<December 10, 2024>
On a recent Friday night, my son was playing video games with his friends. I asked him if he wanted to do something else. He asked, “Like what?” I replied, “How about roller skating?” He looked at me like I’d lost my mind.
When I was in middle school, the place to be on Friday night was Champ’s Rollerdrome. Parents would drop off their kids at 7pm and would pick them up around midnight. After arriving we’d wait in a long line and socialize with our friends. Once we reached the front of the line, we were asked if we wanted regular or speed skates. Regular skates were basic brown high-tops with orange wheels. The speed skates had a lower cut, black leather, with two white stripes on the side. If you were even close to being cool in middle school, you had to roll on speed skates.
Of course there was a catch, or cost—five dollars. While five bucks doesn’t sound like a lot, in the 1980s it could go a long way in the arcade or concession stand. In fact, it was usually all I had for the evening. If only I had saved all those five-dollar bills and let them compound for forty years! The cost of conforming can be very steep, indeed!
The desire to fit in with your peers doesn’t go away after middle school. In the past, we’ve written about the psychology of investing and the role of groupthink. The pressure to conform in the investment management industry is tremendous, especially for relative return investors. As their name implies, relative return investors are measured relative to the crowd. One wrong step and they may look different!
Looking different in the investment management business can be the kiss of death. For some relative return investors, being different (tracking error) is considered a greater risk than losing money. Losing client capital in the relative return world is even considered an accomplishment if it’s slightly less than your benchmark! For many relative return investors, it’s more comfortable to conform and invest in what’s working than to strictly adhere to an investment discipline. If you’re wrong, so what! Everyone else will be too.
How well one plays the relative return game is a major factor in determining how capital is allocated. Asset allocators, such as institutional consultants, allocate trillions of dollars and are hired by large clients, such as pension funds, to decide which managers to use for their plans. The rewards for managers to be selected are enormous, increasing the incentive to manage money in a manner that improves the odds of being hired. Instead of asking if an investment will provide an attractive absolute return, a relative return manager may ask, “What would a consultant think or want me to do?” In our opinion, the incentive to be approved by large allocators and raise assets under management (AUM) has a significant role in how capital is managed.
During our careers we’ve presented numerous times to large asset allocators. While we are very proud of our stock selection (winners vs. losers), our batting average as it relates to being hired by large allocators is probably the lowest in the industry. It isn’t that they don’t understand or like the strategy. In fact, most appreciate the process and discipline, but they have difficulty hiring us because we invest too differently and have too much flexibility. In other words, they’re concerned that our ability to look different could cause large swings in relative performance. In effect, in the relative return world, conformity is preferred over independence, as investing differently can carry too much business risk.
In our opinion, investing the same as your peers and benchmarks conflicts with the main goal of most asset allocators—provide higher returns with less risk (alpha). While this is what allocators say they want, how can portfolio managers generate alpha by doing the same thing as everyone else? Maybe others can, but we cannot. For us, to generate attractive absolute returns over a market cycle, we’re often required to look very different from our benchmarks.
Investing differently and being a contrarian is easy in theory. When the herd is overpaying for popular stocks, avoid them (technology stocks in 1999-2000). Conversely, when investors are aggressively selling undervalued stocks, buy them (energy stocks in 2020-2021). It’s not that complicated, but in the investment management industry, common sense investment philosophies like buy low/sell high have been losing share to passive funds and active managers with minimal tracking error. In effect, there are fewer and fewer managers remaining that invest differently.
Active management in aggregate has also been losing share to passive investing for many years. We believe a portion of market share gains by passive funds is justified. After the last cycle ended in March 2009, we learned many active funds failed to protect capital and even underperformed on the downside. Based on the valuations on today’s buy-side favorites, we suspect active managers will again have difficulty protecting capital during the next bear market. In our opinion, the end of the current market cycle could be the nail in the coffin for active management. If the industry is unwilling to invest differently today—when valuations are screaming risk is elevated—and active managers fail to add value at the cycle’s end, why not allocate to passive?
Value investors often talk about being fearful when others are greedy and greedy when others are fearful. While these are great talking points, from a business perspective it can be easier and more profitable to label yourself as a value manager or contrarian, while avoiding investing like a contrarian. Instead, simply own stocks that are working which are often larger weights in the benchmarks. You know, the feel-good stocks. In our opinion, it’s not hard to find and buy stocks that will improve near-term relative performance. Playing along is easy. Investing differently is not.
As investors race by us with their fancy speed skate portfolios, we sit patiently in our boring brown high-tops, loaded with T-bills and out-of-favor small cap equities. Participants in fads and manias often walk away asking, “What was I thinking?” But for now, owning what’s working is working, so let the good times roll. For us, we’ll stick with investing differently. Just like we’ve done in prior stock market bubbles, we plan to remain disciplined even if that means getting lapped by our peers and benchmarks. As much as we’d like to participate, the price of looking cool, in our opinion, has never been more expensive.
Eric Cinnamond
The Palm Valley Capital Fund can be purchased directly from U.S. Bank or through these fund platforms.
There is no guarantee that a particular investment strategy will be successful. Opinions expressed are subject to change at any time, are not guaranteed, and should not be considered investment advice.
Mutual fund investing involves risk. Principal loss is possible. The Palm Valley Capital Fund invests in smaller sized companies, which involve additional risks such as limited liquidity and greater volatility than large capitalization companies. The ability of the Fund to meet its investment objective may be limited to the extent it holds assets in cash (or cash equivalents) or is otherwise uninvested.
Before investing in the Palm Valley Capital Fund, you should carefully consider the Fund’s investment objectives, risks, charges, and expenses. The Prospectus contains this and other important information and it may be obtained by calling 904 -747-2345. Please read the Prospectus carefully before investing.
The Palm Valley Capital Fund is distributed by Quasar Distributors, LLC.
Definitions:
Tracking error: A measure of the risk in an investment portfolio that is due to active management decisions made by the portfolio manager; it indicates how closely a portfolio follows the index to which it is benchmarked.
Equity Style Box: A visual representation of the key investment characteristics of stocks and stock mutual funds. The equity style box represented in this blog post reflects our belief that many portfolio managers consider how portfolio positioning will impact assets under management or the business of the asset manager. Our view is remaining disciplined throughout an entire market cycle can increase the risk of assets leaving (indicated by red) while buying what’s working and avoiding being different can improve a manager’s career prospects and assets under management (indicated by green).
Alpha: A term used in investing to describe an investment strategy’s ability to beat the market, or its “edge.” Alpha is thus also often referred to as excess return or the abnormal rate of return in relation to a benchmark, when adjusted for risk.