In January, U.S. stocks, after having reached all-time highs on the last day of December, delivered their worst decline in over twenty months. Stocks fell another 2.2% the first day of February, bringing the total decline to nearly 6%–the first drop of greater than 5% since June of last year.
The decline appears to have ended, as stock markets have already recovered over ninety percent of the points lost. Regardless if this decline is finished or not, it raises an opportunity for us to discuss a critical aspect of our strategy: risk management.
It is likely helpful to clarify our risk management strategy first by comparison. It differs from other risk-focused firms–particularly long/short hedge funds–in the degree to which we are willing to take small-to-moderate losses. We view “pauses”, “dips”, “corrections”, or whatever terminology can be applied to a stock market decline, as a necessary component of long-term investing. Broad-market declines such as these are a regular occurrence in equity investing and in most cases represent an opportunity to add to one’s positioning. We do not attempt to avoid these. In fact, we use the volatility to our advantage, as is evident by our record of deploying capital during bouts of market fear.
It is the violent, pervasive, substantial, and sustained declines that we hope to properly manage–the declines driven by adverse inflection points in the economy.
This is critical to understanding our investment philosophy. Many hedge funds would consider it a great crime to be down a quarter or year. With this obsessive focus on absolute returns, hedge funds have underperformed equity markets by an average 12.6% per year since mid-2009. That is, a simple index fund offered nearly twice the amount of return than the average hedge fund over the past five years.
Our largest monthly decline–4.2%–occurred in May 2012. The euro area was in dire straits at the time and the U.S. fiscal cliff spooked markets. We held our positioning, confident in our holdings and the economic landscape, and have since compounded capital another 41% in 20 months, nearly 3 times that of the average hedge fund.
Of course, the period in question coincides with a very strong bull market. At some point the economic landscape will weaken into a recession and the equity experience will swiftly deteriorate. The average hedge fund in that environment will again look brilliant. But that isn’t the point. Excessive risk management, that is, requiring absolute returns over short time horizons, will impair long-term returns.
Even the most diligent of short-sellers, those with short-biased hedge funds that expend all effort finding the best opportunities to bet on a stock’s decline, have lost an average 16% per year over the last five years. By attempting to avoid small-to-moderate losses, you may find yourself praying for the next recession to bail you out.
While we continue to think the stock market is expensive and priced to deliver single-digit returns over the next ten years, there are companies trading for prices that still represent reasonable value. This shouldn’t come as a surprise, as the stock market is really a market of stocks. At this time, there are opportunities among large, high-quality multinational businesses for the potential of low double-digit annual returns.
As far as the U.S. economy is concerned, recent data has been poor. Though, we suspect it has everything to do with the unusually cold weather. As such, we simply have to wait and see. As the weather improves, so too should the data.