Expectations Investing – Michael Mauboussin And Alfred Rappaport: Review And Summary

  • Investors can earn superior returns by reading the price-implied expectations in stock prices and correctly anticipating revisions in those expectations.
  • Expectations Investing provides the tools investors need to read expectations and anticipate revisions of those expectations by manipulating the traditional discounted cash flow model, and by bridging the gap between valuation and competitive strategy.

Overview and Thoughts:

Expectations Investing: by Michael Mauboussin and Alfred Rappaport, provides investors with a fantastic framework upon which to make critical investing decisions. The book is a quick read, and the core concepts are relatively straightforward to apply, especially for investors with previous valuation experience. It’s critical today to be able to understand what expectations are embedded in a stock’s current price (what’s priced in?), and this book provides a useful set of tools to estimate these price implied expectations. One question I always ask in my personal investing process is, how does the market view my target?. Expectations Investing also bridges valuation (through the expectations investing framework) with competitive strategy analysis and the evaluation of management decisions.

Part 1: Gathering the Tools

Chapter 1: The Case For Expectations Investing

The authors argue that investors can achieve superior returns by reading the expectations that are currently embedded in the price of a stock, and correctly anticipating revisions in those expectations through competitive strategy analysis, and by reading management signals. Active investors have underperformed for a variety of reasons including but not limited to: costs, incentives, style limitations, and ineffective tools. The expectations framework doesn’t distinguish between styles like growth or value, leads investors to reduce the number of trades they make, and provides them with the correct tools they need to succeed. Here are the three steps in the expectations investing process:

  1. Estimate price-implied expectations (using a reverse DCF model)
  2. Identify expectations opportunities (where the company is most sensitive to revisions in expectations, ie. sales, costs, investments)
  3. Make a buy, hold, or sell decision

Chapter 2: How the Market Values Stocks

Research shows that despite popular belief that the market is short-term, it actually values stocks based on the magnitude, timing, and riskiness of long-term expected cash flows. In order to understand what expectations are implied in a stock price, investors need to understand a few key concepts:

  • How to get from a company’s financial statements to free cash flow
  • The time value of money and the relationship between discounting and compounding (here’s a cool visual from KeyDifferences.com)

  • Traditional DCF analysis

The expectations investing framework uses the future free cash flow performance implied by the stock price as a benchmark for decision making. The author’s argue (and I would agree) that this is a lot more useful than either struggling to forecast these future cash flows, or using poor short-term valuation proxies like P/E ratio’s.

Chapter 3: The Expectations Infrastructure

In order to correctly anticipate revisions in expectations, investors need to understand the framework of what drives shareholder value. The author’s detail the relationship between value drivers, (influenced by) value factors, (influenced by) and value triggers.

The three main triggers are sales, costs efficiencies, and investment efficiencies, and you can determine the influence that changes in each of these areas will have on the price of a stock by tinkering with them in your model. Investors should focus on the area with the largest expectations revision potential, which is usually sales.

Chapter 4: Analyzing Competitive Strategy

The way to anticipate changes in expectations is to foresee shifts in a company’s competitive dynamics. The author’s recommend a few standard frameworks for analyzing a company’s competitive strategy including:

  • Michael Porter’s Five forces framework: for industry analysis
  • Michael Porters value chain analysis: to understand the company’s choice of business activities
  • Disruptive technology analysis: to analyze if the company will be helped or hurt by innovation
  • Information rules: to evaluate information based business

It’s also important for investors to analyze historical competitive strategy and financial performance, and to compare them with the future performance implied by the price.

Part 2: Implementing the Process

Chapter 5: How to Estimate Price-Implied Expectations

I’ll give a brief overview of the chapter, but this is likely one you’ll need to read for yourself, as this is where the authors dive into the nuts and bolts. I’d also recommend hopping over to the, where you’ll find the necessary resources (including spreadsheets!) to implement the process. These are essentially the key steps though:

  1. Estimate price implied future free cash flows using consensus estimates and back into the current stock price through a reverse DCF model
  2. Evaluate the industry, the competitive environment, and the company’s historical performance to determine whether or not the price implied expectations are reasonable.
  3. Make buy, hold, or sell decisions

Chapter 6: Identifying Expectations Opportunities

The goal of investors is to take advantage of expectations mismatches. There are four building blocks that will help investors find these opportunities:

