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.
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.