Investors, don’t forget the research
For close to a decade, public and private market valuations have levitated with only momentary dips in the road, as central bank liquidity fueled asset prices. In the public markets, “old fashioned” asset allocation and securities analysis have often been replaced with risk parity funds, smart beta, macro hedge funds, CTAs, and a seemingly endless array of other algorithmic-based trading strategies. On average, markets have seen prolonged periods of record low volatility and high correlations making out performance by active managers increasingly difficult. Numerous hedge funds have been shuttered after falling victim to this challenging environment. High profile firms such as Greenlight Capital have survived but experienced large investor redemptions as it seemed this new paradigm of central bank driven markets and quantitative investment strategies have replaced longstanding fundamental analysis. The struggles of famed investor Julian Robertson’s “tiger cub” protégés have been one of the best examples of this seeming shift away from the days where investors rolled up their sleeves to understand all aspects of a company and its industry. In this environment of high frequency trading where computers buy and sell massive amounts of securities in thousandths of a second, the concept of Graham & Dodd’s value investing and margin of safety almost seem quaint.
Do we even have markets anymore or are we just one giant algorithm is a question that has been asked more and more frequently by institutional investors. Just when it seemed like the need for sharp financial analysis and a focus on valuation might be in demand once again as the Fed continued on its planned tightening schedule, we saw a dramatic reversal from Chairman Powell which the market has interpreted as unquestioningly dovish. And once again the machines reign supreme and rage on providing the best January in the market since 1987. Yet despite the V-shaped recovery we have seen since the December sell off of last year, most active managers will still under perform the market in 2019.
Does this somber forecast suggest that the utility of bottoms up/top down, fundamental research has waned in the current investing climate? In the public markets, some might argue that the speed of communication and almost instantaneous dissemination of new information has made already efficient markets efficient to the point of perfection.
Companies in the private market, however, lack Wall Street research coverage and are subject to greater information asymmetries between buyer and seller. The private markets are inherently less efficient than their public market counterparts yet research is less a part of the investment process. The value of research in the private markets will become increasingly critical to the long-term success of any fund. There is an old axiom that says investors make all of their returns when they buy the asset, not when they sell it. Implicit in this belief is the assumption that the price paid was one that will allow for attractive returns without having to “grow into the valuation” or benefiting from “multiple expansion” or some other hoped for occurrence that will compensate for a price paid that was too high. The best method for mitigating the risk of overpayment is an accurate forecast of a company’s future free cash flows combined with the selection of a proper discount rate and valuation multiple that reflects the total risk to an entity through a full economic cycle-not just on the day the acquisition is made. The inputs needed to make these decisions are the direct result of industry and company analysis combined with a keen understanding of current and future margin structure and revenue opportunities. This painstaking research combined with deep vertical expertise will distinguish the leaders from the laggards in the years to come.
The old media company which loaded on mountains of debt immediately before an economic downturn and at the same time that its core revenue stream was being secularly challenged did not wilt under this debt level simply because the leverage ratio was too high. There are companies that thrive with persistently high leverage ratios over extended periods of time. The old media company failed because the company was never capable of supporting this level of debt in the first place-something that proper research would have revealed-regardless of what the banker claimed. Research and investing should be tied at the hip in the private markets-and there aren’t any algos to say otherwise.