Data:

  • Price-implied expectations
  • Historical Results

Analytical Tools:

  • Competitive strategy analysis
  • The expectations infrastructure

Using these four building blocks, there are three steps to finding expectations opportunities:

  1. Estimate bull and bear cases for the sales trigger
  2. Identify the turbo trigger (the variable with the highest impact on shareholder value between sales, cost efficiencies, and investment efficiencies)
  3. Estimate bull and bear values for the turbo trigger

Investors should also strive to mitigate the effects of behavioral traps such as overconfidence and anchoring. Always allow for a margin of safety, don’t overestimate your abilities, challenge your estimates, and seek feedback from others.

Chapter 7: Buy, Sell, or Hold?

When to Buy?

  • Convert anticipated expectations revisions into expected values (basically scenario analysis); buy when your expected value trades at a significant discount to the current share price
  • Account for possible behavioral biases including recency bias, confirmation bias and loss aversion; always allow for a wide margin of safety to help mitigate these traps
  • If the range of expected shareholder values (between bull, bear, and consensus case) is high, a stock can be attractive even when the consensus is the most likely outcome.
  • If the range of expected values is narrow, you must have a contrarian view

When to Sell?

There are three main reasons to sell:

  1. The stock reaches your updated expected value (your new expected value is lower than the stock price)
  2. You find better opportunities
  3. You revised your expectations downward

Finally, make sure to account for taxes!

Chapter 8: Beyond Discounted Cash Flow

This chapter details how investors can value real options for future company projects, essentially using the Black-Scholes option pricing formula. This is useful for valuing companies with very uncertain outcomes like start-ups, which traditional DCF analysis tends to undervalue. Remember to always consider the potential moves of competitors when valuing the real options of a company.

Chapter 9: Across the Economic Landscape

The fundamental principles of economics have not changed, and we do not need new rules for value. There are three main categories of businesses, physical, knowledge, and service, and they can each be understood through the lens of of the value factors in the expectations infrastructure (volume, price, mix, operating leverage, economies of scale, cost efficiencies, investment efficiencies). Understanding the characteristics of these categories can help investors anticipate expectations revisions.

Part 3: Reading Corporate Signals

Chapter 10: M&A

Traditional EPS accretion/dilution analysis of mergers and acquisitions is useless. Investors should instead focus on shareholder value added and Shareholder Value at Risk, or SVAR. For the acquiring company this is equal to the present value of synergies less the premium paid. SVAR shows acquiring shareholders what percentage of their stock price they are betting on the acquisition. Investors can also gauge management’s confidence in the deals by analyzing the consideration; typically all cash deals imply a higher confidence level because the acquiring shareholders take on all the synergy risk. The choice between a cash and stock deal can also signal to investors if the management of the acquiring company thinks their stock is over or undervalued.

Chapter 11: Share Buybacks

The author’s present their golden rule for buybacks in this chapter:

“A company should repurchase its shares only when its stock is trading below its expected value and when no better investing opportunities are available”

Share buybacks can tell attentive investors a lot about a management team’s view of a company. There are different reasons for share buybacks, some that send positive signals, and some that send negative ones. If management is buying back stock because they believe it is undervalued this is likely positive, conversely, if management is buying back stock because they ran out of investing opportunities, or they’re trying to hit EPS targets, this is probably a negative sign.

Chapter 12: Incentive Compensation

“Show me the incentive and I will show you the outcome”

– Charlie Munger

This final chapter dives deep into employee compensation (for upper management, operating executives, and middle management), and shows how paying close attention to incentives of management can help investors anticipate expectations revisions. The two questions investors should ask about employee incentives are:

  1. Is this the appropriate measure? (is the standard of measurement linked to long-term shareholder value creation)
  2. Is this the appropriate threshold level?

The trade-off to keep in mind when evaluating a management team’s measure and threshold level of compensation is that there is a trade-off between the strength of an incentive and losing an executive.

