Dear Investor,
I hope this letter finds you well and you are looking forward to the cooler months to come.
The stock market continued to grind higher in the third quarter just like the T-1000 Infiltrator in the movie Terminator 2. Being like the T-1000 the stock market deflected, absorbed, and walked away from North Korean aggression, Hurricanes Harvey, Irma, Jose, and Maria, the absence of material progress on tax relief, infrastructure spending, healthcare reform, and the September “slump.”
How could this be, you may ask? The answer could be as simple as the economy continues to grow and enjoy an accommodative underlying tone. Corporate revenues and earnings continue to grow and there isn’t currently a clear sense of nervousness about an abrupt slowdown or recession. When investor psychology changes to reflect a slowing or impending recession, buying typically slows and the upward push on stock prices diminishes which could revert into selling. When and how fast this event occurs is unclear, but I believe we still have some ways to go.
During the third quarter of 2017, the S&P 500 Index gained 4.0%, the NASDAQ Index gained 5.8%, while the iShares Barclays 7-10 yr. Treasury Bond ETF (IEF) lost 0.1%.
The current uptrend certainly doesn’t mean potential further progress will be a one-way ride. As everyone is aware, investing is extremely complex and is clouded by many forces. A less obvious danger in the market develops from a slow creep that comes about in a trending market in the way of complacency and familiarity or status quo bias. It could be stated as “I know the company and it has worked well, so I don’t have to worry about it.”
Billionaire investor Howard Marks recently commented on Bloomberg TV that investors are “engaging in risky behavior” and in his summer memo he provided a further explanation which went into passive investments and ETF investing.
“Passive investing is done in vehicles that make no judgments about the soundness of companies and the fairness of prices. More than $1 billion is flowing daily to “passive managers” (there’s an oxymoron for you) who buy regardless of price. I’ve always viewed index funds as “freeloaders” who make use of the consensus decisions of active investors for free. How comfortable can investors be these days, now that fewer and fewer active decisions are being made?
Certainly the process described above can introduce distortions. At the simplest level, if all equity capital flows into index funds for their dependability and low cost, then the stocks in the indices will be expensive relative to those outside them. That will create widespread opportunities for active managers to find bargains among the latter. Today, with the proliferation of ETFs and their emphasis on the scalable market leaders, the FAANGs are a good example of insiders that are flying high, at least partially on the strength of non-discretionary buying.”
The key takeaway from Howard Mark’s writing is that the proliferation of index and ETF investing may be leaving investors too heavily invested in products that aren’t managed with active decisionmaking and that disregard valuations. This provides for an attractive landscape for active managers like us.
Even though investors can be grouped into generalized buckets each investor is unique, at a minimum, as to their objectives, time horizon, and risk level. Proper investing should include active evaluation and adjustment, by someone who has the understanding and time to consider the many forces impacting an investment portfolio.
This can be a daunting task, but here at Torii Asset Management we thrive on our craft of seeking out investments in a disciplined manner to address the needs of our clients.
As the current quarter develops we are anxious to delve into the current round of corporate performance results and the developments concerning taxes, infrastructure spending, healthcare reform and the direction of inflation and interest rates.
If index funds and many market-cap weighted ETFs become more expensive on a relative basis than other choices, it may be an appropriate time to take a deeper look into mid to small companies with growing sales and earnings. One such area which may produce interesting prospects that has been promoted by the media lately are investments that carry the new buzz phrase of Artificial Intelligence (AI). Before investors get too carried away with this new phrase, reflect back on the “Nano Propriety” craze of years past. Nano engineered everything was the new “thing” and it was thought to be the wave of the future, but the term is rarely used to promote investments anymore.
The aura of artificial intelligence may sound exciting as a story used to market investment ideas, but it is nothing revolutionary. Artificial intelligence is, essentially, the field of computer science that creates systems to perform tasks normally requiring human brain power. As a portfolio manager, seeing the AI moniker doesn’t tell me much until I can see that the company has shown it can generate sales and earnings using an understandable business model. This approach is called investing. Buying a company or basket of companies due to its moniker or story is based on speculation which often leads to trouble in the end.
Another topic of heated debate is cryptocurrencies, as in Bit Coin to name one. I wrote about my reservations with Bit Coin in February 2014 and it has continued to have a wild ride since. My past and current thoughts are aligned with the recent comments by JP Morgan Chase & Co. CEO Jamie Dimon. On a September 12th CNBC interview, he said bitcoin is a ‘fraud’ that will eventually blow up and “It’s worse than tulip bulbs. It won’t end well. Someone is going to get killed.” The concept and wide acceptance of cryptocurrencies may develop, but in our current environment it is pure speculation and not appropriate for my clients or me.
My interest rate belief is that there is less than a 50% chance of a December interest rate increase. This is due to unknown effects of the recent weather and fire disruptions on the economy and federal budget and the slower than expected pick-up in inflation to meet the Fed’s target.
To our existing clients, I extend my sincere thanks for your business. You have our continued commitment to your success. To prospective clients, I invite you to come and grow with us.
Very truly yours,
Martin L. Yokosawa