The Bifurcation Economy (h/t)
We’re living in the Upside Down.
2020 has been a year of superlatives and increasing uncertainty. The worst public health crisis in over 100 years. The highest unemployment rate since the Great Depression. An estimated budget deficit approaching $4 trillion. Rising income inequality. Systemic racism and police brutality sparking nationwide protests and riots. Spiking gun sales. An upcoming, divisive election.
And yet, the stock market has responded with a shrug. After a steep one month sell-off from late February to late March, the indices have come roaring back. The NASDAQ continues to post all-time highs and the more widely followed S&P 500 is not far behind.
How the hell did we get here? And how can investors navigate these markets?
The 40 Year Super Cycle — Declining Interest Rates
Interest rates have been steadily declining since the early 1980s. The trend began as a normal reversion to the mean but overshot as a result of the Fed’s commitment to Zero Interest Rate Policy (ZIRP) post financial crisis.
The Fed has also been relying on quantitative easing (QE) to prop up the markets and reduce credit spreads. In response to COVID-19, their balance sheet has expanded by trillions of dollars and the purchases have extended to risk assets such as corporate bonds.
Morgan Housel recently theorized, “Once a new kind of stimulus is tasted it becomes a permanent feature of how downturns are handled.”
We’re like the heroin addict who can’t cope without a daily fix. No investor under the age of 65 has experienced a prolonged rising rate environment, skewing baseline assumptions and investor psyche.
As Warren Buffett reminds us, interest rates act as a gravitational force impacting the price of all assets and the decline in rates has been a major tailwind for equities. The S&P 500 has compounded at 11.6% annualized since 1980, assuming dividends reinvested. Multiple expansion is responsible for ~3–4% annualized gains, pushing returns from high single digits to low double digits.
What if we look at private markets?
Modern private equity (PE) can be traced back to KKR and Thomas H. Lee Partners in the late 1970s. The industry gained momentum in the ‘80s with a surge in leveraged buyout (LBO) activity and the emergence of junk bonds. Well known firms such as Bain Capital, Hellman & Friedman, Blackstone, and Carlyle were all formed during this period.
But it was ultimately a Limited Partner who popularized the asset class and opened the fundraising floodgates. David Swensen became the Chief Investment Officer at Yale in 1985 and famously coined the Endowment Model. Taking advantage of a permanent capital base, Swensen approached investing with an equity orientation and searched for alternatives with an illiquidity discount.
Large pools of capital (e.g. endowments, pension funds, family offices, and sovereign wealth funds) recognized the attractive returns and also redirected funds to alternatives. Private equity was a nascent industry in the ‘80s and has blossomed into a multi-trillion dollar asset class today. It’s a constant story in finance — capital flows towards innovative ideas and reduces outsized return potential.
Similar to public equities, declining interest rates have also propped up purchase multiples.
Dan Rasmussen of Verdad Capital helps summarize PE outperformance in the 1980s, “They bought things at 6–7x EBITDA, 50–60% levered, often things that were growing, and exited at very high rates of return…if you buy things cheap and you get levered multiple expansion it turns out to be a phenomenally good idea.”
But current multiples have doubled. In fact, the emergence of “Adjusted EBITDA” likely means that ~12x is equivalent to a mid-teens multiple on a like-for-like basis. The industry has rationalized higher multiples with higher leverage ratios. In a spreadsheet driven world, increased leverage paired with lower interest rates boosts return to equity owners.
However, the real world doesn’t have bumpers. As Rasmussen explains, “Buying levered micro-caps at 16x EBITDA…is just nuts.”
The Rise of Indexation
In addition to declining interest rates, fund flows have played a major role shaping U.S. equity markets in recent years. Over $1.5 trillion (net of investment returns) has been reallocated from actively managed funds to passive vehicles since 2006.
This seismic shift can be traced back to technology advances, regulatory changes, and demographic trends.
The S&P 500 index was created in 1957 and the first index funds were launched in the ‘70s. The next wave of innovation was in the early ‘90s with the introduction of target date funds and exchange-traded funds (ETFs). Then in 2008, Wealthfront and Betterment launched the first robo-advisors.
While many market pundits point to the Global Financial Crisis as the catalyst for rebalancing into passive strategies, the chart above shows the inflection point occurred in 2006. Right around this time, The Pension Protection Act was signed into law. One aspect of the legislation made it easier to automatically enroll employees in workplace retirement plans and invest the funds into target-date funds, designated as Qualified Default Investment Alternatives (QDIA). Tens of billions of dollars have been invested in passive funds as a result.
