Centre Street Cambridge Corporation

Private Investment Counsel

Commentary

April 2016

Vexations 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.

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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 Butler, MBA, CFA