If you enjoyed this review and summary of Expectations Investing, check out my other book reviews

 

Dead Companies Walking – Scott Fearon: Review And Summary

  • The six most common business mistakes that lead to failure
  • Tips for investors on both the long and the short side
  • Common behavioral biases facing investors and how to overcome them

General Thoughts

Dead Companies Walking: How A Hedge Fund Manager Finds Opportunity in Unexpected Places by Scott Fearon with Jesse Powell, is an engaging and easy read detailing experienced asset manager Scott Fearon’s investments in failing businesses (both on the short and the long side). The book isn’t set up as a how-to guide, but there are quite a few valuable nuggets of wisdom littered throughout. I did my best to distill what stood out the most to me in my summary below, but I would highly recommend checking the book out yourself!

Introduction

Hedge fund manager Scott Fearon starts the book by detailing his first encounter with a large market crash, the oil boom and bust in East Texas. He goes on to describe how this event, along with subsequent manias and crashes including the tech bubble in the late 90s and the housing bubble in the mid-2000s, shaped his views of markets and thinkings on failure. He describes failure as a “natural-even crucial element” of a healthy economy, and that people who are willing to accept this fact can “make a hell of a lot of money”. Through his long career in the asset management business, and experience interviewing managers to invest both on the long and short side, Fearon detailed the six most common business mistakes that lead to failure.

  1. They learned from only the recent past
  2. They relied too heavily on a formula for success
  3. They misread or alienated their customers
  4. They fell victim to a mania
  5. They failed to adapt to tectonic shifts in their industries.
  6. They were physically or emotionally removed from their companies’ operations.

Importantly, Fearon notes that the vast majority of executives of failing companies are neither stupid nor fraudsters, and that most are in fact intelligent and hard-working. These six common mistakes are traps that anyone can fall into, and that’s why it’s so important to understand and recognize them.

Chapter 1: Historical Myopia

“You can be richer, smarter, and more successful than anyone else. But if you’re not brutally honest with yourself about your own potential for failure, you’re going to have a problem—and you’re going to lose money, maybe a lot of money.”

Most people have a behavioral tendency to overweight the importance of recent history in their analyses (whether they be management teams or investors/analysts). Businesses move in both small and large cycles, and the latter are often ignored. Fearon’s mentor believed it was critical for investors to speak to and evaluate management teams, but to do so with a healthy dose of skepticism as they are often overly-optimistic, and prone to fall into these same behavioral traps. Falling prey to historical myopia is one of the greatest risks for value investors who focus on recent performance and financials (current multiples) to decide something is cheap, while simultaneously ignoring larger cycles, trends, and secular changes; investments of this type are often called value traps. This lead Fearon to the growth at a reasonable price ((GARP)) model, and to his focus on businesses with increasing cash flows and intrinsic values.

Chapter 2: The Fallacy of Formulas

“Oppenheimer & Co. put out in which it rated SPMD an “outperform” stock, boasting that the company “trades at 5x/6x our 2010/2011 EBITDA estimates.” There it is. The culprit, the root of Supermedia’s irrationally exuberant rally: the EBITDA formula.”

Markets are dynamic and ever-changing, and no one formula is going to lead investors to success. Fearon described how his personal favorite GARP formula led him to miss out on early investment opportunities in both Costco (COST) and Starbucks (SBUX), because he thought the multiples were too high. This is not to say that investment formulas and standards are not useful, they are most of the time, but all rules have exceptions. One such formula that Fearon singles out, is the valuation technique commonly used by analysts of slapping a comparable EBITDA multiple on the next years projected EBITDA. He also details a couple of his personal strategies for entering short positions and describes what investors should be wary of, stating that he will generally hold off until the stock has lost at least half of the value of its 52 week high (to avoid the wrath of momentum investors and the potential for a short-squeeze), and likes his positions to have, “enough downward velocity that there’s little chance it will stop before it hits bottom”.

Chapter 3: A Minor Oversight, Your Customers

“It’s okay to be wrong; it’s not okay to stay wrong.”

Probably the most important take-away from this book is the too often overlooked reality that customers are the lifeblood of any business. Too often, analysts and management teams misread their customers and mix up what they would personally want, with what the what the customers want. It’s critical to understand what people in the real world want, and how they actually behave. Fearon details a personal experience with this and writes of his own failure to account for his customers when he started a Cajun restaurant in Marin County, California.

Chapter 4: Madness and Manias

“Men, it has been well said, think in herds; they go mad in herds, while they recover their senses slowly, one by one.

