Archives for May 2016

Here are my notes and takeaways from the GMO Quarterly Letter for Q1 2016, released May 10th, 2016. I always pick up something educational when reading these letters (previous editions may require free registration.) I already discussed their Q1 2016 Asset Class Forecasts with the previous Q4 2015 letter, but in the future I’ll try to align the same quarterly information into one post.

GMO investment philosophy is that asset prices will eventually mean-revert back to their historical valuation levels. However, “eventually” can mean prices moving in the opposite way for a very long time periods. Right now is one of those periods:

It’s no secret that the last half decade has been a rough one for value-based asset allocation. With central bankers pushing interest rates down to unimagined lows, ongoing disappointment from the emerging markets that have looked cheaper than the rest of the world, and the continuing outperformance from the U.S. stock market and growth stocks generally…

Of course, such deviations are exactly the source of potential excess returns for such value investors. GMO still believes in long-term value-based asset allocation.

A quick primer on how future returns work for bonds. Excerpt:

It is universally understood (I hope) that a 10-year Treasury note yielding 1.84% held for 10 years will give a return pretty close to 1.84%. It is not quite so widely known that the rate of return of a dynamic portfolio of such bonds – a “constant maturity strategy” – is also pretty well fixed for certain time horizons.

To take the Barclays U.S. Aggregate Bond index (Agg) as an example of a dynamic portfolio, with a duration of a little over five years and a current yield of 2.17%, the range of possible returns over the next seven years is not very wide. We are not guaranteed to get 2.17%, but the return if the yield were to gradually drop to zero over that period would be about 2.9% per year, and if the yield were to gradually double, it would be about 1.5% per year. No matter what happens to yields over the next seven years, returns are going to be something pretty close to 2.17% on the Agg.

Wrong prediction on oil prices. In 2005, Grantham made a rough 10-year prediction that rising oil prices were not in a bubble, but instead actually a “paradigm shift” where oil prices would stay high permanently. He also predicted that we would start to run out of other finite resources, resulting in higher commodities prices. As it turns out, we saw that oil prices have crashed along with other commodities. Grantham outlines again why he made the prediction, what he got wrong, and of course goes ahead and makes another set of predictions:

– Oil stocks should do well over the next five years, perhaps regaining much of their losses. But, after 5 years, prospects are more questionable, and, beyond 10 years, much worse.

– Mineral resource stocks are unlikely to regain their losses, but from current very low prices they will probably outperform based on historical parallels following similar major crashes.

– Farmland is likely to outperform most other assets. It is still my first choice for long- term investing.

– Forestry should perform above aggregate portfolio averages and be less volatile than equities.

Why should we listen to this new forecast when his last one was wrong? It all goes back to the first point of the letter. These are all long-term calls based on history and a bit of common sense. Grantham is telling you to buy exposure into finite resources – oil, minerals, farmland, and timber. Sooner or later, if you have something that everyone needs like oil and is also selling at historically very low prices, prices are going to go back up eventually.

The problem is “eventually” could be this year, or it could be another 10 years or more.

High US housing prices are more worrying than high US stock market prices. Housing prices are certainly bouncing back…

…the threshold for a bubble level for the U.S. market is about 2300 on the S&P 500, about 10% above current levels…

… Thus, unlikely as it may sound, in 12 to 24 months U.S. house prices – much more dangerous than inflated stock prices in my opinion – might beat the U.S. equity market in the race to cause the next financial crisis.

Climate change warning.

Let me just make the point here that those who still think climate problems are off topic and not a major economic and financial issue are dead wrong. Dealing with the increasing damage from climate extremes and, just as important, the growing economic potential in activities to overcome it will increasingly dominate entrepreneurial efforts in future decades. As investors we should try to be prepared for this.

You read this letter for Grantham’s opinions, and you definitely get them. Personally, I don’t see anything that would change my boring portfolio. If anything, I would make sure to have some international exposure to emerging markets stocks as they have low historical valuations and are also correlated with commodities.

