Market Commentary

Cash. One of the most misunderstood terms in investing (except lately, alongside “defensive” or “low volatility” sector investing, perhaps now one of the most dangerous places to be). The accepted modern approach to investing is to be all allocated all the time. How odd, since the greatest investors for their own accounts, ranging, alphabetically, from Warren Buffett and Carl Icahn through Wilbur Ross and Sam Zell, make generous use of cash. Cash is put at risk not any ol’ time, but only when they believe it will earn a suitable return. And they have plenty of it now. As do we. Having 25% or 35% in cash is a wonderful feeling when you see everyone else is ‘all in’, and it hasn’t had any noticeable negative impact on our performance this year. We believe when you’re in that position, you have a special advantage the market doesn’t.
For the first time since the late 1940s, stock and bond yields have essentially converged.  Once upon a time - say for the prior 80 years - investors demanded higher yields from stocks since the risk was greater.  So what does this mean?  If nothing else, caution is in order, and investors should be very thoughtful, perhaps more than at any other time in their careers, about where capital is being put at risk and why.
Which brings us to cash and public companies.  Cash earns effectively no income, and can lower various valuation metrics, which are surely also  important to executive compensation and performance benchmarking. As a result, many investors wish for the cash on the balance sheet to be deployed  -- a nice word for "spent" - through share repurchases, dividends, or acquisitions. But this is only a productive use of cash if the transactions are done at attractive valuations, and without taking on more leverage than appropriate. As is usually the case, well, take a look.
We’ve heard a lot about the historically low interest rates.  But what does this mean? First, by historic, we mean in recorded history, so we’re already, in a sense, footnotes in a future economics textbook.  Second, we really don’t want to be footnotes in a future financial markets textbook, as casualties of the greatest interest rate risk in history. But it appears that the potential impact from rising rates is underappreciated. The search for yield in all the ordinary places – long-term bond funds, REIT and utility funds, the ‘dividend aristocrats’ – is not diversification and it’s not safe. They’re at historic high valuations and it all hinges on interest rates.  One must escape them, which means to step outside the indexation/ETF vortex.
We’ve heard a lot about the historically low interest rates.  But what does this mean? First, by historic, we mean in recorded history, so we’re already, in a sense, footnotes in a future economics textbook.  Second, we really don’t want to be footnotes in a future financial markets textbook, as casualties of the greatest interest rate risk in history. But it appears that the potential impact from rising rates is underappreciated. The search for yield in all the ordinary places – long-term bond funds, REIT and utility funds, the ‘dividend aristocrats’ – is not diversification and it’s not safe. They’re at historic high valuations and it all hinges on interest rates.  One must escape them, which means to step outside the indexation/ETF vortex.
Keep hearing the phrase “historically low interest rates”? What do you think that means, exactly? Since World War II?  Since the Great Depression? World War I?   The Civil War? The War of 1812? What it means is “in the recorded history of mankind.” Meaning in the last 5,000 years. Near-zero and negative long-term interest rates, which are now a near-worldwide phenomenon, have never happened before.  That should arouse at least a moment’s reflection, should it not?  
Keep hearing the phrase “historically low interest rates”? What do you think that means, exactly? Since World War II?  Since the Great Depression? World War I?   The Civil War? The War of 1812? What it means is “in the recorded history of mankind.” Meaning in the last 5,000 years. Near-zero and negative long-term interest rates, which are now a near-worldwide phenomenon, have never happened before.  That should arouse at least a moment’s reflection, should it not? 
If it has ever been advisable to own idiosyncratic securities – which will rise or fall based on factors specific to each company’s circumstances – as opposed to widely-held stocks that will react primarily relative to systematic risks, now is the time.  Many of our portfolios benefited from idiosyncratic exposures this quarter: positions in precious metals royalty companies, a content company that will soon be acquired, and a self-liquidating land trust all appreciated significantly, and none is a significant holding in a major index. As we look to introduce new “orphan” securities to the portfolios, we are finding extremely attractive investment candidates in out of favor sectors and outside the indexation vortex – accept some trading liquidity risk and the market provides a whole range of margin-of-safety opportunities. While their success as investments is not assured, at least their propensity for success or failure will be based more on their own fundamental financial attributes than on rising interest rates or other macroeconomic events.