Changing demographics is the final piece of the puzzle. It’s been widely cited that passive now has roughly 50% market share in U.S. equities. But Mike Green of Logica Capital notes that it’s not evenly distributed. Millennials have an unusually large share of passive as they’re primarily saving via a 401k plan. And forced sellers over the age of 70 actually have a relatively low passive penetration. The marginal dollar is flowing from active to passive.
This shift shows no signs of slowing down. But how is it impacting markets?
Price is a key input for fundamental, discretionary investors. Howard Marks elaborates, “No asset is so good that it can’t become a bad investment if bought at too high a price.”
On the opposite end of the spectrum, passive strategies are price agnostic. Mike Green beautifully summarizes the algorithm, “If you give me cash, then buy. If you ask for cash, then sell. At what price? Whatever price I can get. It doesn’t matter. The presumption is that every price is the right price.”
The fundamental premise underlying passive investing is that one can own the entire market at very low fees without distorting prices. But that’s absurd when trying to deploy trillions of dollars.
For example, why did Standard & Poor’s shift to float-adjusted market cap weightings in 2004? As assets increased, it became a challenge to purchase stakes in companies with limited float, such as founder-led companies with high insider ownership (e.g. Microsoft, Apple, Google, and Amazon). The adjustment helped index funds scale, but the algorithm change makes discretionary investors cringe. Here’s the summary, “If a founder/CEO buys stock in the open market, then sell. If she sells, then buy.”
As more and more dollars purchase the same basket of stocks, publicly traded equities have been segmented into haves and have-nots. You’re either above the line of indexation or below it.
Let’s compare the S&P 500 returns vs. some less popular indices and exchanges.
The popular indices are benefiting from a virtuous cycle and it’s hard to compete against a tidal wave of fund flows.
Changing Markets Create Opportunity
To recap, low rates and the rise of indexation have elevated valuation multiples, particularly among popular index constituents. Investors are left with three options:
- Accept lower returns: I am certainly not calling a market top. The trends driving the market are powerful forces and multiples can continue to expand significantly from here. However, my base case for the S&P 500 over 10–20 years is mid-single digit annualized returns. And we haven’t even discussed above trend-line profit margins or historically low U.S. corporate tax rates. If those metrics revert to the mean, we could be facing a lost generation as it relates to wealth creation. Nobody is prepared for this.
- Speculate and reach for yield: Investors have been conditioned to expect double digit equity returns and to buy the dips. Disclaimers about past performance are ignored and complacency is rampant. We’re tempted to purchase riskier assets, increase leverage, and hold less cash. This story never ends well.
- Search for less competition: The rise of indexation offers a generational buying opportunity. One can swim against the current, chase illiquidity, and search for gems among the have-nots. Although this strategy has limited scalability, it’s actually a key feature as larger institutions can’t join the fray. This option also requires investors to lengthen their time horizon and accept significant volatility. It’s certainly not for everybody.
Publicly Traded Alternatives (PTAs)
I’m choosing door number three. I believe a long-only, concentrated portfolio of publicly traded alternatives can generate 15–25%+ annualized returns.
Venture Capital is a game built around slugging percentage and asymmetric bets. You can only lose 1x your capital (as long as you don’t double down along the way). Yet the upside can be 100x or greater. There are certainly some compelling VC-like opportunities amidst the sea of publicly traded microcaps. But the challenge is holding these winners through periods of uncertainty and volatility. Illiquidity is actually a key feature in venture and helps protect investors from themselves. I tend to be very selective in this category given the high probability of capital loss. I also try to build in the appropriate guardrails, such as sub 1% position sizing and a deep understanding of the home-run scenario, to protect against the behavioral biases that will inevitably arise.
Growth equity used to be lumped in with late stage venture or private equity. But the industry has grown tremendously over the past decade as mobile devices and cloud computing ushered in a new wave of technology disruption and startups have opted to stay private longer. Additionally, Yuri Milner’s 2009 investment in Facebook established a blueprint that many others have followed. In the public markets, growth tends to go in and out of favor over time. Although the category appears to be fully valued currently, there are still a handful of opportunities in misunderstood or underestimated companies. My favorite growth investments have both accumulating competitive advantages and low penetration rates. Buyside and sellside analysts almost always model decelerating growth rates but this powerful combination enables sustained growth for many years. Early in my career, legendary tech investor Roger McNamee offered this advice, “If a product is successful, the estimates are always too low. And if a product fails, the estimates are always too high.”
