A letter from Hilton Portfolio Manager Tom Maher:
The life of a portfolio manager is many things, but boring is not one of them. Even with decades of experience you are constantly learning and adapting. I had to write a self-evaluation in the early days of my career, a common and often dreaded task for investment professionals. At the time, I was an analyst, and had been for several years. It was while I was writing the assessment that it dawned on me that I was still learning things about my role—all the time. When I discussed this concept in my review, the president of the firm quipped, “You won’t stop learning things until the end of your career.” Very true. 2020 was a tumultuous year for both the markets and the real economy. To some extent, it was like an entire market cycle compressed into a very short time period. For portfolio managers, it presented many never before seen situations, and provided many more opportunities to succeed (or fail) than a typical year. I thought I’d share some thoughts on the year, and things I learned—some for the first time, others all over again.
1. Indexing Won’t Do Us In, But The Fed might.Even as an active manager, you’re often looking over your shoulder at the index. Much ink has been spilled heralding the death of active investing, and most of the commentary revolves around the idea that you cannot beat the market and it’s more efficient to just buy the index. This philosophical debate has been raging for years, and 2020 was no exception. Once the COVID-19 pandemic hit we all fell into the abyss—active managers, passive products, you name it. It was the first time any current investor (I think I can safely say that) had to deal with a complete shutdown of the economy and the ensuing carnage in the stock market. In that first phase, little differentiation was made between good and bad companies, as defined by balance sheet strength, business durability, likelihood of making it to the other side, etc. Then, in late February, the market started to make some distinctions. Most stocks were still dropping—risk assets were for sale—but those likely to see a catastrophic impact were in freefall whereas more steady fundamental stories remained weak but fell in a more orderly fashion. I spent a lot of time analyzing the balance sheets of stock in the portfolio to confirm what I already believed: all of our holdings likely could make it to the other side. But then the Fed and Congress took unprecedented actions that had two major outcomes: 1) They halted the drop in the markets and 2) they ignited a desire to take risk. The combination of their easing, printing and various emergency lending programs had the intended effect—providing real support to businesses and confidence to market participants. One notable caveat of the rescue was that the worst off companies often benefited the most. The stocks of companies in the worst shape were plummeting, and the Fed’s efforts put a floor under most of them. To some degree, the Fed enabled investors not to fret over weak balance sheets and miserable near-term prospects. Instead investors were encouraged to look further out, toward an eventual recovery in the real economy, and these stocks ran up. Stocks of companies that likely would have survived without Fed action also appreciated, but less so. They hadn’t had the near-death experience, so the rebound wasn’t as pronounced. Additionally many of these companies have more steady businesses. Perversely, steady models, with less variable results, have less “swing” as things recover. This made them relatively less attractive[BM1] [TM2] . Now, as much as I’d like to think I’m special in seeking quality investments, there are plenty of active managers who do the same. I’d go so far as to say that most, aside from those hugging benchmarks or focused on distressed situations, endeavor to own better companies. So, when the weakest companies are disproportionately boosted by government action, the broad indexes (which include good and bad companies alike) become very strong performers. The question for investors is this: How long will the market ignore fundamentals? I believe it is an unattractive proposition for investors to focus on companies with shaky fundamentals. I am very focused on risk and view adherence to quality as a way to reduce risk in our portfolio. Avoiding fundamentally weak companies may present a challenge when the market is rocketing, but that’s a trade-off I am willing to make.