If a company has had declining revenue and declining earnings, and if those are unlikely to return to their prior lofty levels, then its share price should be lower, too. Right? In the world of passive indexation, as it turns out, that would be wrong.
As investors continue to search for yield in a persistent low interest rate environment, many are turning to “bond-like” securities, which offer high dividends and are perceived to be “safe.” These include utilities companies, which currently yield 3-4%, well above the yield offered by US 10-year Treasury Bonds. But the perceived safety rests on a precarious foundation. Simultaneous with their historic high valuations, they face serious risks that we do not believe are appreciated by most investors.  These include: loss of marginal demand due to the rapid incursions of solar power, shrinking earnings as a result, and rising interest rates. Investors in utilities companies are urged to proceed with caution.
Over the past several years, the emergence of indexation as the dominant mode of investing has been to the detriment of the stock prices of those companies not included in the major indexes. However, as is usually the case when an idea is pushed to the extreme, this dynamic has now led to new investment opportunities.
Following years of steady flows into the major index funds, coupled with systemic supports for stock prices of the largest, most liquid companies, valuations in the broad stock market are excessively inflated. Yet, most sectors contain companies outside of the major indexes, which are creating shareholder value but which are relatively invisible to institutional investors. Accordingly, they can trade at deep discounts.  Those are the stocks we choose to buy, and several are reviewed herein. The broader investing community, however, continues to allocate assets to index products, using descriptive data and backward-looking metrics such as market capitalization and beta (which is simply a measure of past stock price volatility) to make decisions, while ETF providers use beta as a guide when creating new products. But beta is merely a statistic – without context, it is not only uninformative, but potentially misleading, really misleading.
A growing share of retail investment is made via automated asset allocation programs – robo-advisers. But how do these programs assess client needs and assemble recommended portfolios?  Do potential fees earned by the provider factor into the proposal?
The trading volume for the largest index ETFs is truly astonishing, and is an order of magnitude greater than the turnover of the companies that comprise the underlying index. Why does this occur? One small part of the answer may lie in the emergence of robo-advisors.
This past year was interesting on so many more fronts than 2015. And this coming year could be more interesting still. In 2016, the financial markets saw all sorts of records and precedents – and not in a good way.  We have been taking some time to prepare our client portfolios for advantage. Advantage hinges on the ability to make opportunistic investments, to take what the market gives, not what it doesn’t.  Opportunism has a field of play when prices have declined. Sometimes they decline suddenly, other times slowly, sometimes the whole market together, other times just pieces of it. But entry to that field of opportunity itself hinges on having sufficient liquidity; without liquidity, the opportunities are just an idea of what might have been.
Money flows into ETFs and similar funds have not only pushed up the prices of the major index-centric companies, but also created an artificial downdraft among the thousands of non-indexation securities. That is where the companies with less systemic risk will be found. There will be more in the way of idiosyncratic investments with the opportunity for true optionality.  Perhaps our portfolios will have to have fewer, but more selective securities with perhaps larger weightings in those companies with truly discounted valuations and a truly superior business position.  
So, the watch words are preparedness, and sobriety. Dr. Louis Pasteur said, "fortune favors the well-prepared mind."
Why does one invest in an index?  Surely one goal is diversified exposure to the market. It might come as a surprise, then, that without the 10 top contributors, the S&P 500’s return in 2015 would have been negative instead of positive. Those 10 stocks, out of the 500, which together amount to a 10% weight in the Index, had an average return (weighted by index position size) of 44%. What does that mean for Horizon Kinetics? Well, those stocks are not found in our strategies, as they trade at extremely high valuations. Meanwhile, the ETF providers are facing fee compression, which is forcing them to market new, differentiated, higher fee products. While the ETF providers move on to new products, we continue to position our strategies for the long-term.
The Beta Game Part I described one of the most important ETF statistical measures: beta. Beta is important, even though all it does is measure the historical day-to-day price variance of a stock or index fund versus the S&P 500, because ETFs are generally sold on the basis of both high performance AND low volatility.  In fact, all the high-beta labeled funds we could find had, in aggregate, less than ½ of 1% of the assets of funds labeled low-volatility.  
In Part II, we give some explanation–since it doesn’t otherwise really make sense–as to how, by the measure of beta, India or Peru has lower risk than the S&P 500, and as to how horribly wrong past reliance on historical correlations has gone. (It was Mark Twain who popularized the following phrase–attributed to Benjamin Disraeli but without definitive authorship: There are three kinds of lies: lies, damned lies, and statistics.)

