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also:
General Index
of all guest columns written by Dennis C. Butler,
CFA
APRIL
2016
exations in the energy sector roiled
financial markets in the quarter just ended as oil prices — marked by
a sharp plunge in January — dropped to a low of around $27
per barrel (from $100 just a couple of years ago). Oil prices then bounced
back nearly 50% and stock prices followed suit (though less dramatically),
which is curious since there is normally very little correlation between the
two. Additionally, expected economic benefits from lower energy costs have
been slow to materialize, perhaps due to fears that lower oil prices
actually reflect slowing growth worldwide, or that the impact in regions
directly affected by lower commodity prices (oil, but other materials as
well) might be spreading. A more complicated explanation was put forth by
the IMF, which suggests that lower energy prices reduce inflation, which
paradoxically increases
real
(inflation-adjusted)
interest
rates, thereby dampening the effect that cheaper energy might have on
stimulating economic growth.
As
investors it is essential to get beyond the preoccupation with the current
dynamics of the energy and financial markets. We believe that if one looks
ahead over a period of several years, the probability of significantly
higher energy prices during that time frame is quite high. Hence, while
Americans are fortunate to be enjoying sub-$2 per gallon gasoline prices,
they should resist the urge to let the unexpected bounty fuel their appetite
for big SUVs. The downside of lower prices brought about by an oversupplied
market is that they do not encourage investment in an industry that requires
vast and continuous spending just to maintain production. Declines in
production from existing wells require measures to keep the oil flowing,
and, over time, exploration for and production from new sources is needed to
replace the resource that has been exploited.
Recent
reports provide some figures that illustrate the impact of reduced industry
spending since the steep price declines began. In the early years of the
decade, during another period of elevated oil prices, producers (oil
companies and national operators) approved projects that have resulted in
about 3 million barrels per day ("BPD") in new production this year (such
projects have long lead times). However, natural declines from older fields
will remove approximately 3.3 million BPD from production in 2016. This will
be the first time in several years that falloffs have exceeded additions.
The result of waning investment beginning in 2014 as commodity prices
weakened, the imbalance promises to become more pronounced during the next
few years, as oil companies have cut their spending for two years running
for the first time since 1986.
Not even significant reductions in exploration costs (due to the sudden
appearance of excess capacity in the business) have been enough to offset
falling commodity prices. Production declines are now expected to exceed new
output by 1.2 million BPD in 2017.
The impact
is also seen in reserve replacement rates for the large oil companies.
In 2015, these companies reported decreases in their commodity
reserves for the first time in a decade as new discoveries replaced only 75%
of their production. Exxon, the largest, replaced only 67% of output, its
first failure to make up for depletion in more than 20 years. Part of this
is due to reserve accounting conventions, but in general companies are
cutting back on spending and focusing on extracting as much cash flow as
possible from existing fields.
Meanwhile, consumption of hydrocarbons as an energy source continues its
gradual rise, helped by lower prices. Despite some success in efforts to
reduce the world's carbon footprint
— the International Energy
Agency reports that $5.7 trillion has been saved over 25 years due to
efficiency measures
— demand for
oil and gas promises to grow for the foreseeable future. While the exact
timing cannot be predicted, the supply/demand picture promises significantly
higher commodity prices at some future date. Americans enjoying low gas
prices at the pump would be wiser if they put their savings towards buying
fuel-efficient vehicles.
I'm Not Like Everybody Else
— The Kinks
These are
woeful times for those in the business of managing other people's money,
particularly fund managers who invest in equities. The financial press has
been replete with stories detailing the failure of stock jockeys to beat
their "benchmarks"� ("performance"� targets based on one or more market
indexes) and "earn"� their fees.
The numbers do indeed look poor from this perspective; in 2015, about
two-thirds of so-called "active"� managers (those seeking to "beat the
market") turned in results that trailed their bogeys, but that was at least
better than the 90% failure rate of the previous year. A shifting of money
into "passive"� fund vehicles (those aiming to
be the market, not beat it) has
paralleled the downbeat news. Adding to their challenges, traditional fund
managers have a new competitor
— "FinTech"� (aka "Roboadvisors"�) which aims to
turn the entire investment process over to computers, that, following an
initial data upload from the client, spit out portfolio constructions. This
latter development holds particular appeal to the young, who are partial to
trusting software algorithms with all aspects of their personal lives.