2. “We mock what we don’t understand.”I’m sure this quote originated from a more erudite source, but I know it from the, ahem, classic Chevy Chase/Dan Aykroyd film “Spies Like Us.” Regardless, I’d suggest this quote could be applied to some recent market action, or more accurately some recent market participants: the “Hoodies.” The Hoodies are the most recent crop of retail investors, and they’re not shy about exploiting every modern method of flogging their ideas—Reddit, Twitter, blogs, etc. On top of that, many have adopted options as a way to play, effectively giving them “free leverage” on their bets. Keep in mind many of these investors are refugees from sports betting, so the idea that you lose all your money if you lose is not off-putting. As you may know, professional portfolio managers tend to exhibit some modicum of arrogance. If you didn’t get it, that’s a joke—many exhibit a nauseating level of arrogance! In all fairness, confidence is a necessary trait to be successful as a portfolio manager, but in some cases it spills over into arrogance, which can be counterproductive or downright dangerous. Throughout 2020, this arrogance was on full display, aroused by the rise of the Hoodies. Many professional investors I know have smirked at the gyrations this new class of investors has caused, and are quick to dismiss them as uninformed, essentially saying: “This will end badly and they’ll regret it.” Perhaps so, but in the meantime their effect on the markets, at least in the near term, is significant. In my view, it’s important for a portfolio manager to perceive new market dynamics, and rather than dismiss them try to understand them and determine how to operate alongside them. As an investor you have to operate in the market you have, not the market you’d like to have. I do not think it’s prudent, nor do I think it will end well, to discard your underlying process and to simply day trade—but be sensitive to the effects, and if you can, benefit from them. For me this means seeking to harvest gains created by the frenzy and remember an old adage: know who’s in a stock with you. I believe the Hoodies fancy may be fleeting, and stocks that have rocketed well beyond what their fundamentals merit may fall precipitously. I believe this also means you don’t specifically try to play names they’re manipulating (such an ugly word, maybe not fair), but if a name you’re involved with catches their fancy, take note. I do believe, however, that proactively altering your investment approach in order to chase their quarry could be a very dangerous game. The point is stay cognizant of the current market participants and their behavior, regardless of what you think of it. It might enable you to add some value. It might also help you avoid disaster.
3. Valuation Matters. The hard part is figuring out when it matters.The famous John Maynard Keynes quote “the markets can stay irrational longer than you can remain solvent” has been on my mind a lot over the last year. I believe there are large swaths of the market trading at astronomical valuations, driven by a variety of factors, including very low interest rates, an influx of new investors, the desire to own secular winners at any price, etc. I believe at some point it is likely these high priced stocks may falter. They actually may need to drop, or perhaps they will simply idle for a while so their earnings streams can catch up to their stock prices. Trying to call when, or why that reckoning will come is a fool’s errand. Those looking to short these stocks should realize doing so solely on valuation may be a perilous pursuit, and they should remember the potential loss on a short is infinite vs. a “mere” 100% for a long position. I am not a traditional value manager, but valuation does figure into my investment approach. I seek to invest in good companies at attractive valuations. Over the course of my career I have come to realize that either extreme, cheap or expensive, generally represent risky investments in my opinion. Is it currently frustrating to see some stocks trade into the stratosphere? Sure. But the constructive approach leads you to investigate ideas that meet your investment criteria and are in industries or sectors benefiting from massive investor interest. In my case I also loosen—but not discard—my valuation discipline. I am valuation sensitive, but run a fully invested strategy. What constitutes an attractive valuation, a key part of what I look for in potential holdings fluctuates with the overall tenor of the market. A successful investor will listen to the market and adjust accordingly.
