The Big Picture

“The average American is from Missouri everywhere and at all times except when he goes to the brokers’ offices and looks at the tape, whether it is in stocks or commodities. The one game of all games that really requires study before making a play is the one he goes into without his usual highly intelligent preliminary and precautionary doubts. He will risk half his fortune in the stock market with less reflection than he devotes to the selection of a medium-priced automobile.” -Jesse Livermore

For those unfamiliar with Jesse Livermore, he is one of the most famous investors to have ever lived. Beginning his career at age 14 after running away from home and a life of farming his father planned for him.

Jesse’s point in the above quote came from his years of watching novice investors approach the market the way they would approach a game of chance. Betting with the crowd and hoping for the best! Today, this observation couldn’t be more relevant.

Investors have embraced a relatively new vehicle for accessing the markets. The new vehicle is exchange traded funds, or ETF’s. While the first ETF traded 25 years ago. This is the first market cycle where this product is altering the investment landscape. And while there are some great benefits to ETF’s, there may be some unintended drawbacks as well. The primary drawback is the price insensitive nature of most ETF’s. 

Have a Plan and a Process!

From the Trenches

“A great company is not a great investment if you pay too much for the stock.” – Benjamin Graham

A must read when you get into the investment business is “The Intelligent Investor” by Benjamin Graham. I have read it twice and referred to it many times over the years. The lessons were more valuable than much of my traditional investment management education. If you’ve never heard of Ben Graham, he is the one who taught and mentored another gentlemen by the name of Warren Buffet. The book is considered the “value investing bible” and discusses many concepts for selecting securities with a margin of safety.

Today, value investing is generally met with boredom and lethargy. Value is seen as the old man’s approach. Value investing is dead! So they tell me. It is difficult to make an argument for value investing with what we have witnessed over the past 9 years post financial crisis.

In the chart below: Using a common value metric we can see that value investing has taken a back seat to growth during this market cycle. What is striking is value investing has nearly always outperformed growth investing throughout history, until now. Below is the Fama-French HML (or high minus low) value metric. During this cycle growth has been outperforming value materially. Paradigm shift, or cyclical observation?

Bottom line: In markets and economics, a balance must be maintained. When we locate an imbalance, or a dislocation from the norm; It is important to assess the reasons as well as the potential risk it may deliver. 

The Weeds

“Given the performance of certain stocks, we wonder if the market has adopted an alternative paradigm for calculating equity value.” – David Einhorn

David Einhorn is a successful value investor who admittedly has had a very tough run of late. His statement above has been widely discussed. While many may conclude that the old rules no longer apply. I would likely be betting the other way, and caution others not to fall into this trap. Every cycle brings proclamations that the rules have changed. And every cycle brings harsh and costly reminders that they haven’t!

A year ago I wrote a post titled “Objects in Motion” that pointed out how only a relative few companies tend to “carry an index” when the index is capitalization weighted. While we see this trait in every cycle; It may be being amplified with the shift towards ETF investing. 

Security selection, or active stock picking, has given way to “passive-selection” primary through ETF’s. I am a proponent of ETF’s. However, it is important to analyze how ETF’s may have changed the market landscape. How diversified are most ETF’s? They would seem very diversified at first glance. On closer review some issues arise. The below chart is the top 5 companies by market capitalization, or size, in the S&P 500. They are worth $4,095,058,706,432. The chart creator then figured how many companies beginning from the smallest it would take to reach that value. It took 282 companies starting from the smallest in the S&P 500.


You are not as diversified as you think you are in the majority of these products. In reality, a relatively small number of companies dictate the movement of the index as well as the investment product. In the chart below: These top 5 companies carry the weight of 282 companies. We find 4 out of 5 of the “FAANG” names in the top 5. (FAANG – Facebook, Amazon, Apple, Netflix, and Google).


The concern is when investors become insensitive to the prices of the securities they are buying, and the majority of buying focuses to one area of the market, the question of value and valuations become more significant. A margin of safety becomes non-existent. The primary factor becomes fund flows and momentum. Increasing flows buying a very few number of companies solely based on their size with no consideration of value. The more fund flows buying, the more expensive these names become. The more expensive they become, the less likely future returns will be satisfactory.

Deep breath…

Value investing is not dead, it has merely taken a back seat to fund flows and momentum. Active investing, or stock picking, is not dead either. While large-cap growth fund managers have failed to perform against their benchmarks due to the predominant passive-selection taking place; We do find that mid and small cap managers are still able to add value. There may be a significant dislocation in the prices of certain issues. The potential reversal of this dislocation is a material risk. 

Bottom Line: While ETF’s have brought many positive attributes such as ease of access and low fees; they have also changed the overall market landscape.