Hummingbird Partners letter to investors for the second quarter ended June 30, 2016.
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“Economics is a discipline for quiet times. The profession, it turns out, … has no grip on understanding how the abnormal grows out of the normal and what happens next, its practitioners like weather forecasters who don’t understand storms.” -- Will Hutton, journalist, The Observer, London
Hummingbird Partners - Second Quarter 2016 in Review
The chart below portrays the market’s (S&P 500’s) reaction to both the signals and the noises during the second quarter. The daily high-low-close bar chart for the bellwether index is in white, as is the solid white curved horizontal line, which is the moving average for the index’s closing value for the preceding 200 trading days. It helps to differentiate the longer-term trend from the shorter-term squiggles. Their values are found on the legend to the right. The purple line is the daily closing price of West Texas Intermediate (WTI) crude oil, the price of which is on the left legend.
Apparent to even the casual observer, the fluctuations in the price of oil have been closely correlated with the S&P index. Though sure to diminish in importance, as has been the case since quarter end, oscillations in the price of oil have been instrumental in calling the tune to which the market has danced for some time. Stock selection continues to play second fiddle.
We’ve added two data points to the chart to shed light on the puppeteer behind the market’s curtain. The stair-stepping orange curve represents S&P trailing 12-month operating profit margins, and in green it’s the trailing 12-month S&P earnings per share (see right legend). While oversimplifying to make the point, the near-record level of share repurchases1 has dampened the effect of decreasing profit margins on the earnings-per-share calculation. This is visually apparent on the chart by the rate of decline of earnings per share, which is substantially less than the rate of decline of profit margins. The decline in profit margins, far from an energy sector-only problem, is frequently a harbinger of more difficult economic times ahead.
Winning by Minimizing Unforced Errors
The timing was perfect: 1987. Thomas Wolfe’s story of a Wall Street “Master of the Universe” whose comeuppance is grippingly depicted in The Bonfire of the Vanities or the swagger and arrogance of Gordon Gekko (Michael Douglas) in the movie Wall Street are appropriately stinging satire. Stripped of vainglory and intrigue, winning investment strategies are, quite simply, prosaic: In tennis parlance, they are more about minimizing unforced errors2 than they are about hitting crowd-pleasing winners. Below are several of the more common and beguiling unforced errors. If we come to know them, just maybe we can avoid them. Friend and fellow investment manager Richard Oldfield’s book’s title, Simple but Not Easy: An Autobiographical and Biased Book about Investing, should leave little doubt in the reader’s mind that the game won’t be without faults, pardon the pun.
“Prediction is very difficult, especially if it’s about the future.”
“Even repeated forecasting failure will not deter the unachievable pursuit of prescience, because our nature demands it.” Thus wrote Alan Greenspan quixotically in 2013.4 Appealing to our “inbred” nature, though certainly not our common sense, in May the Philadelphia Fed, which produces the oldest quarterly survey of macroeconomic forecasts in the U.S., released its latest report. The projected median real GDP growth rate of 42 prominent and independent economists is to be 1.7% in 2016; 2.4% in 2017 and 2018; and 2.2% in 2019. According to the selfsame economists, the mean probability of negative GDP growth in each of the years is approximately 5%. Although GDP has trended downward for the last three quarters, with the final revision for Q1 2016 at 1.1%, the forecasters see subpar growth but no recession for the next three years. Steady as she goes? Before you bank on it, read on.
In back-checking the prognostications of this highly qualified and largely homogeneous group, it seems these folks struggle to identify tipping points. For example, on the eve of recession in February 2000 they actually raised their estimate of real GDP growth for the year from 3.1% to 3.8%. Seven years later, in the fourth quarter of 2007, at what turned out to be the end of the 73-month expansion and the beginning of the Great Recession, essentially the same prognosticators had revised their growth expectations down modestly for 2008, although they remained confident about the big picture, reducing the probability of negative growth from 5% to 3%. Going back farther in the archives confirms that the problem is congenital.
The proximate causes for the fallibility of these experts in detecting when expansions roll over into contractions have several dimensions. Some of them are personal, inextricably linked to career risk. Even economists have mortgages and families. As John Maynard Keynes pointed out, if one who opines about the future wishes to remain employed, one must never be wrong … by oneself. Following that strain of logic, since data are ubiquitous in the digital age, professional herding and groupthink are all too common—and therefore the collective forecast’s mean, median, and mode tend to be more tightly clustered than ever before.
Most importantly, the backward looking, structurally naïve models that economists employ are incapable of incorporating the “unknown unknowns,” risks that we don’t know that we don’t know, contingencies that we haven’t even considered. Flash back to March 2000 and December 2007. Forecasters’ models were not—by design, could not be—robust enough to embrace an indeterminate variety and magnitude of unknown unknowns. To be sure, there was a handful of iconoclasts5 who were able to connect disparate dots in 2006 and 2007, but their warnings fell on deaf ears. Invariably the case in the court of the amorphous market’s opinion, right is invariably trumped by might. And when we look forward from today, the reality (about which we must not delude ourselves) is that forecasters have been unable to predict recessions more than a few months in advance … yet not for lack of trying.
Our policymakers are flying blind and if we—as risk-averse, absolute-return investors—fall into lockstep with our peers we are certain to join them as all-too-witting victims in a loser’s game. Harking back to career risk, the irony is that we can only win individually if in the long run our clients win collectively. Otherwise, when months become years, the outcome will be mutually assured misery. The quarter-to-quarter performance battle is not so easy. Winning the war rests in large measure with the patience and understanding of the clients we serve. In pursuit of our mutual gain, we must leave the false security of the herd and reject Keynes’ admonition, “It is better to fail conventionally than to succeed unconventionally.” In the simplest of truisms, if we think and act like everyone else, we cannot expect to be above average. We have no choice but to take the lonely road less traveled.
Not only have business cycles stumped the forecasters and those who blindly follow them, but over time they have been undergoing subtle but significant changes, exhibiting a false sense of stability that could ensnare even the wary. For the
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