Private equity is predominantly known for leveraged buyouts. Again leaning on Dan Rasmussen, the early success formula can be boiled down to “small, cheap, and levered.” This framework can be applied to public equities as well. Some PE firms have also been successful with roll-up strategies in fragmented industries. Small, tuck-in acquisitions can often lead to multiple arbitrage as the platform company benefits from scale and operating efficiencies. Some of the best performing stocks also pursue this model. I’m always searching for the next Outsider CEO who deeply understand both operations and capital allocation.
As we touched on earlier, the alternative asset management business has exploded over the past few decades. Most hedge fund and private equity commitments are invested directly into the funds and are therefore valued at net asset value (NAV). Even PE secondaries are typically done at only a small discount to NAV in non-distress scenarios. However, in the public markets, it’s possible to get access to talented alternative fund managers at only ~50–60% of NAV. Essentially, you’re getting a massive fee discount.
Real estate has made and lost many fortunes. For example, Donald Bren became one of the wealthiest people in the world by purchasing and developing the Irvine Ranch. But many public investors shy away from land developers — it’s a capital intensive, cyclical business that requires a time horizon measured in decades. Additionally, GAAP accounting isn’t particularly helpful as profits are lumpy and land values are carried at cost. Therein lies the opportunity for a long-term investor willing to take on significant volatility.
Many investors pitch a “private equity approach to public markets.” As far as I can tell, this typically means rigorous analysis and a slightly longer time horizon. But is it possible to find attractively priced, publicly traded opportunities that look and feel like alternative assets from a prior decade?
You have to be willing to search in underserved corners of the market where capital is scarce due to structural forces and/or behavioral biases.
For example, Westaim is a small cap that trades on the TSX Venture exchange. Almost 60% of this exchange is comprised of materials and resource-related companies. Aggregate returns have been abysmal and capital has sprinted for the exits. A company like Westaim — with two U.S. based financial services subsidiaries — has been thrown out with the bathwater primarily due to their legacy listing.
I also gravitate towards opportunities that other investors actively avoid. Or even better, situations that generate a visceral, negative reaction. Many professional investors are looking for a relatively near-term catalyst to unlock value. But the lack of any apparent catalyst is one of the primary reasons why a company that owns world-class land in Maui trades at a massive discount. Minority investors can’t gain control or force monetizations so obviously you need to trust management and the board. But private real estate investors would be salivating over this purchase opportunity.
The Liquidity Flex
Private market investors usually get one bite at the apple to buy or sell a portfolio company. Many investors view this lack of liquidity favorably due to less [apparent] volatility.
On the other hand, PTAs offer the ability to adjust position sizing over time and take advantage of wild shifts in sentiment. However, I’m not advocating for completely selling out of your winners if valuation increases. If a great management team is firing on all cylinders, I try to hang on for as long as possible. But flexing the position size along the way has historically been very accretive to returns.
For example, Interactive Brokers has been a core position since April 2014. The forward earnings multiple has bounced between ~20–35x as growth expectations and competitive dynamics have shifted over this period. Since my first purchase, the stock has compounded at a respectable ~17% annualized. However, my annualized return has been ~33% as I’ve traded around the position. The chart below shows my purchases and sales and the corresponding forward earnings multiple.
Edge — Stay Small, Think Long, Be Flexible
Here’s the irony of investing — we’re all searching for great businesses with durable competitive advantages, yet our business has paper-thin barriers to entry.
I try to take Paul Graham’s advice and do things that don’t scale. Instead of attempting to constantly level-up, I want to stay small and continue to fish in less trafficked ponds. Most professional investors measure success based on assets under management, fee income, and notoriety. I want to redefine the game and instead prioritize annualized returns over the next 50+ years.
Long-term thinking can also lead to outperformance as time horizons continue to compress in the public markets. Technology has created a fire hose of information that’s always on. Additionally, the vast majority of capital allocators require monthly reporting. The ability to look past quarterly earnings and think about value 5–10 years down the road is increasingly rare. This capacity to suffer in the near-term and accept periods of under-performance allows investors to take advantage of market volatility rather than panicking. Quality partners and structural advantages (e.g. permanent capital or lock-ups) are therefore key inputs that most emerging managers underestimate.