— Charles MacKay, Extraordinary Popular Delusions and the Madness of Crowds”

Though we often think of the largest and most recent examples when we think of manias and bubbles, the truth is they are happening all the time, just on a smaller scale. Fearon argues that at their core, manias are about storytelling, and they happen when people convince themselves that something must be true no matter what. One common mistake that investors make is averaging down on positions that move against them. While it is true that sometimes this could just mean an undervalued stock is getting cheaper, it could also very well mean that your oginial analysis was wrong. The fact is that everyone is going to be wrong a lot, and it’s important to not keep chasing losing ideas and let them blow up your whole portfolio. As the saying goes,“Double-up, triple-up, belly-up.” Fearon believes that the best money managers are the best quitters. This advice rings true with what we’ve seen happen recently with famous money managers who became publicly attached to losing positions and poured massive amounts of money into them (ex. Ackman and Herbalife). Fearon also wrote about his time trading options in college, and detailed the four lessons he learned.

  1. Stockbrokers are useless and conventional wisdom/tips are usually wrong (groupthink)
  2. Trading on trends is a fool’s game
  3. Stocks tend to go up gradually but often go down rapidly
  4. Effective money managers do not go with the flow. “They are loners, by and large. They’re not joiners; they’re skeptics, cynics even.”

In Fearon’s mind, the top personality trait of a successful investor is intellectual curiosity. It’s important to be someone who can’t accept conventional wisdom, reads vociferously, craves new ideas, and isn’t afraid to try them out and fail.

Chapter 5: Deck Chairs on a Sinking Ship

Buggy Whip Syndrome: “they failed to recognize that their industry had fundamentally and permanently changed”

Failing businesses often hope small changes will guide them back towards prosperity, when in reality, a successful change would take nothing less than a complete overhaul of the dying core business. Fearon gives the perfect example of this scenario with the story of Blockbuster. Blockbuster had the opportunity to invest in its online business to compete with Netflix (NFLX), but that would have meant making the painful decision to close its stores and lay off thousands of people. Instead, the company went with easier, smaller changes to its stores, including selling more candy and other movie theatre snacks. We all know how that story ended. The same is often true of entire industries,

“Warren Buffett once said, “When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.”

Chapter 6: The Buck Stops…There

“The Bible says, “Pride goeth before destruction.” I think they should put that quote in business textbooks, because pride often goeth before bankruptcy, too.”

This chapter is on various red flags to look out, and is probably best summarized with a few concise pieces of advice:

  • Watch out for excessive leverage, especially in cyclical commodity-based businesses.
  • Beware of lavish execs/elitism in upper management, (Fearon gives the great example of Ron Johnson at JCP).
  • Watch out for companies that continuously make excuses and blame their poor performance on external factors or scapegoats, and check how their competitors are doing.

“Whenever I see the “sluggish economy” chestnut in a disappointing earnings report, I make sure to check how the company’s competitors are faring.”

This next quote also rings especially true as of right now, (TSLA) anyone?

“investors and corporate executives alike love to blame that old bogeyman, short-sellers. It’s a convenient way to justify unwise investments and deflect attention from the real reason companies lose value: the poor decisions of the people running them”

  • And lastly, be wary of growth driven primarily by acquisitions. This growth can often serve the interests of management teams more than the interests of shareholders.

Chapter 7: Short to Long

“failure might be more common than people like to admit, but it is not inevitable—even when things look irreversibly dire.”

Despite his success on the short side, Fearon has made the majority of his money on the long side. He presents some compelling reasons why short-selling isn’t as attractive as it used to be, along with a few tips for investing on the long side, which he argues will always be the best way to earn outsized returns.

  1. The investable universe has gotten smaller
  2. SOX reduced a lot of aggressive accounting
  3. Low interest rates have led brokers to charge short-sellers expensive daily borrowing rates
  4. Investors have gotten better at short-selling and the competition for good shorts is high.

On the long side:

  • Managements matter, don’t go “Excel crazy.” One of his earlier mentors would tell him,

“Get up and go outside, Scott…you’ll learn more in five minutes of talking to someone at a company than you will in a week crunching its numbers.”

  • Don’t average down, and don’t sell your winners too soon.

“Quit early and quit often”

  • Stay humble; recognize your own failures and learn from them.

