What follows is a section from the “Thoughts & Analysis” portion of my monthly letter to investors at T11 Capital.
Running Through Molasses
Being a bit of a stats nerd, it is not lost upon me that the past two years have been a run through molasses. We have seen periods of outperformance that quickly turn into periods of underperformance, leading to a whole lot of nothing accomplished when all is said and done.
New ideas have been extremely difficult to successfully implement as the market simply doesn't care. Most recently I have run through a host of investments that have turned out to be net losers, almost from the outset. Of course, the most beneficial decision when observed in hindsight would have been less activity in order to preserve profits. However, the decision to forgo opportunities I deem as being attractive can only be made in hindsight as there were no macro scenarios in my book of outcomes that had small companies underperforming in the manner they have over the past two years.
Since April of 2014, the Russell 2000 is down 5%. Worse still is IWC, which is the Ishares Russell Micro-Cap ETF down 12% over the same time period. Further, our longest running investment in the portfolios is down 29% since April 1st, 2014.
At the root of the two year malaise is a growing liquidity problem that has become increasingly apparent in recent months. There simply isn't market participation down past a certain level of capitalization. The lower down the capitalization scale you go, the less liquidity you face as an investor.
I like to say that T11 Capital is a discovery firm first. Meaning that my system of sifting through the thousands of names that populate the small-cap space occasionally turns up opportunities that very simply aren't on the radar of other investors, institutional or otherwise. This allows us to be first on the scene of companies that are sometimes selling at absurd valuations due to a series of transformative events that have gone unnoticed by investors.
What is occurring presently that hasn't occurred at anytime since the 2009 bottom is that the bar for taking notice of how these transformative events change the value proposition of the company has been set inordinately high. It used to be that growth in earnings while tempering fears of a negative event was enough to peak investor interest to create exceptional volume and some upside price movement. In today's market environment, it simply doesn't create the impetus for investors to act. These are very few bidding parties and the offers are extraordinarily heavy relative to how cheap some of these companies are priced.
This leads me to believe that investors are looking for liquidity more than they are opportunity. And if they gain liquidity by selling a stock that's cheap to an opportunistic investor, they are happy to accept the trade-off, opportunity cost be damned.
This type of pervasive mentality becomes dangerous to investors in the event of a rush to sell as logical support levels will be overwhelmed by those attempting to discover the “true price” of a security.
As spring turns to summer and the election for President comes into focus, I am expecting this issue of liquidity across all market caps, but especially small-caps, to become further enhanced. Price discovery for a vast majority of small company shares, when pressed by large sellers, will turn out to be quite a bit lower than where the current bid is quoted. This phenomenon of illiquidity will make for volatile, erratic trading conditions past spring.
I would expect that the inefficiencies of the market will become glaring enough by Q4 to attract opportunistic investors who will drive prices up quickly. Q4, however, is still a ways off and there is likely to be a long, winding road ahead to arrive at the happy destination.
Second Term Election Cycle
More than any election cycle in recent memory, the choice of candidate for next President is gaining world focus due to the most likely candidates being a Trump and a Clinton. The upcoming political hijinx that will be played out in front of a global audience will undoubtedly create an endless flow of headlines along with the accompanying ratings for hungry media outlets.`
The impact of what will be a vitriolic election cycle on the equity markets cannot be underestimated. With the specter of a Trump presidency, the markets will be starring in the face of glowing uncertainty, as his erratic views on corporate America and foreign policy deviate from any traditional party lines. The effect will, of course, be magnified among the global viewing audience who will then be making allocation decisions accordingly.
In any case, the summer and fall months leading into November elections have a strong possibility of being extremely volatile, with a pervasive downside bias. This opinion is not only due to the current mood of politics, but it seems that whenever a two term President is at the end of his term, the markets become fearful as dictated by negative performance.
Going back to 1928, looking at the final year of a two term President, the markets have lost on average 4%.
Of course, in recent memory during 2000 at the end of the Clinton presidency, the S&P lost 10% as Bush Jr. was eventually elected. After Bush Jr's second term had expired, the S&P lost 38% in 2008 ahead of the Obama presidency.
Going back further, at the end of Reagan's tenure in 1988, the S&P gained 12%. The caveat to 1988 is that the S&P crashed just three months before in October, 1987, ending the year near 25% below the highs made 6 months earlier. In other words, a good deal of whatever 1998 had in store for investors was taken care of in one swift blow in October of 1987.
At the very least, the data along with market action warrants being careful past May, as upside will likely be limited until Q4 in the midst of political jousting and policy uncertainty.
What To Do When Feeling Blue
In the face of what is rare pessimism on my part after being almost perpetually bullish for the past 5 years, the natural question is how I plan on handling such an opinion within the framework of a portfolio that I regard as being occupied by deeply undervalued companies?
The answer is not much. I will not be raising inordinate amounts of cash. I will not be selling short a basket of securities in an effort to hedge. I will, however, be hedging through one or two index/volatility positions in the coming months in an effort to dampen risk a bit during the perceived tumult that lies ahead.
There are numerous reasons why the expected value of making short to intermediate term decisions to liquidate a portfolio around expected downside volatility is a long-term negative:
- We are in decidedly illiquid securities that would be difficult to repurchase without driving the price substantially higher.
- Predicting the exact timing of any market bottom is extremely difficult, creating a significant possibility that I miss reallocating our cash into securities.
- I could be absolutely wrong about the coming downside, with the market moving consistently higher, while we remain underinvested.
- The companies in our portfolio contain a great deal of long-term value and I would like to stay focused on that fact above all other considerations.
- Even if I am absolutely correct in my assessment of generally negative conditions ahead, nailing a potential top and the subsequent market bottom, the emboldening of this strategy will eventually lead to substantial missed opportunities. In other words, if I am right now, I will be emboldened to act in the future, with the likelihood of being wrong increasing, resulting in missed opportunities or substantial loss.
The bottom line here is that simplicity creates the greatest long-term returns on capital. The more layers of decision making within any portfolio strategy the more the opportunity for an investor to make an error. You're essentially giving a highly sophisticated opponent - the market - the chance to outsmart you due to participating in far too many situations that you, as an investor, simply shouldn't be involved in.
This is exactly why there are many new daytraders but few old daytraders. This is why the average hedge fund only lasts a few years before shutting down. This is why the average investor ends up resenting the market due to an endless cycle of losses.
A system of investment that is built upon immediate access to liquidity creates the impetus to act when it is unnecessary to do so. As a result, investors are goaded into taking frequent, unnecessary action within a framework that encourages it only as a means of feeding itself. In other words, a system that is based on immediate liquidity needs to encourage liquidity in order to survive. Investors, unfortunately, all too frequently and unbeknownst to themselves are simply perpetuating the infrastructure to their own detriment.
I'd rather not perpetuate the infrastructure but rather, take advantage of it in the best way I know possible. To take advantage of it is to be an investor in companies, not the stock market. And on occasion, attempt to mitigate our risk profile through selling short a handful of ETFs. Anything more than this complicates the situation unnecessarily.
Regards,
Ali Meshkati
