Mar 27

Portfolio Manager Commentary — “Prediction is very hard, especially about the future”

A recent Wall Street Journal article on value investing caught our attention (Jason Zweig, February 15, 2013), as Jean-Marie Eveillard of First Eagle Funds summed up the challenge inherent in adhering to an out-of-favor discipline:

“After one bad year investors were upset,” he recalls. “After two they were mad, and after three they were gone.” Between 1997 and early 2000, investors yanked out two-thirds of the fund’s assets—and then missed out on its later years of superb performance.

To download a PDF of this report, click here.

The article continues:

The fund industry has long marketed the chimera of “consistency,” the idea that a great stock picker can always earn higher returns than the market. Investors who buy into this myth often sell in a panic as soon as the next crash proves that no stock picker can always outperform.

Over the decade ended Dec. 31, value funds specializing in large stocks returned an average of 6.7% annually. But the typical investor in those funds earned just 5.5% annually, according to Russel Kinnel, director of fund research at Morningstar.

Summit Street Capital Management, an investment partnership in New York, recently analyzed a group of value investors with long records of superior returns and found that even the best underperformed one-third to 40% of the time. ”It’s hard not to get shaken out unless you understand that and have conviction,” says Summit Street partner Jennifer Wallace.

Since 1999 St. James (sub-advisor to MOATX) has managed equities through euphoria and despondency. The excesses that contributed to the internet and housing bubbles and the corresponding collapse of asset prices has coincided with somewhat predictable human behavior. In fact, “Greed” and “Fear” have seemingly dominated short-term market action since Charles Mackay first identified the phenomenon of financial manias (Extraordinary Popular Delusions and the Madness of Crowds, 1841) and they do a lot to explain why the typical individual investor performs so poorly when measured over a ten-year interval.

Around the time of our inception in 1999, James Glassman and economist Kevin Hassett wrote an instant best-seller titled Dow 36,000. As the title suggests, the authors made a 3-5 year prediction about the future level of the stock market, which Hassett now admits was a “guess”. Further, consistent with the times, the Dow 36,000 prediction was fueled primarily by “declining risk premium” leading to multiple expansion. And, given the backdrop of the raging dot-com fueled bull market, the book sold well.

It’s our guess that a book titled Dow 8,500, the approximate level of the index at the beginning of 2003, would not have proven commercially successful. In fact, many skeptics were dismissed in the late 1990s, as no one wanted the party to end. Participants’ tendency to extrapolate the market’s rise well into the future (Recency Bias) resulted in Marie Eviallard losing assets to surging market vehicles such as the Janus Twenty Fund, which had amassed over $25 billion by April of 1999…concentrated in just 20 stocks! By mid-2001 the Janus Twenty had lost over 50% of its value.

Although today’s market euphoria does not rival that of the late 1990’s, there are some interesting parallels. Among the numerous pundits making the rounds on CNBC is Wharton professor Jeremy Siegel. The “Wizard of Wharton” rolls out his Dow predictions regularly and, despite his academic credentials, at least part of his approach is rooted in self-admitted recency: “With (the Dow) trading around 14,500, 15,000 by year-end looks pretty easy now, with 16,000-17,000 within range by the end of the year.” As one might imagine, this extrapolation technique worked well in 2012 but faltered badly in 2008. We can only assume that students are required to bring rulers to his class.

Such tendency to extrapolate future results based on recent returns reminds us of Howard Mark’s caution in The Most Important Thing:

Economies and markets cycle up and down. Whichever direction they’re going at the moment, most people come to believe that they’ll go that way forever. This thinking is a source of great danger since it positions the markets, sends valuations to extremes, and ignites bubbles that most investors find hard to resist.

Criticisms for his process aside, we acknowledge that Jeremy Siegel could very well be correct. As Yogi Berra famously said, “Prediction is very hard, especially about the future”. As a result, we don’t even try to guess short-term market behavior…the world doesn’t need another prediction on the Dow. However, we do spend a lot of time thinking about risk.

Given our focus as bottom-up managers, most of our energy goes to evaluating investment opportunities and trying to quantify potential downside scenarios. However, we do take some interest in the macro environment, as economic conditions profoundly affect the business models we are evaluating. As a result, we find it surprising that pundits choose to talk more about market performance than company performance:

Many are surprised to learn that, despite prevailing optimism, last year’s 16% market rise (S&P 500) was fueled by less than 1% earnings growth. Looking forward, the market clearly considers this an aberration, with Wall Street touting expectations of 14%+ earnings growth for 2013 and similar growth in 2014. We can only guess the prevailing extrapolation of market performance since 2010, coupled with a helpful Fed, allows everyone to overlook the earnings growth challenges most companies are facing in this environment.

Despite our skepticism, we fully acknowledge that greed can propel this market a lot higher….leaving our value-focused strategy to likely underperform commonly-referenced benchmarks and likely suffering outflows from a (hopefully) small group of frustrated investors. Although this is not a great scenario for our business, it’s an acceptable – and somewhat expected – outcome of our investment process. In contrast, what’s unacceptable is meaningful participation in a major market sell-off such as 2002 or 2008. Our focus on risk first is rooted in our commitment to our investors that we’ll never use the “no one saw it coming” excuse. We turned in our rulers long ago.

The opinions expressed are those of the Fund’s portfolio manager and are not a recommendation for the purchase or sale of any security.

The Castle Focus Fund’s prospectus contains important information about the Fund’s investment objectives, potential risks, management fees, charges and expenses, and other information and should be read and considered carefully before investing. The investment return and principal value of an investment in the Fund will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. You may obtain a current copy of the Fund’s prospectus by calling 1-877-743-7820. Distributed by Rafferty Capital Markets, LLC-Garden City, NY 11530, Member FINRA.

The risks associated with the Fund, detailed in the Prospectus, include the risks of investing in small and medium sized companies and foreign securities which may result in additional risks such as the possibility of greater price volatility and reduced liquidity, fluctuations in currency exchange rates, and political, diplomatic and economic conditions as well as regulatory requirements in foreign countries. There also may be risks associated with the Fund’s investments in exchange traded funds, real estate investment trusts (“REITs”), significant investment in a specific sector, and non-diversification.

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