Style Boxes: Growth, Value, and Spite

It’s been two years since I recommended returning capital and interrupted my eighteen year track record. Although it was a difficult decision, in hindsight it appears to have been the right course of action. Since 2016, valuations have become even more expensive, making it challenging to find a sufficient number of undervalued equities to build an absolute return portfolio. Furthermore, while I worked with very sophisticated clients who understood my process well, holding an equity fund invested in T-bills would have been difficult for most advisors and consultants (especially over the last two years).

I never intended to recommend returning capital and go all-in on patience. My long-term goal was to manage an absolute return fund through as many market cycles as possible. However, the broadness of this cycle’s overvaluation, along with my determination to remain disciplined, caused me to pull myself out of the game. And of course I remain out of the game and on the bench today (literally – as I write this I’m sitting on a bench at Starbucks next to a guy trying to sell commercial real estate loans 🙂 ).

During my final days of employment I had some time to reflect on my career and decision to recommend returning capital. I remember staring out my office window wondering if I made the right career choices. For most of my adult life my dream was to be an equity analyst and portfolio manager. And there I was, sitting alone in an empty office, days away from giving it all away.

Despite some initial regret and second guessing, deep down I knew it was the right move, or the only move. It was unfortunate, but as an absolute return investor, it’s what I signed up for. When getting paid to take risk, you take it and when you’re not, you don’t. It’s pretty simple and straightforward – never, ever, knowingly overpay, especially with other people’s money.

There are other things I remember about my final days at the office. I remember putting together an unemployment checklist, or things I wanted to accomplish and avoid during my time away.

First on my list was “stay busy”. I’m typically happiest when busy. To keep my mind active, I made a commitment to continue following my 300 name possible buy list and maintain my absolute return process. Furthermore, I decided to start a blog as a way to stay involved in investing, organize my thoughts, and document the profit and market cycles through the eyes of operating businesses. Throw on the additional duties of Mr. Mom and Uber Parenting, and I have far exceeded my goal of remaining busy.

Other items on my checklist include what you’d expect, such as: spend more time with the kids, clean and organize the garage (oops), exercise, avoid ice cream, avoid financial television, reduce expenses, and detox from the markets.

And finally, at the end of the list was a directive related to investing personal funds. I must have thought it was important as it was the only item on the list underlined and made bold. It said, “Do not short or buy put options!!!”

My advice to myself came from experiences I had with individual stocks and the markets over the past twenty-five years. During this period I learned important lessons related to valuation and its usefulness in timing asset prices. Specifically, while valuation is very effective in determining future returns, it provides little information on when those returns will be realized. In effect, knowing an investment is undervalued or overvalued tells us little about when the price of the investment will converge with its underlying value.

As the past three market cycles illustrate, asset prices can remain mispriced for many months and even years. Furthermore, as we experienced with the tech, housing, and “The Third Time is the Charm” bubbles, overvaluation is often an insufficient deterrent for investors determined to chase prices higher and higher. Therefore, while shorting overvalued assets makes sense to me intuitively, the risks associated with crowd psychology and the ineffectiveness of valuation-based shorting keep me away.

The decision to avoid shorting is not as easy as it sounds. As an investor guided by valuation, there is a natural desire to take advantage of asset mispricings. Furthermore, sometimes it just feels good shorting an overvalued stock or market. The feeling is difficult to explain, but resembles a sense of satisfaction that comes with voting against something irrational or something you don’t believe in. I call it spite investing.

While spite investing may feel good, there is a reason spite investing is not an investment category, style box, or ETF. Spite investing tends to be emotional and often requires precise timing to incur a profit – something I haven’t mastered. In fact, I have put options on tech stocks (1999) and homebuilders (2006) that expired worthless to prove it!

Today’s market, in my opinion, is filled with overvalued equities and potential spite trades, making it very tempting to short the high-flyers. However, for the most part I have stayed true to my goal of refraining from shorting and buying put options. That said, from time to time this cycle, I’ve fallen off the wagon and bought a very small amount of put options (nothing consequential) out of spite. Last week was one of those times.

As a result of a rotation into small cap stocks, the Russell 2000 exceeded 1700 last week (another all-time high). It’s my understanding the rotation is based on the belief small cap stocks will perform well during a trade war. While I’m not an expert in the asset allocation game, I’d be very reluctant to pay 73x earnings, 38x median earnings, and 18.9x EV/EBITDA (ex-financials) in an attempt to profit from a trade war. In fact, the belief that small caps, at today’s prices, are some sort of safe haven was too much for my mind to overcome. We all have a breaking point, right? As such, last week I implemented a small spite trade and bought puts on the Russell 2000.

As most of my spite trades end, I will not be surprised if I realize a loss on my put options. Incurring losses and investing on emotion are mistakes absolute return investors are expected to avoid. Even knowing this, I must admit, there’s a unique sense of satisfaction that comes from voting against the madness of crowds. Spite investing may not be smart, disciplined, or profitable, but it in very small doses, it sure can feel good!