We also offer a proof that some of the best investors of the past 30 years cannot survive in a beta-driven world. And as a bonus, we’re even giving away a classically good investment idea, because having the best kind of high beta (yes, there is good high beta) we know it would fail to even be considered as an ETF or fund product.
In yet another example of the ever widening gulf between fundamentals and valuation in the world of indexation – year-to-date, the S&P 500 was up 2.9% as of November 30, 2015; excluding just the 10 top contributing stocks, it was down 0.6% – momentum investing has become accepted practice. Momentum investing simply means buying stocks that have gone up (or, conversely, selling those that have not). Momentum indexes, and of course the ETFs that track them, create continued demand for those stocks that have risen recently, pushing them yet higher, while at the same time further pressuring the prices of stocks with recent underperformance. The momentum process is starkly different from the asset allocation process, and by design, seems likely to result in an unpleasant experience for those who are invested in (or perhaps anywhere near) momentum ETFs or the stocks that comprise them if/when the tide turns.   
We have frequently observed that data without context is, at best, meaningless, and at worst, misleading. For many investors, beta (a statistical measure of the historical price risk of a stock or ETF relative to the broader market) has become among the most important factors in selecting an ETF. The implications for ETF providers can’t be ignored: demand for high beta ETFs is simply not there, so new ideas for high beta products are not likely to make it to market, while low beta products, no matter how irrational the beta may appear (e.g., does the Peru ETF really have the same beta as the S&P 500?  Yes, it really does.), continue to gather assets. But if, as proposed in past commentaries, index constituent prices are driven by demand for ETFs rather than by the intrinsic value of the constituent companies themselves, what is the low beta of your ETF telling you? 
Following the $1 trillion+ flow of post-2008 funds into index products such as ETFs, the valuations of the securities widely held in ETFs are driven more by demand for those ETFs than by the merits of the companies themselves. What would happen if that demand reversed – do the ETFs have sufficient liquidity to handle it? On August 24th, some of the most liquid ETFs experienced temporary, dramatic price drops though their constituent securities did not – the safety of indexation doesn’t feel so safe anymore.
After years of writing about the flow of assets out of actively managed funds and into index funds, there are signs that the inevitable reversal may be near. This quarter witnessed the highest ETF trading volume on record, and the pricing anomalies resulting from flows into index products, both in equity and in fixed income ETFs, are ever more numerous and obvious. How else can one explain that, for several years, a biotechnology ETF had a beta well below that of the S&P 500, or that the Republic of Lebanon’s bonds trade at lower yields than bonds issued by Wendy’s?
Just as investing in high yield bond ETFs provides, paradoxically, little exposure to high yield bonds, investing in emerging markets ETFs does not really provide all that much emerging market exposure. The Indian market, for example, is exceptionally broad, with thousands of securities that participate in the economy’s robust growth. However, the ETFs that purport to provide exposure to the Indian market turn out to hold the same roughly 50 large-cap companies, companies that are either truly global in nature (minimal Indian exposure) or in great demand and quite expensive . If one seeks exposure to the local Indian economy, the current generation of ETFs are not the way to achieve it.
For those dubious that indexation and the indiscriminate buying it has cultivated have massively distorted equity prices, the reality is startlingly clear viewed through the impartial valuation prism of bond prices.   Attached is a brief excursion through an emerging markets high yield bond ETF.  Care to guess the yield of a 10-year Republic of Lebanon bond?  How about Russian Federation 7.5% of 2030? The terminal experience for investors may be quite different than they originally anticipated. 
Electric Utility stocks fell 15% between January 2015 and the end of July.  Given the serious structural decline facing this sector and how important it is to many income investors, we republish our late 2014 white paper on the threats facing these companies, including the first instance of reduced demand in the history of the industry. The modest stock price drop thus far may well be just the tip of the iceberg – the Electric Utility sector should be approached with great caution.
This quarter, we return to our previous inflammatory statement that the standard macroeconomic variables considered critical to the portfolio management process – GDP growth expectations, interest rates, etc. – probably detract from performance more than they help.  Also, why, even if we gave you today’s World Bank results for the last decade of GDP growth for all the major emerging market nations, as well as for the U.S., – but gave them to you 10 years ago, a private crystal ball –and gave you the pick of which emerging markets ETFs to buy, you would still probably have made the wrong decision.