4. Hunker down when it’s rough and spread out when it’s smooth.Entering 2020 I was fairly defensive in my posture. The market had benefited from the late 2019 “Not QE QE” (seems like an eon ago) but conditions resembled a late cycle. That said I wasn’t in a bunker, and had some more pro-risk positions in the portfolio as well. As we entered the pandemic and the music essentially stopped, this stance was good, not great. As conditions weakened at a pace never before seen it was prudent to cut back the more speculative names, and to find those stocks that would weather the storm best. The result? The number of names in the portfolio fell from low to mid-50s to 48 names. As SMCO is a fully invested strategy, though, the proceeds didn’t simply stay in cash. I rolled them back into those stalwart names—those I believe have solid balance sheets, positive cash flow and no need for near-term financing or refinancing. This led me to favor mid-caps over small caps, and led to a higher percentage of the portfolio in what I describe as sustainable models. These tend to be recurring businesses, with long term contracts and less dependence on new business wins in the current period. The fully invested aspect of the strategy had an unintended benefit as well. When the markets turned—a rapid about face while the world still felt very uncertain—I was not sitting with a large cash position. True, the lower octane names that now dominated the portfolio didn’t keep pace, but they still appreciated. Had the money been sitting in cash, the performance deficit created would be hard to overcome. As the year progressed, the potential for recovery became clearer. As usual the markets anticipated an economic recovery before it has taken root, and pro-cyclical names have caught a bid. As this was happening across various industries I moved the portfolio to get more exposure. The result? New names were introduced into the portfolio, largely financed by trims or elimination of the steady names that got the portfolio though the early year bear market. I tend to be a long term investor, so many of the sustainable names still have a place in the portfolio, but at reduced weights. Conversely some of the cyclical exposure came from additions to names in the portfolio. This approach may not catch all the “swing” in one direction or the other, but may help protect on the downside while providing exposure to the upside. We’re focused on long-term returns with an attractive risk profile, and I believe this approach helps us achieve that goal.
5. The Rolling Stones.You may be wondering what the heck the Rolling Stones have to do with equity investing. The answer is nothing, although I’d happily manage some money for Mick and the boys. I’m a classic rock junkie, but even the casual observer knows the Stones have stood the test of time, with a career that spans from the early ‘60s to current day. Luck may have played a role in the Stones’ long career, but undoubtedly skill figured prominently as well. Obviously to succeed you have to be good at what you do. The Stones may not be the best players in the world, but it’s fair to say they are more than competent in their chosen music genre. Clearly they have the base requirements needed to succeed in spades. I believe the same goes for an investor—you must have some innate talent. It can be refined and disciplined, but there has to be a basic capability and interest. But there is one skill that sets the Stones apart: Adaptability. Their chameleon-like adaptability is why they’ve endured while so many other bands have come and gone. They stay true to their underlying essence, their “Stones-ness” if you will, but incorporate a little of what’s popular at any moment into their music. Initially they were part of the British Invasion. These early rock bands from England emulated the music of their heroes, mostly R&B artists from the US. Early songs, like their cover of “Route 66,” sound a lot like the music of Chuck Berry, but altered just enough to be their own. As the ‘60s wore on, in came psychedelia. “2000 Light Years From Home” fits right in with other songs of the time, but again had that Stones imprint. In the late ‘60s and early ‘70s hard rock ruled, and the Stones fit right in, with songs like “Can’t You Hear Me Knocking.” Then mid-’70s rolled in, bringing us into the dreaded disco era. The Stones were right on point, again producing danceable songs like “Hot Stuff” and “Miss You.” Ok, ok, I don’t know how many of you are as big rock aficionados as I, so I’ll stop there. But you get the point. The trick—and this is what portfolio managers must do—is adhere to an underlying repeatable process, but incorporate the market realities at any moment in time. The Stones put out music that had elements of R&B, disco, or whatever else was happening at the time, but the music was always their own, identifiably so. I believe a successful investor must do the same—employ a repeatable and disciplined philosophy and process, but thoughtfully incorporate what’s going on in the markets. Adaptability was critical to managing through 2020. The rapid swings in the market, up and down, value to growth, large to small, etc., all required some adaptations to stay competitive.
Again this is not your typical year-end investor letter, but rather some thematic observations. I hope you find them illuminating or thought provoking. If you are interested in a more traditional year-end review, I’d steer you toward our most recent SMCO video here. As we enter 2021, I am listening to the market and learning new things, as always. I have no doubt 2021 will be an interesting year, though something a little less interesting than 2020 would be welcome.
I wish you all a successful and prosperous new year.