Third Quarter 2022 – The Sloth Value StrategySubmitted by Alsworth Capital Management, LLC on October 27th, 2022
When I was in business school, we learned about the fundamentals of accounting to be able to measure the health of a company and to determine its current value. In more advanced courses, we learned how to make financial projections and we studied ways to optimize our decision-making based on these estimates. With the advent of powerful computers, and now even artificial intelligence tools, much of this work can be programmed to replace these decisions with automated actions that can be completed in fractions of a second after new data is received. We often romanticize investment portfolio management as a group of seasoned pros sitting in a fancy board room with a beautiful window view, hashing out investment moves. The reality these days, is that most of this work is done via computers with analysts feeding data into the program and human executives reviewing the work as a “double check” or to tweak the model.
Knowing what a company is worth today based on yesterday’s accounting figures is largely solved with a calculator. However, the only way to make money is to outguess someone else on the future financial performance of a company. As such, most investment markets are traded based on expectations of future financials, about 12 months out. You might assume that rational people and their computer models would come to similar conclusions based on the same information. As such, it is reasonable to expect that prices would be relatively stable with trends emerging only slowly over time as new information comes in. But in reality, this is not how it works. Some of this price variability can be explained by investors having different time horizons and risk tolerances. Someone investing for retirement in 30 years might be more willing to accept the impact of a near term recession and hold on to their stock, since they have decades of time horizon to focus on. A day trader that is borrowing money to invest in the same stock, would have a much different tolerance for bad news and perhaps be more eager to trade at any price. However, even these factors don’t explain away the degree of volatility we see in stocks. Some portion of the volatility can only be summed up as “behavioral” factors. Human beings are emotional and emotion is not bound by reason. At every interval of history in investing, market prices have overshot to the upside with excessive optimism and overshot to the downside in despondency and fear. That is the nature of the beast. The most powerful behavioral factor is “recency bias” or the belief that whatever has happened recently, will continue as a trend forever. This often manifests itself as thinking that an investment in an uptrend can only ever go up, regardless of its price (Tesla, Apple, Amazon, Real Estate, Bitcoin). Also, in periods like we have today, this bias can lead investors to believe that an investment in a downtrend will inevitably continue down to zero. Controlling these behavioral biases is critical to earning your required rate of return.
Leading up to the pandemic we experienced stock and bond valuations at extremely optimistic levels, exceeding even past bubbles by many measurements. The pandemic induced sell off was course corrected with trillions of dollars of spending and investors recovered to new highs within about two months. As a result, a new wave of young investors started their savings in an era in which investing didn’t require a calculator because it was so obviously easy. You just double up on social media and technology companies with an interesting story! Similar to prior bubbles and bursts, the prevailing wisdom was that price didn’t matter. You could pay any price for a growing exciting company. Then came cryptocurrency, SPACs, NFT’s and meme stocks as glitter inside the balloon. Simulus funds, low interest rates and pent-up demand provided the helium for a real estate boom and eye-popping returns on speculative stocks. Famed tech investor, Cathy Woods created an investment called ARK Innovation ETF, which invests soley in technology stocks that have a great growth story, with no consideration for
valuation. The investment gained notoriety after posting a 152% gain in 2020. Trading stocks became as easy as downloading an app. Many new trading apps have been aimed at new young investors, giving them rewards to encourage trading and the interface is very similar to playing a game. Trading can really be like a legal form or gambling, which can be entertaining. There are tons of news feeds giving up to date information about your bets, talking heads on TV and on social media offer up lots of forecasts, and it’s exciting to see popular stories lead to fantastic financial gains. The emotional eagerness of traders is what led prices to go up beyond historical valuations. Counterintuitively, as prices for real estate soared, the number of real estate transactions catapulted. Apparently, home buyers are eager to pay more and more for their real estate. Recency bias in believing that a recent trend will persist forever is powerful! Then came inflation, supply disruptions, generational labor market shifts, higher interest rates, hot war in Ukraine and a growing cold war between the US and China. The mood changed quickly and the eagerness to sell has created a powerful down draft in asset prices. Remember that ARK Innovation ETF? As of this writing the fund is down over 71% since the end of 2020, wiping out all gains for the fund going back to October 2017.
Valuations for stocks had been at historic highs even before the pandemic. However, if I had sold out of stocks completely at that point, we would have missed out on the pandemic surge to even higher extreme valuations and you likely would have abandoned our strategy. Unfortunately, knowing that prices are trading too high, is not informative for timing short-term markets that are driven by emotion. As such, our strategy has always been to maintain a strategic allocation that can be held through any type of market environment, then make small incremental moves based on valuations. I like to think of it as the “sloth value strategy.” The sloth doesn’t get excited in the exuberant stages when investing is done for entertainment. The sloth doesn’t get moved by greed or fear of missing out as prices escalate. The sloth also doesn’t get panicked or depressed as prices retreat. The sloth doesn’t get seduced by emotion. The sloth also moves slowly and methodically to avoid getting whipsawed by new information. The sloth is a value investor, seeking to buy unloved assets trading cheaply and avoid overpriced fad investments.
This summer, stocks shot higher in a classic “buy the dip” frenzied market that typically follows an “air pocket” drop in prices. The market then gave back all of those recovery gains and sold off to new lows. We took advantage of this pattern and sold off a small portion of the stock allocation. The S&P 500 index of US Stocks ended the quarter down 4.9% and is down nearly 24% year to date. The MSCI EAFE index of international stocks is down 27% year to date. With interest rates still shooting higher, the Bloomberg Aggregate Bond index is down over 14% year to date. My best guess is that we will have more rallies and drops before the market finds a true bottom. The investing landscape is dramatically different now, since safe treasury bonds are more attractive, currently yielding 4-5% interest rates. We also believe that corporate profits are likely to be under pressure from high labor costs and higher borrowing costs. We have built into our base case, the expectation that we are heading into a global economic recession in 2023, which I don’t believe is fully priced into valuations today. Our expectation is to have more opportunities to make additional small moves in anticipation of aligning for an eventual recovery. As always, we will channel our inner sloth and reject emotion, while moving slowly and methodically to manage through this difficult environment. Please feel free to setup a meeting anytime to go over any questions or concerns that you may have.
Shane M. Alsworth, MBA, CFP®, CLU®, CIMA®