In 2005, the S&P 500 Index methodology was changed to reflect float adjusted market capitalization.  In this commentary, we consider the impact of this change on Index returns.
In this first “Under the Hood: What’s in Your Index?” series, we test a widely held assumption in many (if not most) investors’ allocation decisions. Most investors have some portion of their equity portfolio assigned to international stocks to diversify their exposure to U.S. stocks. But what if, through a major index like the S&P 500, you’re already allocated (or over-allocated) to non-U.S. economies?
As prevailing interest rates remain low, investors continue to seek out ways to generate income from their portfolio.  In this commentary, we discuss high dividend paying stocks, using a popular exchange-traded fund as an example, and wonder whether such stocks are likely to generate results in line with investor expectations.
This quarter, we question what it means to take a long term view, discuss the holding periods for some of the Core Value strategy’s holdings, and compare valuation characteristics, both descriptive and predictive, for selected Horizon Kinetics holdings as compared to well-known major index constituents.
This month’s commentary revisits the importance of a buy and hold strategy, especially during periods of market volatility.  While the temptation may be strong to pull assets from the market during pullbacks, historical data show that, over the long run, attempting to time the market is detrimental to an investor’s long run returns.
This quarter’s commentary discusses the anomalies we observe in the current market, and the risks we see for investors following the current prevailing trends. In particular, we discuss the continued and growing prevalence of indexation, and the risks to sectors such as real estate investment trusts, which have been sought out for their high dividends in a low interest rate environment. Finally, on the occasion of the new year, profiles of the larger holdings in a number of our strategies are available on our website.
This quarter, we continue to examine the fallacies embedded in some widely held assumptions regarding asset allocation. We discuss the surprising correlations among what one might assume are unrelated asset classes and the impact of indexation on stock prices, factors impacting the utilities sector, and the benefit of idiosyncratic, diversifying securities. In addition, we review a new position in the Core Value strategy: Royal Gold, Inc.
From year-end 1994 through year-end 2013, the Russell 2000 outperformed the S&P 500 by only 23 basis points per annum. Extend the time period by only eight months to August 29, 2014, and the Russell 2000 underperforms the S&P 500 by 20 basis points over an almost 20-year period. We discuss the relative valuations of the two indexes, and the flows into and out of the exchange-traded funds that track them.
Understanding the basic presumptions of asset allocation can hardly be more critical, since we all invest based on these foundational assumptions.  This quarter, we examine the historical returns from investing in private equity, revisit the topic of slowing revenue expansion at the largest companies, identify some common attributes of companies that do not appear to be suffering from a lack of growth opportunities, and discuss the potential diversification and inflation hedge benefits of land.
This month, we discuss large capitalization companies. In the past, large capitalization companies tended to be stable, established firms. Recently, however, some nascent firms have rapidly expanded their business such that a large market capitalization is warranted, and are investing in their business at a rate that may justify a high price to earnings ratio. We consider the implications of this shift on investment decisions.
This quarter, we question some widely held views on investing, focusing on the nearly universally accepted assumption that emerging markets investing provides higher returns than investing in the developed markets.  In addition, we review two positions in the Core Value strategy: The Wendy’s Company and Platform Specialty Products Corp.
As investor biases increasingly emphasize liquidity needs over investment, the largest companies continue to prioritize cash balances at the expense of long-term value creation.  Along with other headwinds, the unwillingness to deploy cash reserves seems likely to adversely impact earnings for the largest companies and indexes going forward, such that the companies and sectors with the most attractive predictive attributes will be found outside of the major stock indexes.
With tax season fast approaching, K-1-generating securities come up frequently in client discussions. It is timely, then, to review why we hold publicly-traded private equity companies, a number of which are structured as LPs, in some of the portfolios.  You might find some of the reasons surprising.
As we enter the 20th year since the founding of Horizon Kinetics, we take a look back at recent commentary themes, revisit the sway of the media on investment decisions, and discuss selected current positions.  
This month, we discuss the discrepancy in valuations between Canadian-listed companies and their US-listed peers, highlighting real estate investment trusts and real estate developers.
This quarter, we review the important and often surprising ways in which indexation is impacting security valuations, risk, and returns, and point out the merits of the antithesis of indexation: active management and individual security selection.
