Risk Mitigation
Smead Capital Management
by Bill Smead
September 4, 2012
Dear Fellow Investors:
How
did the job of an asset allocator move from seeking out undervalued
asset classes and securities to one of seeking to mitigate risk? Is risk
mitigation a worthy goal or even possible without abandoning real
return goals? When and why did wealth creation become wealth management?
What opportunities exist today for those who seek wealth creation
through intelligent risk taking?
In
the last four years, we at Smead Capital Management have been fortunate
to sit down with numerous top-notch institutional investors and
financial
advisors. We repeatedly hear about the approaches which are being used
to mitigate risk. We believe that the asset allocation being practiced
by the largest and most successful institutions is no longer dissimilar
to that of the smallest financial advisory
practice! This came about the same way all concentration develops in
the investment business; it worked well for awhile and was spawned by
the prior concentration.
By
the late 1990's, the institutional and individual investors had crowded
into the technology and telecom stocks and most of them were US-based.
US large-cap growth became the darling sector of the favored asset
class (US large-cap equity) among allocators. Things got way out of
balance. We remember seeing the capitalization of tech and telecom grow
to as much as 48 percent of the S&P 500 Index by
the end of 1999. The popularity of the category was exposed by large
ownership of non-dividend paying tech stocks in funds dedicated to
rising dividends. Avoiding the tech sector shoved Robert Sanborn out at
Oakmark, George Vanderheiden out at Fidelity, caused
Julian Robertson to give up on Tiger Management and nearly got Don
Yacktman fired by the board of his own mutual fund.
This
hyper-concentration left almost every other asset class starved for
capital. Some very smart institutional investors (think Harvard and Yale
Endowment) recognized the imbalance and spread money across multiple
asset classes and under-weighted US large-cap equities. Warren Buffett
expressed in 1999 how doomed forward returns would be in US large equity
in his Allen and Company talk in July of that
year. The proverb Warren likes to quote remains quit germane, "what the
wise man does in the beginning the fool does at the end". Harvard and
Yale did very well and their approach has been mimicked for about the
last five to ten years by nearly all asset allocators
and Markowitz ideologues.
Two
bear market declines between March of 2000 and March of 2009 in US
large-cap indexes pretty much sealed the distrust and disdain for the
asset
class among allocators. The University of Washington Endowment proudly
told us in 2009 that they had 12 percent of their assets in US equity
and 5 of the 12 percent in US large-cap. Institutional investor studies
like NACUBA show that they are not alone. Since
US Equity has been a leading asset class for long-term investors over
the decades, these circumstances contributed to a "rational despair"
about returns and led to an intense urge to reduce risk and mitigate it
if possible.
We
believe that mitigating risk is neither useful nor ultimately possible.
In our opinion, drastically reducing risk reduces long-term returns and
creates the risk which Buffett is occupied with-the loss of purchasing
power. Today's asset allocators define risk as the possibility of loss
in the next year. We have argued during these last four years that
long-duration common stock investing incorporates
the risk of early year losses. The short-term risk becomes rewarded
with above average long-term returns. A look at the Ibbotson charts
proves that there is a reward in common stocks for those early year
risks.
Why
did wealth creation become wealth management? The advent of 401k and
IRA accounts put the average American into the securities markets. Lower
interest rates and the 1990's bull market in stocks brought them
flocking to risk. Lastly, the aforementioned 40-plus percent bear
markets of the 2000's eliminated any hope investors had of creating
wealth in the US large-cap stock market. Consultants and
advisors want to get compensated by institutional and individual
investors for a long time and the way to keep the money the last ten
years has been to play defense or mitigate risk. In effect, the wealth
manager is a custodian of wide-asset allocation.
Therefore,
we've gone from asset allocation "Nirvana" in the ten years ended last
summer to the asset allocation "Nightmare" of today (see our missive
of this title July 2011). Everyone is crammed into a very similar asset
allocation template and over-valuing most asset classes in the process.
Watching investors get food poisoning from gorging on emerging market
and bond investments could cause Anna Faris
to make another "Scary Movie". One sector of the US stock market asset
class (US Large-Cap Equity) is as under-owned today as it was over-owned
in 1999. The other asset classes, which were incredibly starved for
capital in late 1999, are stuffed with capital
like a Thanksgiving Turkey. We believe they offer a great deal of risk
and little reward.
What
is today's opportunity? In our opinion, heavily over-weighting US large
cap equity should be a winning trade until there is a massive and
sustained
net inflow into the category. Lipper reported last week that US
large-cap equity funds have seen 38 consecutive months of net
liquidation. We believe the long-term rewards in this category could
continue for five to ten years, because it will take that long
for the category to gain popularity among asset allocators.
Best Wishes,
William Smead
The information contained in this missive represents SCM's opinions, and should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities we recommend will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.
(c) Smead Capital Management
