Horizon Kinetics’ annual letter for the month ended December 31, 2015.
[buffettt]
Dear Valued Partners,
In 2015, Horizon Kinetics continued to observe evidence of the impact of indexation as the primary investment modality. At the risk of sounding like a broken record, we can’t help but share yet another data point illustrating the valuation dichotomy created by the ETF divide, which to our knowledge is unprecedented, at least in our three-plus decades of investing experience. The largest 15 companies in the S&P 500 Index have an aggregate market capitalization of $4.7 trillion dollars. That is also the total market capitalization of the smallest 346 companies in the S&P 500. Looked at in another way, the 15 highest-contributing stocks, with an average aggregate weight of 13%, produced about 280% of the S&P’s return1. That’s the extent of bifurcation which investors face. Mind-boggling as it is, this is reality.
Of course, our ongoing study on the subject of indexation begs the question: how does it all end? Fee competition continues to trend toward a dead end: the iShares Total Market ETF (ITOT), which purports to include every possible subset that is buyable in the stock market, just lowered its expense ratio to three basis points, which is three 100ths of 1%. We believe that this is a seminal moment in indexation mass-investing. As the profitability is squeezed out of it, so too will be the incentive of the manufacturers and promoters to practice it. This change will have completely unpredictable consequences for equities at large, because ETF asset flows have been dominating valuations with no regard whatsoever for the fundamental properties of the underlying securities they comprise.
One of the well observed impediments to contrarian value investing, albeit, only in the short run, is competition with growth stocks selling at high P/E ratios. These represent a group that has especially been flourishing from low interest rates and, more recently, also the group that has been legitimized by the appearance of momentum indexes, which further inflate the valuations of the most overvalued stocks. The underlying premise in the world of computer back-tested models that animate quantitative strategies is simple: the future will mirror the past. The purchasing power of this school of thought inevitably crowds itself into a handful of investments, recklessly abandoning other reasonable investments that have produced disappointing price rates of return in terms of share price, even if they have produced positive financial rates of returns for their corporate accounts and shareholders as owners of the underlying businesses. These quantitative index models form the basis of asset raising and marketing.
Therefore, it should not be surprising that even the most esteemed active managers with a value or contrarian bias have been dramatically underperforming the S&P 500 Index. The failure of the active managers to pay these unwarranted multiples is used to illustrate the failure of active management—indeed, active management has failed in that sense, though it is our belief that in the long run, demand will ultimately return to fundamentally sound companies, such as the contrarian or more idiosyncratic securities we happen to prefer.
That brings us to more questions: what’s ahead and what to do about it? We can’t say that it won’t get worse before it gets better, but we have readied our research and portfolios to take advantage of the tremendous opportunities that we believe will present themselves in the not too distant future.
Last but not least, on behalf of Horizon Kinetics, we thank you for your partnership, and we look forward to continuing to exchange perspectives with you in the year ahead.
Murray Stahl
Steven Bregman
Peter Doyle