Research Affiliates, an asset-management firm founded by Rob Arnott, also offers long-term forecasts across a variety of asset classes via their Expected Returns tool. Here is a paper explaining their equities methodology [pdf]. I would like to note down some of these predictions, in the hopes of coming back later and seeing how they turned out. I’ve already been around over 10 years, what’s another 10? 🙂

Here is what they have as of April 30, 2016 (click to enlarge):

Overall, their conclusions suggest that we should have very modest expectation for US stocks and US bonds, while some international diversification can help boost expected returns. More specifically:

• Future 10-year average returns for US Stocks are expected to be very small on an inflation-adjusted basis (between roughly 0%-1%). US equities are highly-valued based on historical values.
• Broad US (Core) Bonds, Long-term US Treasuries, Short-Term Treasuries, and TIPS are all expected to have low forward returns (between roughly 0%-1%). Their low current yields offer little other alternative prediction.
• Relatively bright spots, at least returns-wise, include Emerging Markets stocks, Developed International (EAFA) stocks, and Emerging Markets bonds (both local and non-local currency).

Have an individual stock idea brewing the in the back of your mind? Perhaps the recent LendingClub drama has you itching to buy a few shares of LC at under $5 a share? Above is an interesting chart that shows the distribution of total returns for individual stocks when compared to the S&P 500 index (1989-2015). It was created by Longboard Asset Management, found via Abnormal Returns.

We analyzed 14,455 active stocks between 1989 and 2015, identifying the best performing stocks on both an annualized return and total return basis. Looking at total returns of individual stocks, 1,120 stocks (7.7% of all active stocks) outperformed the S&P 500 Index by at least 500% during their lifetimes. Likewise, 976 stocks (6.8% of all active stocks) lagged the S&P 500 by at least 500%. The remaining 12,404 stocks performed above, at or below the same level as the S&P 500.

I felt that this chart shows you the psychological risks of investing in individual stocks. I’ve been dipping my toes back into individual stock investing with a very small portion of my portfolio. My general idea is to invest in some high-quality, dividend-earning stocks and thus being able to earn those dividends without paying the expense ratio of an ETF. I’d also avoid some tax-efficiency issues if I am able to hold them for very long periods as opposed to a dividend ETF that keeps changing the components of their underlying index. Here’s one of my inspirations. In other words: Buy good stocks, hold them forever.

But as the chart above shows, some of your picks will do great, and some will do horribly. Some people will tell you about their “ten-baggers” and neglect to mention the losers, while the final math will show you lagging the index. As active investors, Longboard concludes that you should focus on avoiding the underperforming assets. But I’d be wary of being so careful about avoiding losers that they miss out on the winners. (The winners often look like losers at some point… can you say Apple?)

Even if you just plan on make a few trades here and here, individual stock investing is a mental sport that takes self-discipline and a calm rationality. Very few people have the characteristics needed, even when managing their own money with no management fee drag. Charlie Munger has his own take, but also admits that only a small percentage can add value:

I think a select few – a small percentage of the investment managers – can deliver value added. But I don’t think brilliance alone is enough to do it. I think that you have to have a little of this discipline of calling your shots and loading up – if you want to maximize your chances of becoming one who provides above average real returns for clients over the long pull.

[…] I think it’s hard to provide a lot of value added to the investment management client, but it’s not impossible.

As an early adopter and IPO participant of LendingClub, I was disappointed to read about their recent happenings. The major financial media outlets have been covering it closely, with summary-style articles from the NYT here and WSJ here. This is my condensed understanding of the situation.