“Peter Lynch, probably the most successful money manager in history, said the best you can hope for is to be right six times out of ten when it comes to picking winning companies”

  • And finally, Fearon recommends that investors look in less efficient areas of the market (small/microcaps), and keep from growing too large.

Chapter 8: Losing Money Without Even Trying, Welcome to Wall Street

“But for all of his talent, he also had a critical weakness: he thought he had friends on Wall Street.”

In this final chapter, Fearon tells a few stories about the many unethical actions he’s seen in his career in the investment management business. One story in particular stood out to me. It was about a time he called a broker to let him know of some serious downside risks that he had discovered in one of the stocks he (the broker) was promoting. Fearon was met with outright hostility by the broker, who warned him not to mess with his commissions, and then threatened to call his boss. Fearon describes that managers also tend to just be focused on what’s going to make them the most money, fees. This is why many are focused on growing AUM rather than on earning excess returns with the capital they already have under their disposal. This reminds me of the Charlie Munger quote, “Show me the incentive and I will show you the outcome.” As Fearon puts it, “Asset size is the enemy of returns.”

He next details why he thinks most people in the financial world are terrible investors.

  1. They’ve spent their whole lives going along to get along – prone to groupthink, manias, and bubbles
  2. They are hypercompetitive – don’t admit failure and adjust strategies, average down, and cling to bad ideas
  3. They worship rich and powerful people – defer to authority instead of questioning popular assumptions

Conclusion

“If we want to return to a growing and dynamic economy, we have to learn to embrace failure again.”

It’s important to recognize that failure is a normal and natural part of business and the financial system. The markets collective fear of failure has led to extreme policies like the tax payer bailout of the financial system in 2009, along with the simultaneous push to near 0% interest rates by the federal reserve.

Passive Index Investing: A Bubble Bound To Burst?

  • In the last decade, trillions of dollars have flown into assets irrespective of both fundamentals and price.
  • Investor’s are euphoric about passive indexing, and it is becoming an overcrowded trade with low prospective returns over the next 5-10 years.
  • Because of changes in index construction mechanics, historical index returns are misleading.
  • Informed investors seeking a margin of safety should hunt for stocks that have been largely ignored and excluded by passive index/ETF products, especially those with high insider ownership.

Over the past decade, trillions of dollars have flown out of actively managed equity funds and into passive investment vehicles, most popularly in the form of mutual funds and ETF’s that track specific indexes or sectors (SPY),(IVV), (VTI), (VOO).

(Via ThinkAdvisor)

We’ve seen similar shifts in the fixed income markets, though the main focus of this article will be on equities.

Though the original rationale for passive indexing makes a lot of sense, and while it still may be the best strategy for many market participants, the prospective returns for passive indexing strategies over the next 5-10 years look dismal (especially when considering changes in index structures and current diversification levels), and investments at today’s valuations lack a true margin of safety.

The Shift Towards Passive Investing

A few arguments are commonly used in favor of passive index-based strategies.

Fees: Most active fund managers have charged excessive fees, eating away at the returns of investors: This is one positive outcome that the shift towards passive investing and the under-performance of active managers has led to. Notably, because of the rise of the index as a performance benchmark, many active managers are focused on relative performance and charge high fees for portfolios that are essentially closet-indexes (largely for reasons of career risk, given that a few years of under-performance can be detrimental, even to managers of former all-star status like David Einhorn or Bill Ackman). Chasing relative performance detracts from the value active managers can add, and this shift has actually led to a shaking out of managers who may not have been adding much value in the first place. Fortunately, for investors across the board, the shift towards passive investing has put pressure on fees throughout the whole industry

(Source: Morningstar)

Historical Returns: The S&P 500 index has returned an annualized return of around 10% since its inception in 1928 (though as I’ll get into, this number is misleading). Subsequently, most active mutual-fund managers have not historically not outperformed a low-cost index strategy.

(Source: CNBC)

In his address to the American Finance Association in 2008, Kenneth French presented data showing that the average investor would have realized annual returns that were “67 basis points higher in a passive portfolio” than in an active portfolio from 1980 through 2006.”

While it’s true that most active managers have under-performed their benchmarks after fees, these historical return metrics are not an accurate representation of what active and passive investors can expect going forward (especially in the next 5-10 years, but also over a longer time horizon), and investors would be wise to be more forward thinking.

