases in price all around in the top 2000 equity names listed on the US exchanges, it compromises the patient resilience that accompanied the original investment thesis.
Investors tends to become distracted easily by the seemingly endless array of opportunities encompassing Wall Street. The only solution for which I have found to be a strict adherence and belief in the long-term expected value of a certain edge which is not discovered easily or readily. Instead, it takes experience, mistakes and many years to develop an understanding of the importance of that edge and the long-term expected value gained from it.
Once that understanding takes place, it becomes relatively easy to focus on a small universe of names, unaffected by the virtual projectile vomiting of information that derails investors so frequently. It took me 15 years to understand and truly appreciate this one concept.
They Hate Us
“To a contrarian like me, constant advice not to do something almost always starts me quickly down the risky, unpopular path.” --- Michael Bloomberg
Being a contrarian by nature, I must confess that I had dreamed of this day. The day when my line of business would be so loathed by the general public that the mere mention of my occupation would draw scoffs and guffaws that would cause my inner-voice to assert that I am indeed in the right place. The day when I would mention stocks to highly-intelligent business men and they would only talk about the losses they have suffered at the hands of the markets, vowing to never invest in the public markets again.
That day is officially here. Six years into one of the greatest bull markets of our time, nothing can thaw the icy hearts of those who have had their bankroll broken at the hands of back to back debacles of the internet bubble collapsing, followed by the debt crisis that almost took us back to the stone age. They only remember the pain and that pain won't allow them to move forward.
Perhaps the greatest demonstration of this is in the chart below. Courtesy of Tom Lee at Fundstrat the charts show that since 2007 net inflows into U.S. equities are a net zero. Meaning for the past 8 years, there has essentially been no new investment in U.S. equities as judged by the mutual fund/ETF complex.
As if we needed proof apart from the anecdotal conversations on a day to day basis, they do indeed hate us. The finance community has become a brain eating amoeba at the bottom of an algae infested pond.
Fortunately, the global capital markets being an enormous flow chart for wealth do not leave any imbalance undisturbed. Most recently, we have seen the effects of the imbalance that took place as investors during the past decade over-allocated into emerging market economies and the commodity products facilitating their rapid emergence. This imbalance continues to be unwound causing tremendous volatility in energy, metals and material names. Not to mention nearly sinking several emerging economies that were being heralded as the kings of a new world order just a few years ago.
We must assume then that the current imbalance which has rendered U.S. equities utterly repellent will be corrected at some point in time. What triggers that rebalancing to take place is anyone's guess. More importantly, the guarantee of that rebalancing taking place not only puts a floor beneath U.S. equities as we have experienced recently, but creates upside in U.S. equities that few are expecting or can even fathom at this juncture.
This is a message that I have been reiterating for some years now and will continue to reiterate for a number of years to come. The markets will not truly turn down until the point in time when they force the hand of everyone that loathes it at present. This can only be done as a function of overwhelming greed that occurs through wealth creation that is simply too generous to ignore.
Take your valuation measures. Take your technical measures of breadth and volume. Take your numerous statistics about a liquidity enhanced rally that is built on illusions. Take your fears of emerging market failures spilling over to the developed world. Take your data on hawkish Fed policy influencing bull markets. Take all of these measures that have been consistently failing investors during the entirety of this bull market and bury them.
The function of the markets, at its core, will always be emotional in nature. As a matter of emotion, how can there be a peak when a majority of capital is detached from the outcome completely?
Regards,
Ali Meshkati
