What do you do when you think markets are expensive?
Of all the financial commentary that appears online every day/week/month/year, by far the most interesting to me are Howard Marks’ monthly memos. In particular, the last two have been packed with insights, and with the most recent one being released a week ago, I wanted to share some things that could be beneficial to private investors. Specifically, I wanted to talk about a section in the memo entitled “Investing in a Low Return World”.
A time for caution?
Anyone with an appreciation for financial market history will admit that timing the market in any capacity is extremely difficult. This is particularly the case for more passive investors. Howard Marks is most assuredly not a passive investor – in fact, a good argument could be made that he is one of the five all time best investors ever. He has shown an ability to take risks at times when risk-taking has been well paid, and has also shown the ability to lower his risk levels during periods where investors are not demanding adequate compensation for risk-taking.
The crux of Marks’ last two investor letters has been: It’s time for caution. I think it might be wise to heed his insights.
Given the environment, what does Marks suggest?
6 options – some of them not so good.
- Invest as you always have and expect your historic returns
- Invest as you always have and settle for today’s low returns
- Reduce risk to prepare for a correction and accept still-lower returns
- Go to cash at a near-zero return and wait for a better environment
- Increase risk in pursuit of higher returns
- Put more into special niches and special investment managers.
Lets look at these briefly. Option 1 is interesting, but if you believe that valuations ultimately matter (and I do), then I agree with Marks here – this is “sheer folly”. Option 1 is out.
Option 2 is the most sensible, low maintenance option on the list. Continue to invest as you have always done, and be aware that returns may be lower (or higher) than they have been in the past. Again, as Marks says: “sensible, but not highly satisfactory”
Option 3 and 4 are similar, given individual investors rarely have access to some fo the tools hedge fund managers use. There are arguments to be made for reducing risk depending on where you are in your lifecycle of investing (those closer to retirement may be more risk adverse for example), but the question remains – are you willing to accept a return of zero on your cash assets to be insulated from a potential correction? Most aren’t.
Number 5, in my opinion, is the worst of the bunch. Firstly, investors are typically bad at identifying their risk tolerance, and are most likely to say they have a high risk tolerance following a sequence of strong returns,. This is a terrible combo. Secondly, any time investors increase risk to compensate for low returns, I start to become concerned. It is very similar to reaching for yield ion dividend stocks – at some point you are ensuring a nasty shock down the road from mispricing risk. Do I want to be part of that crowd? Not at all.
Number 6 is the most interesting for me. This one isn’t easy however. And pursuing this means that you implicitly beliewe that a) markets are inefficient and b) you can identify people who can take advantage of it. Not everyone believes this, and not everyone can. This is the option I have been pursuing recently hwoever, and I’ll share some of the areas I’m hunting in.
Special Niches and how to find them:
Everyone knows that I’m a fan of listed investment companies. Luckily for me, there are a number of listed investment companies that focus on alternative or special niches. These funds include (but aren’t limited to) companies such as Bailador Technology (BTI), Australian Leaders Fund (ALF), Watermark Market Neutral (WMK), Monash Absolute (MA1), Blue Sky Alternatives (BAF) and Global Value Fund (GVF).
All of these companies focus on niche markets where mispricing can occur. Most of them have reasonable track records. So whats the kicker?
The fees are high. Most charge higher management fees and performance fees over hurdles, which may or may not be particularly demanding. But since you are paying for specialist investors operating in niche markets, you might argue that the fees are fair.
Now, its important to note that just because these companies operate in more niche investments, this doesn’t mean that they will be unaffected by any sort of turmoil in financial markets. While their portfolio performance is unlikely to be as heavily affected as some of the more vanilla LCIs, its almost certain that the trading price of some of these companies will fall substantially, leading to larger than usual discounts to NTA. This could provide some opportunities for savvy investors.
Howard Marks, as per usual, has given investors some incredibly useful nuggets of wisdom in his latest newsletter. By considering the uncertain investment market that his firm faces, he has outlined some strategies that investors may use going forward. Importantly, the Australian market may offer some opportunities to put Marks advice into action, at reasonably low costs and low effort to the individual investor. With a number of fund managers providing easy access to niche investment markets, investors should investigate the merits of these particular managers’ offerings.