Efficient Market Hypothesis: Many who believe in passive investing are also proponents of the Efficient Market Hypothesis. The logic goes, markets are very efficient, and therefore, if you can’t beat them join them.

I’m not going to do a deep dive on market efficiency, but here are few great resources to dig into:

The Superinvestors of Graham-and-Doddsville – Warren Buffet: In this famous piece, Buffett argues against the claim of the Efficient Market Hypothesis that any excess returns delivered over the long term were merely the product of chance, in favor of value investing. He uses an example of coin-flipping orangutans, and uses an analogy that if you found out the majority of the winning orangutans came from the same zoo in Omaha (referring to value investing), it most likely means something.

Adaptive Markets: Financial Evolution at the Speed of Thought – Andrew Lo: This is an interesting book that gives a solid overview of both the Efficient Market Hypothesis and the foundations of behavioral finance, before drawing from both camps as well as from various biological sciences, to come up with a better theory of how financial markets function. Lo argues that modern finance theory (drawing from physics) doesn’t paint an accurate depiction of financial markets because in essence, they are a social construct.

Looking for Easy Games, How Passive Investing Shapes Active Management – Michael Mauboussin: This is a fantastic paper about how passive and active investing influence one another, the pros/cons of both, and on how passive investing leads to more inefficient markets (which are required for active managers to generate alpha).

Crowded Trade With Low Prospective Returns

Though passive indexing may prove a wise choice for investors with little to no market knowledge, there are a few problems with it that will likely lead many investors to be disappointed over the next 5-10 years.

The large shift towards passive investing has changed markets, and we’re now at a point where many of the original rationales for the strategy no longer make sense. The flow of trillions of dollars into passive funds (along with central bank actions) has pushed financial asset prices through the roof, via massive buying irrespective of price and fundamentals. In addition to sky high valuations, historical return and diversification metrics are misleading. Passive index investor’s expecting returns similar to the S&P 500’s quoted 10% annualized historical returns are in for a big let down.

Simply put, this trade is crowded, right down to the definition (as defined in the Mauboussin paper referenced above) :

Crowding, a condition where investors do the same thing at the same time without full consideration of the implications for future asset returns

Valuations

Though valuations could certainly get higher, the stock market today is far from cheap and the prospective returns are low. The worlds largest asset managers (who sell most of these passive products) agree.

BlackRock, Vanguard’s Jack Bogle, Morningstar – do not expect more than about 2% to 4% returns from stocks over the next five to 10 years.

Horizon Kinetics Q1 commentary

We’ll take a look at a few common valuation metrics here:

Stock market to GDP: This is a measure of the price of the stock market (market capitalization) relative to the U.S. GDP. (Also known as the Buffett Indicator or Yardstick):

(Source: Advisor Perspectives)

Here’s a variant of the same measure, with the Wilshire 5000 as a proxy for the entire stock market:

Both seem to paint a pretty similar picture about today’s valuations, but differ slightly when looking back to the tech bubble years of 1999-2000.

S&P 500 Cyclically adjusted P/E ratio:

Along with a definition/some summary statistics:

(Source: Multipl)

Though not the highest it’s ever been, it’s definitely getting up there.

S&P 500 Earnings Yield: This is an inverse of the commonly used P/E ratio, meaning that the lower the yield, the higher the implied valuation (though watch out for years with drop-offs in earnings like in 2009).

Painting a little more color on today’s relatively low earnings yields, it is also important to consider that we are coming off of a quarter with record high profit margins.

Overall, it’s clear that valuations are high across the board, though they can always persist or go higher. This isn’t about trying to call a top as valuations aren’t very predictive of short-term market movements, though this does provide some insight into prospective returns over longer time periods.

Historical returns metrics

S&P 500 Float Adjustment: This is actually something I just found out about, after listening to an episode of Jesse Felder’s podcast with Steven Bregman, and I’m stunned that it isn’t more widely discussed.

In 2005, Standard & Poor’s (SPGI) changed the structure of the S&P 500 index. The index had historically been market-capitalization weighted (price multiplied by shares outstanding), but the company moved to a float-adjusted index structure. The float adjusted index structure basically excludes the percentage of a stocks insider ownership from its float, thus stocks with higher levels of insider ownership are weighted proportionately less in the index. This was a business decision to make more money for Standard & Poor’s, given that this is a low fee business that must be operated at scale.

