A Memo to Investors

Dear Stock Picker,

I know, these are weird and trying times.  It all makes you wonder what the point of stock-picking is.  What is the purpose of kicking the tires, looking under the hood, and doing our jobs?  

Michael Green at Logica, who is as smart as you like, will tell you the entire game now is all about passive flows, and that fundamental analysis is borderline useless. Cliff Asness at AQR, possibly an even smarter guy, will tell you that all this stuff we used to call alpha really was just factor exposure (e.g. quality, value) and there are cheaper ways to get it. Or perhaps fundamentals should matter, but Chamath Palihapitiya or Elon Musk will go out and buy OTM YOLO calls on some dog with fleas and then tweet “Gamestonks” to their hordes of acolytes – all but destroying normal price discovery.

Despite the protestations otherwise, despite the popular view that the market is now purely narrative-driven, despite the recent emergence of wholly unfundamental stories like the one we all just experienced with Gamestop (and probably are still experiencing with Tesla[1]),and despite the power of Ben Graham’s voting machine; in my very strong view, the stock market will always eventually be a weighing machine.[2]

This surely will sound quaint and stale to a few readers, but – and I’m sorry – the future value of a thing is ultimately based on the dividends the thing will eventually pay you, or someone to whom you are prepared to sell your shares.  Whether the proxies for those dividends are cash flows, earnings, margins, sales, or the dividends themselves, alpha happens when expectations of those future dividends change.

That’s it.  That’s the stock-picking game.  Stocks are not pieces of art.  They are not fiat money.  Cults of personality do not last forever in the stock market.  Narratives break.  Eventually, everyone figured out that Galileo was right.  Eventually, everyone will figure out that Cathie Wood isn’t.  And it won’t take as long either.

Sure these individual mo-machines can raise money, and in terms of surviving, there is some degree of self-fulfilling prophecy.  Elon is being very smart about this.  So were the guys at AMC a few weeks ago (GME evidently couldn’t do anything about it because they were in a quiet period, but you can believe they wanted to).  But for those making money on big investments in these particular securities as they go from unreasonably overpriced to preposterously overpriced, this is not investing.  This is greater-fool speculation.  Sure, this is fun (for the longs); but calling it anything else is pulling the wool over the eyes of clients, or perhaps over your own.  

What may even have started as a reasonable and strong fundamental reason for ownership must be tempered if the share price of the thing is 10x higher than it was when you first established your thesis.  Price matters.  There is a difference between a company and its share price.  This gravity of this logic has not dropped on many market participants.  But it will. It always does.

As sure as the sun will come up tomorrow, there are some incredible overreactions happening right now in the stock market, and they will continue to happen. And it isn’t just for the things with rocket emojis lifting them off, but in the other direction as well.  

And this, my fellow stock-pickers, believe it or not, is GREAT for us.

Why? Because almost any overreaction not supported by a fundamental justification will eventually be valuable for opportunistic stock-pickers.  

Take these meme stocks for example. Using an analogy from popular culture, these stocks were/are being bought by participants controlled by the Matrix[3]. Morpheus hasn’t come to save them yet, and they haven’t had the red pill.  GME shareholders (for example)just got red-pilled; but at TSLA, Elon’s narrative machine is blocking production of red pills, so the masses continue to enjoy the ignorant bliss of naïve optimism.

There are countless (well, not countless) other overpriced and underpriced securities.  And when Ben Graham’s weighing machine eventually shows up – and it will – we, very simply, are going to have the opportunity to capture alpha that the factor machines and index funds can’t.

And this isn’t just about stock-picking, it is about your portfolio.

By definition, you can’t have a big, diversified portfolio that captures alpha.  That was true even before value, momentum, quality and investment factors arrived; and it is even more true today.  If there is any alpha out there, anything left over after throwing all those factors in the regression equation, any reward for more objectively analyzing the right information and concluding that the market has it wrong, then those opportunities are only few and far between.

For the individual investor, this means buying index funds, and reserving a small amount (like, 5-10%) for the fun stuff.  

For institutional investors, you need to be smart about paying very little (a.k.a. nothing) for market exposure and little for factor exposures.  If you want to beat the market without making a huge style bet, you must invest a small portion of you larger equity portfolio in concentrated managers.  That’s just math.  But at the same time, you must ensure these investments are neither too correlated nor too diversified across these concentrated equity managers.  

And for the equity manager providing that service to institutional partners, one that is not interested in asset gathering but driven by a motivation to seek alpha, this is where you step in.  Build concentrated portfolios, provide (hopefully) process-led excess returns to aligned clients, create wealth and stability for retirees, endowments, and make markets efficient.

Eschew the blue pill and keep discovering how deep the rabbit hole goes.

And stay in the game.

Happy Hunting,

Drew