Liquidations are an extremely interesting type of investment, but they are incredibly rare, and require an extended investment horizon. Therefore, they are of little interest to the majority of investors. The timing of the payout, if any, is unpredictable. However, if and when it comes, it may handsomely reward the investor’s patience. This month’s commentary reviews some of the idiosyncrasies of investments in companies in liquidation, as well as provides an overview of a past liquidation investment made by the Firm.
While the S&P 500 Index level has appreciated significantly over the past year, revenues at the 20 largest constituents of the Index have increased only modestly. This quarter’s commentary considers the impact of indexation methodology on the representation of entrepreneurial companies that are likely to generate expanding revenues, many of which have significant insider ownership, by looking at the historical insider holdings and performance of two famous owner-operators: Wal-Mart and Microsoft.
Continuing our series on predictive attributes for outperformance, this month’s commentary highlights companies based on products with long lifecycles. Companies whose products have short lifecycles face pressure to regularly reinvent themselves; otherwise, they are likely to experience decreasing market share or profitability as demand for their products wanes. In general, companies whose products have long product lifecycles enjoy more consistent demand, leading to more predictable long-term results.
This quarter’s commentary addresses some tax reduction techniques utilized by owner-operators, continues our review of owner-operator actions, and discusses master limited partnerships as part of our series on the challenges faced by investors seeking yield in the current low-interest rate environment.
We discuss scalability as a predictive attribute for outperformance, highlighting publicly-traded private equity firms as example of companies with operating leverage in their business models.
Highlights companies with significant investments in other publicly-traded companies, including Dundee Corporation (DC\A CN), Icahn Enterprises L.P. (IEP), and Brookfield Asset Management (BAM).
This quarter, we examine the pitfalls of using standard valuation metrics as a substitute for thorough analysis.  We consider a different valuation metric: management actions, which we believe is more predictive of future performance than most standard metrics.
This month, we continue our series on predictive attributes by highlighting companies with dormant assets, focusing on the areas of spectrum capacity and land or real estate development.
Following strong performance by several of our larger holdings, we take this opportunity to highlight some of the companies that contributed little to performance for the year.  We also address the many challenges facing equity investors, including the prevailing low interest rate environment.
In the past several months, we have noticed increased spin-off activity in the equity markets.  We have published research reports monitoring spin-offs for many years, including a 1996 study examining the long-term returns provided by tax-free spin-offs as compared to the broader market returns.  This month, we highlight some notable spin-off transactions from the past several quarters, as well as discuss selected pending spin-offs. 
In this month’s commentary, we discuss the recent introduction of high- and low-volatility exchange-traded funds (ETFs).  For a selection of high- and low- volatility ETFs, we review their performance in the year following launch and opine on the inferences, if any, that may be drawn from the valuations reflected in these securities.
We review the current bond market environment and discuss the implications of an extended low-interest rate environment.  We also offer a discussion of the predictive qualitative and quantitative attributes we consider in assessing investment opportunities.
What might happen if, contrary to common expectations, interest rates do not rise? Has that situation ever occurred before? We consider the historical context for the current interest rate environment, as well as the implications for investors should the current low yield levels be sustained over an extended time horizon.
Given the elevated level of the bond market, “the bond market panic” may sound like a preposterous term.  However, given the manifest absence of yield available in the bond market, we believe it is appropriate.  As higher-coupon bonds are due to mature and newer bonds are issued at lower coupons, we estimate the potential loss of income to fixed income investors may be substantial.
The current industry sector diversification system used frequently by individuals, professional money managers, and risk managers is based on Securities Industry Classifications (SIC codes), which have very obvious deficiencies. We will advance the proposition that examining portfolios on an ecosystem basis rather than a position basis, using a measure of diversity called the Herfindahl Index, is a better approach to diversification. 
At the close of 2011, Murray Stahl providedan overview of the markets in 2011 and discusses what might occur in 2012.
We offer our thoughts on recent market conditions as compared to those experienced during the last period of high volatility: the financial crisis of 2008.
We explore how the rapid proliferation of open architecture, specifically through the development of various application (“app”) stores, is having a profound impact on cellular phone companies, computer manufacturers, video game developers and a host of other businesses.
We examine the standard calculation of the Price to Book Ratio of the S&P 500 Index, address the shortcomings of various methods of computing the metric, and discuss implications for market analysis.
© Horizon Kinetics LLC 2016