Initially,
we were inclined to dismiss the complaints against traditional fund
management as being typical of certain points in the ebb and flow of market
cycles. After an extended period of rising stock prices, garnering good
investment results looks easy, even for the untutored. At the top of the
bubble in 1999, for example, equity index funds were widely and
unfortunately viewed as a shoo-in for 10% returns (they produced losses for
the next ten years). Because the record of stock prices since 2009 is quite
strong, the rising chorus of calls for "passive investing" does not surprise
us. The complaints about the failings of professional advice are also
nothing new. In the old days, before fund companies came to dominate the
business, "What do I need you for?"� was an epithet often hurled at brokers
during bull markets.
Nevertheless, we are hesitant to downplay the criticisms entirely because
they do have some validity. There are a lot of money managers who fritter
away gains with excessive trading and taxes, or who are simply incompetent.
But the very fact that the critique revolves around the matter of
"performance"� relative to benchmarks points to more fundamental problems
with the entire industry. It has become big, bureaucratic, and beset by
intense competitive pressures, which over time have evolved into an
obsession with short-term results relative to indexes and competitors. The
business has forgotten the simplest maxims of investment (e.g., buying
discounted securities, low turnover) and created procedures that virtually
guarantee mediocrity. Instead of making good investments, money managers
have become obsessed with "index hugging,"� avoiding volatility, and
accumulating assets. The fact that �risk"� is now often defined as how far
your holdings stray from those contained in an index indicates just how far
industry practices have departed from sound investment methodology. Even
holding cash is viewed as a career-threatening risk, although it may be the
best alternative purely from an investment standpoint.
Studying
the methods employed by highly successful investors current and past reveals
an instructive contrast. A common thread among all of them is the ability to
think differently, and act
accordingly. Obsession with "beating the market"� is nowhere to be found
— it
will not happen every year, and, indeed, at times it may neither be
desirable nor wise. Straying from an artificial index is not a cardinal sin.
Ironically, if you want to do better than an index, you do so by deviating
significantly from it, not hugging it, or better still, by ignoring it
altogether. The best investors have also tended to hold big positions in a
limited number of securities, or periodically carry large amounts of cash. Few asset owners today will tolerate such courses of action, as they can
lead to extended periods of sub-par results. Sadly, the modern investment
industry has taught its customers to abhor deviations from the comfortable
norm, validating a remark attributed to Keynes: "it is better for reputation
to fail conventionally than to succeed unconventionally."
Thinking
differently can pose its own risks, however, if not done with care. For
every Buffett or Klarman there are many who, perhaps out of hubris or, at
least, overconfidence, make unsound commitments and pay the price. A recent
blow-up at a mutual fund with an outstanding long-term record was due to the
stock price collapse of a pharmaceutical company that at one time accounted
for 30% of the fund's assets. This is a sad reminder that misjudgments with
respect to businesses and risk exposure can have dire consequences, even for
the best firms.
Passive, or
index, investing is deceptively attractive. It is easy to explain and
comprehend, and its apparent cost can be dramatically lower than traditional
alternatives. It has its place, especially when done over very long periods
of time, such as in a young person's IRA account. Putting larger sums into
such instruments at elevated market levels (an �active" decision, by the
way) increases the risk of disappointment, however. The
price paid for assets does matter, and it is at those times when
price is most important that advice is very valuable. Much of the time
professional investors do not do very much to distinguish themselves in the
eyes of the beholder (a lot of that time is devoted to the unglamorous task
of staying out of trouble). But at turning points, when risks are very high
or very low, their experience adds tremendous value and earns its fee. That
so many asset owners lack the perspective needed to tolerate the in-between
times is a sad commentary on the modern investment business, and a factor
that undermines the objective of producing good long-term results.
One of the
more interesting market phenomena of recent vintage occurred over several
months from the winter to summer of 2015, when the S&P 500 index fluctuated
within a very narrow range of 2-3%. You have to go back about a century to
find a like period of calm. Few noticed. A return to more or less normal
volatility this year had the pundits predicting the demise of Capitalism as
we know it. Composure returned, however, and the popular market gauges
closed the quarter mixed, with the NASDAQ down 2.7% and the others showing
gains of about 1.5%. Capitalism may indeed meet its end, but not just yet.
______________
Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over
33 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at
www.businessforum.com/cscc.html.
"Current low valuations reward the long-term view", an article by Dennis Butler, appears in the May 7, 2009 issue of the
Financial Times (page 28). "Intelligent Individual Investor", an article by Dennis Butler, appears in the December 2, 2008 issue of
NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. "Benjamin Graham in Perspective", an article by Dennis Butler, appears in the Summer 2006 issue of
Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or
"What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at
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