Lastly, I hope to benefit from a flexible approach as investment strategies go in and out of favor over time. I started my finance career on Wall Street and grew up as an investor in Silicon Valley. I try to migrate between these two worlds and balance the inherent optimism vs. skepticism. It allows me to invest in both disruptive technology companies as well as deep value opportunities.
Publicly traded alternatives are some of the most compelling investment opportunities I’ve seen in my career. Let’s build something great.
Appendix — Examples of Publicly Traded Alternatives
Disclaimer: This content is for educational and entertainment purposes only and should not be construed as investment advice or a recommendation to buy or sell any security.
Growth Equity — Stitch Fix
Founded in 2011, Stitch Fix is bringing window shopping on the web and disrupting the retail industry. The value proposition is rooted in personalization, curation, and discovery. Fashion conscious consumers aren’t looking for the cheapest/fastest pair of jeans. Instead, they want jeans that fit well and give them confidence.
Stitch Fix has all the characteristics I look for in growth opportunities: visionary founder/CEO, capital efficient with proven unit economics, accumulating competitive advantages via data network effects, and a massive penetration opportunity.
Yet despite consistent growth above 20%, Stitch Fix trades at only 1.3x forward revenue. This is equivalent to a high-teens steady state earnings multiple assuming ~10% long-term operating margins.
Investors lump Stitch Fix in with other subscription commerce companies which have struggled due to high churn and unprofitable unit economics. Stitch Fix has always identified as a personalization company and five things in a box was just the first product iteration, akin to the Amazon bookstore. Over the past year, Stitch Fix has been aggressively expanding into direct-buy digital storefronts. It’s still a highly personalized and curated experience, but allows customers to shop in a more familiar environment with less commitment.
As Stitch Fix demonstrates they can evolve beyond five things in a box, investors are likely to return at least the growth of the business due to the modest entry multiple. I believe annualized returns can be in the 20–30% range over the next decade.
Growth Equity — Interactive Brokers (IBKR)
Originally founded as an automated market maker in 1977, Interactive Brokers has morphed into an electronic brokerage platform. The value proposition stems from an obsessive focus on automation in every aspect of the business (e.g. account opening, trade execution, settlement, compliance, and reporting). IBKR leverages their technology advantage to offer a powerful combination of low all-in costs and broad market access in 33 countries.
Despite 20%+ annualized account growth the past five years and industry leading margins, IBKR trades at only ~28x 2021 estimated earnings.
U.S. investors are focused on increasing domestic competition but they’re underestimating a massive international growth story. This is very similar to Priceline post the Booking.com acquisition in 2005. With significant competitive advantages overseas and low penetration rates, I believe IBKR will be able to sustain account growth above 20% for the next 5–10+ years.
Here’s Thomas Peterffy at a recent investor conference, “The strongest factor in our growth outside of the U.S. is basically lack of competition. Total account growth as of May is 31%, but it’s 19% in the Americas, 44% in Europe, and 35% in Asia.”
IBKR’s relatively small public float may also contribute to the mispricing. Only 15% of the company is freely traded as Peterffy owns ~75% and other insiders own another ~10%.
Private Equity — Cambria Automotive
Cambria Automotive is a roll-up of auto dealerships in the United Kingdom. Owner-Operator Mark Lavery raised ~£10.8 million from a private equity firm in 2006 to finance the first acquisition. From a standing start 14 years ago, Lavery has paired operational excellence with a “buy and build” strategy to grow to nearly 30 locations and over £650 million in revenue. Even more impressive, he hasn’t raised any additional equity — all growth has been funded with cash flow from operations and modest debt drawdowns.
Cambria has been profitable every year since inception, averaging a ~16.5% return on equity. The company has continued to grow revenue and profits through difficult economic periods, such as the Global Financial Crisis and Brexit. Auto dealerships tend to be less cyclical than most believe — service and maintenance generate approximately 40% of Cambria’s gross profits and tend to be relatively stable through economic cycles. And now due to more advanced technology embedded in cars, dealerships have been able to retain a greater percentage of service appointments post sale.
Lavery is also a best-in-class operator which generates a reinforcing feedback loop as the auto manufacturers want to work with the best operators. McLaren, Bentley, and Lamborghini are three high luxury brands that have recently awarded dealerships to Cambria.
Cambria is trading at ~5x F2019 earnings. Between continued growth and multiple expansion, I believe this has the potential to be a five-bagger over the next five years, equivalent to a ~35%+ IRR.