• On Monday, May 9th, LendingClub abruptly announced in a “by the way” manner that their celebrity CEO Renaud Laplanche had resigned. (His only other alternative was to be fired.) Three other high-level executives were also fired.
• LendingClub improperly sold $22 million of loans to an institutional investor that did not meet the investor’s standards. The origination dates were changed some loans in order to make the loan meet the investor’s specifications. Other loans had other features of their disclosures altered and/or misrepresented. LendingClub later bought the loans back for full price.
• LendingClub as a company decided that it was good idea to invest in outside investment funds that own… LendingClub notes. Can you say conflict of interest? Will the fund get better access to loans? LendingClub was supposed to be the middleman, so why are they quietly taking on risk as the lender?
• For one of these funds that LendingClub invested in, then-CEO Laplanche had a personal stake which he did not disclose. Director John Mack also had a personal stake, which apparently was disclosed. So now LendingClub as company is investing in outside funds that invest in LendingClub notes and are (shhh) partially owned by their CEOs and Directors?
• On Tuesday, May 17th, an SEC filing disclosed that LendingClub received a grand jury subpoena from the U.S. Department of Justice (DOJ), which indicates they will be subject to additional investigations as well as potential lawsuits in the future.

When LendingClub started out a peer-to-peer lender, the grand idea was that the spread that banks got between taking deposits and making loans would be made thinner, with the difference going to individuals, NOT Wall Street. Individual borrowers got loans at lower rates. Individual lenders got paid higher interest. An illustration from their own materials:

In opinion, LendingClub then became too aggressive in their chase to stay on top as the “industry leader”. The majority of their notes are now sold to large, institutional investors, not individuals. But this also means risk if the big investors decide to stop buying their big chunks of loans. In turn, they loosened their standards and became willing to take on additional risk by essentially buying their own loans if demand drops. You can decide if it was coincidence that they started fudging dates and other “little stuff” to keep things going.

Finally, another way that LendingClub was aggressive is that they pursued a way to allow them to sell notes in all 50 states called a “blue sky exemption”. However, by doing it this way, they could not create a “bankruptcy remote vehicle” where individual note-holders were protected in case of a LendingClub bankruptcy. This is another way where the individual investor is not their #1 concern. Here’s the official statement from the LendingClub website (emphasis mine):

When you invest in a Note, you are investing in an obligation of Lending Club. Borrowers make payments on their loans to Lending Club, and in turn, Lending Club distributes payments to investors in the Notes net of fees. If Lending Club were to go out of business, investors may not receive the full amount of payments due and to become due on the Note, or such payments may be delayed as bankruptcy or other proceedings make their way through the courts.

We have taken steps to ensure continuity to protect investors and borrowers if Lending Club were to go out of business. For example, we have executed a backup and successor servicing agreement with Portfolio Financial Servicing Company (“PFSC”). Under this agreement, PFSC stands ready to service borrower loans.

Following five business days’ prior written notice from us or from the indenture trustee for the Notes, PFSC will begin servicing the loans. If the underlying loans are determined to be part of Lending Club’s bankruptcy estate, PFSC may not be able to make payments on the Notes. If our agreement with PFSC were to be terminated, we would seek to replace PFSC with another backup servicer.

Here’s another take by Kaddhim Shubber in a FT article.

The short answer is that yes, there is a chance that if LendingClub files bankruptcy that investors individual notes may lose their principal and/or interest if other creditors claim priority over those assets. The question is determining the probability of this happening.

Why an acquisition is much more likely than bankruptcy. If I am reading their recent filings correctly, LendingClub has over $800 million in cash along with little company debt (other than the notes created to be sold to outside investors). Their company value dropped to as low as $1.5 billion this week, which means the company itself could technically be bought for $700 million. (Less than a year ago, the company was worth over $5 billion.) A mega financial institution like Wells Fargo or J.P. Morgan Chase could easily buy the entire company (and keep servicing the notes) if the value dropped further. I believe the LC platform still has real value, but if trust erodes further then it may need the backing of a bigger name. Then we’d be full-circle, the former peer-to-peer lender now owned by Wall Street. I’m not saying such an acquisition is likely, but instead something that would happen well before bankruptcy.

At the same time, unlikely is not zero. I would not put any more than 5% of my net worth into LC notes. I had great hope for LendingClub, but also never put more than a few percent of my net worth into LC notes. Here is my post on liquidating my LendingClub notes on the secondary market. I have no position in LC stock either, as I sold my shares immediately after the LendingClub IPO. I’m just watching this one from the sidelines.