Though the structure of the index was changed, common historical return quotations were not. This is why historical index return metrics are so misleading, and why the prospective return profile looks so much worse, even with a longer-term time horizon. Much of the historical returns to the S&P 500 index have come from owner-operator type companies, and these historical figures used to advertise passive index based strategies have not been adjusted downward.

Here are a few reasons why prospective performance looks dismal for the float adjusted index, and why this move came at the expense of investors:

  • Insider Selling: When insiders sell, the available float increases. This means index funds will be picking up shares as insiders get out (usually a bad sign when en masse).
  • Insider Buying: When insiders buy, the available float decreases. This will lead the index funds to sell just as insiders are deciding it’s time to buy.
  • Equity Issuance: When a company issues new shares it dilutes the ownership of its current shareholders. This also increases the stock’s float and leads to index fund/index fund tracking product buying.
  • The agency problem: High levels of insider ownership lead to an alignment of interests between management and shareholders, quite simply, because the managers are also shareholders. Aligning interests between shareholders and managers is an often difficult goal that many corporations have failed at over the years, and this problem is solved by having owner-operators. Reducing the weighting of these companies in the index subsequently reduces the potential for many attractive investments.
  • Historical returns were driven in large part by owner-operator type companies. This is another research piece by Horizon Kinetics, promoting their “Wealth Index”, which tracks these owner-operator type companies.

Inflation:

The often quoted 10% annualized return number is before inflation. After adjusting for inflation the number is close to 7%. This number is also the battleground for some debate as there is a lot of skepticism over the accuracy of the CPI (which is used to gauge historical inflation).

Index Diversification levels are sub-optimal

Often referred to as the only free lunch in finance, diversification is not being well-served in many passive index investment vehicles.

  • The 30 largest companies in the S&P 500 account for almost 40% of the index’s total market capitalization.

(Source: Slickcharts)

Though this isn’t actually too out of line with historical levels, it’s still something to take note of.

  • Many passive index products are actually poorly diversified. Here’s an example of the weightings of Amazon (AMZN) in different passive ETF’s.

Not mentioned earlier, (QQQ), (VUG), (XLY), (FDN), (IVW), (IGM)

(Via Horizon Kinetics)

Beyond diversification between individual companies and sectors, it’s also important to consider diversification in money flows. Investors may gain a false sense of comfort by being diversified by metrics such as market capitalization, sector, and geography, when potentially, all of their money could be tied up in the same trade. Because stock prices in major indexes are being supported by the same source of supply and demand (flows into passive funds), inflows have propped up prices across the whole market. While beneficial on the upside, as always, this works both ways.

Opportunity for Informed Investors Seeking a Margin of Safety

The fact is that for the average person, individual security selection or manager selection is unrealistic. Passive buy and hold strategies are still probably decent advice for the average person with little to no market knowledge, though the fact remains that those with little to no market knowledge cannot expect high returns. For enterprising investors, much better opportunities abound.

Informed investors seeking a real margin of safety should look outside the realm of commonly covered stocks with high-levels of passive ownership and Wall Street coverage. (though this not to say that all stocks with significant levels of passive ownership should be avoided like wildfire, opportunities may still exist, they are just much less likely).

Here are a ways active investors can do just that:

  • Use indexation and passive fund rules to your advantage. Hunt where the money isn’t flowing, and look for stocks without large passive index ownership. On the podcast I mentioned earlier, Steven Bregman explained that investors can look for these sort of stocks systematically by first screening based on daily trading volume to find low volume stocks, then looking into those with higher levels of insider ownership and lower levels of passive/ETF type ownership. This is an approach I’m currently looking into.
  • Because valuations are high across most financial asset classes, investors may want to look into real assets. Here are some of the benefits as described in a great paper by Brookfield Asset Management.

Conclusion

The original rationale for passive indexing makes a lot of sense, and it still may prove to be the best strategy for many market participants (if they are able to stick to it). That being said, the prospective returns for passive indexing strategies over the next 5-10 years look dismal when considering current valuations, changes in index structures, and current diversification levels. Enterprising investors in search of a margin of safety should do their work in more lucrative hunting grounds with higher levels of dispersion, such as stocks that are under-represented in passive investment vehicles, and certain real assets.