Private Equity — Lawson Products
Lawson Products is an industrial distributor focused on vendor managed inventory (VMI). This is predominantly a service business — sales reps are visiting customer locations on a weekly or bi-weekly basis to ensure adequate levels of inventory. VMI makes it less likely that a business will be forced to shut down a manufacturing line due to a stock out of raw materials.
President and CEO Michael DeCata joined Lawson in 2012 when revenue was declining and the business was losing money. He drew on his background at leading industrial and distribution companies (e.g. W.W. Grainger, General Electric, United Rentals) and implemented Lean Six Sigma to turn the business around. Revenue is now growing and EBITDA margins have increased to the initial targeted range of 10%.
In addition to operational excellence, DeCata sees an opportunity to roll up a fragmented industry. Lawson has executed on a handful of smaller acquisitions in recent years and integrations have gone well. The company hopes to scale up M&A capabilities going forward and they recently hired Brian Hoekstra from W.W. Grainger to lead the effort.
At current prices, investors are paying ~8x EBITDA for an unlevered, capital-light service business disguised as a distribution business. We’re also co-investing alongside a private equity firm who has experience in the industry. LKCM Headwater began purchasing shares in mid-2013 and has steadily increased their position. In late 2018, they agreed to purchase shares from members of the founding family at $32 per share and increased their ownership from ~29% to ~48%.
Asset Management — The Westaim Corporation
Westaim is a holding company that controls a credit-focused hedge fund (Arena) and a specialty property and casualty insurer (HIIG). The stock is trading at 60% of book value despite significant operational progress and momentum.
Westaim seeded Dan Zwirn in 2015 to launch Arena, which has scaled to over $1.3 billion AUM and has built out an impressive team, process, and infrastructure. The fund targets mid-teens returns by going after niche opportunities in underserved markets via a proprietary sourcing engine.
HIIG has had a rocky operating history the past few years but recently brought in new leadership and is extremely well capitalized to go after the first legitimately hard insurance market since the early 2000s.
Due to a legacy listing, Westaim trades on the TSX Venture exchange and is way below the line of indexation. The transition out of actively managed funds has been a headwind for the stock. In Q4 2018, the Sun Life Sionna Canadian Small Cap fund shut down and liquidated their stake in Westaim. And late last year, Harbour Growth & Income (part of CI Investments and Westaim’s largest shareholder) was merged into a larger CI fund due to under performance. Likely as a result of this reorg, CI Investments reduced their Westaim position by a third and sold over 5% of the company.
As the stock has languished this past year, insiders have been aggressively buying in the open market. I’m thrilled to invest alongside them as I believe this has a chance to be a long-term compounder. In fact, CEO Cam MacDonald has referenced the White Mountain playbook of buying back the majority of shares over a 10–20 year period. Once Arena and HIIG reach escape velocity and start returning capital to the holdco, I expect the share repurchases to commence.
One way to frame the investment is buying a secondary stake in Arena at 60% of net asset value. Plus, you get a 25% seed stake in the GP which I believe can ultimately be larger than the entire current market cap of the company.
Real Estate — Maui Land & Pineapple (MLP)
MLP owns 23,000 acres of land on Maui which is roughly 5% of the entire island. Over 90% of the acreage is located in West Maui, primarily contiguous parcels in and around the Kapalua Resort. The company originated as an agricultural operation in the early 1900s but has since transitioned to focus exclusively on land development.
The crown jewel is 900 acres in Kapalua with full entitlement rights. This is a world-class property and development is expected to be completed in the next 10–20 years. The majority of other land is zoned for agriculture and conservation.
Former AOL CEO Steve Case purchased control of MLP during the Global Financial Crisis. He has been tight-lipped on his plans and many skeptics believe he considers this a trophy asset and is not looking to maximize shareholder value. However, the company has consistently and opportunistically monetized assets since Case gained control. Despite selling less than 5% of total acreage, the asset sales brought in over $215 million — more than the entire current market cap of the company.
Initially, all proceeds went to pay down debt. But the company has been debt free for a couple of years and the asset sales continue. In fact, the Central Resort sale is expected to close in mid-September bringing in over $40 million. The excess cash on the balance sheet could serve as the next catalyst for the stock as we’ll get a glimpse into Case’s capital allocation philosophy.
My best guess is I’m buying this land at ~50% of net asset value. And this is not a melting ice cube — the company is cash flow break-even as small leasing and resort operations cover corporate overhead. I expect land values to continue to increase and also serve as an inflation hedge. Additionally, long-term investors will occasionally see step-changes in asset values as MLP goes through the long process to convert agricultural land to development land.