This is the second piece in Seeking Alpha's Positioning for 2014 series. This year we have once again asked experts on a range of different asset classes and investing strategies to offer their vision for the coming year and beyond. As always, the focus is on an overall approach to portfolio construction.
Chris DeMuth, Jr. is a partner at Rangeley Capital, a family-run partnership that invests in mispriced securities with limited downsides and corporate events that unlock shareholder value. He is responsible for the investment and philanthropic activities related to this partnership.
Seeking Alpha's Abby Carmel recently spoke with Chris to find out how he planned to position partners in 2014 in light of his understanding of how a range of market- and sector-specific issues were likely to unfold in the coming year.
Abby Carmel (AC): How would you describe your investing style/philosophy, broadly speaking? As an avowed value investor, please take our audience through your typical process when approaching a potential new investment idea. What is your preferred method of capturing the value premium? To which particular fundamentals do you assign the greatest and least significance in your single stock analysis?
Chris DeMuth, Jr. (CDM): I am within the value investing tradition of investing in securities that can be purchased for a price that is at a discount to their value. Many of my ideas about investing are inspired by the Buffett Partnership that preceded Berkshire Hathaway (BRK.A/BRK.B).
More specifically, I focus on event-driven opportunities that involve a corporate event that will result in the return of some or all of our capital over some period of time. But what I am most interested in is the price system itself and the occasional failures of that system. So I look for non-economic counterparties that occasionally exist for peculiar reasons.
(AC): As we approach 2014, are you bullish or bearish?
(CDM): Neither of those words applies to me. All of my professional attention is on individual securities. In fact, I have to glance at the screen once before the end of the day if I even want to notice if the market is up or down. I am bullish on owning mispriced securities. But, I am always bullish on owning mispriced securities. There are mispriced securities in up markets and down markets.
While I generally lack a top down view of market levels, it is possible to compare the value of asset classes. One year ago, the S&P 500 ETFs (SPY) appeared to me to be cheap relative to long-dated US treasury ETFs (TLT). We expressed this via our idea to short the leveraged long bond ETF (TMF). But, over the past year, we have experienced a bull market for multiple expansion that has partially closed the gap between equity and the more expensive bond market.
(AC): What do you feel are the major catalysts for the market in 2014 and beyond?
(CDM): There is a lot of money available for deals. Both strategic buyers and private equity funds are ready and able to make deals when companies are willing to sell. Certain industries, such as banking, are particularly ripe for consolidation.
2013 was a particularly strong year for bumps in prices paid to secure acquisitions, such as in the T-Mobile (TMUS) acquisition of MetroPCS. I have high hopes and expectations for deals in 2014. In particular, I am thinking about Loral (LORL), the Provida (PVD) minority, T-Mobile as a seller this time and two banks - Ocean Shore (OSHC) and OBA (OBAF). By this time next year I expect a majority of those will have been acquired for a premium to today's market prices.
(AC): To which index or fund do you benchmark your performance?
(CDM): Zero. I benchmark my performance to be substantially better than zero over a statistically significant period which I generally define as from three to five years. If performance ends up being substantially better than the bond markets and the equity markets, that is gratifying but it is not the intent. It is important to have an absolute value, as opposed to relative value mandate because it liberates the investor to maintain high standards regarding a margin of safety while maintaining flexibility regarding activity. If there is lots to do, I do lots. If there is little to do, I do little. That is not impacted by whether or not the overall market is getting more expensive or less expensive.
That being said, I am also intensely conscious of the long-term records of my favorite competitors such as Oaktree (OAK), Third Point (TPRE), Greenlight (GLRE) and Och-Ziff (OZM). We do our own research, but keep track of their 13Fs and try to understand what the best minds in the alternative investment business are thinking about. At the same time, many of the greatest asset allocators are not in hedge funds. Many of my favorite investors are in the insurance business at places such as Alleghany (Y), which was run for many years by my hero and neighbor John Burns, Markel (MKL) and White Mountains (WTM). Their long-term track records put most hedge funds to shame. One of the all-time best asset allocation jobs has been done for a small newspaper at Daily Journal (DJCO) by their Chairman, Charlie Munger. These are the types I admire and copy shamelessly.
(AC): What is your highest conviction pick heading into the New Year and why?
(CDM): My highest conviction short idea is to short the Renaissance IPO ETF (IPO) and/or its components. In my adult lifetime, there have been four periods of extremely high prices for IPOs: 1999, 2007, 2011, and today. During each of these periods, there is a number of months in which wild enthusiasm for a given group of equities is given full force when connected with large market capitalization companies with relatively low floats. For a short time, the amount of this enthusiasm from the marginal enthusiast is able to drive the price.
This is much like a large club with a long line outside; there may be no imbalance between the supply of the club space and the demand behind the velvet rope; however, there is an artificial appearance of desirability created by opening only a single door guarded by an intimidating bouncer. The IPO frenzy is the moment when you are waiting to get past the bouncer. But then what? Once inside, one quickly notices that there is tons of supply and that the exclusivity was contrived.
With IPOs, months pass, insider lockups expire, and prices revert to making sense - returning to prices that clear the overall supply and demand in the broader market. When that process of reversion to making sense happens next year, the price of the IPO ETF and many of its components will converge on its value, which I believe is substantially lower than today's price.
What is in the Renaissance IPO ETF today? A who's who and what's what of today's enthusiasms. Take into account that I am not at all immune from being enthusiastic about some of their products and services, but many awesome companies are currently demanding awesome share prices. What's hot? Many recent IPOs are in technology. Social media such as Facebook (FB) and Twitter (TWTR) top the list of IPO's holdings and are frequently above the fold in the news. Such rarified territory is unlikely hunting grounds for bargains. Anything related to the cloud, such as Veeva (VEEV) is also quite fashionable. What will be above the fold and at the top of IPO's holdings a year from now? I don't know, but it will almost certainly be something different.
(AC): How many stocks is too many to hold in a portfolio? How many is too few to be properly diversified?
(CDM): Statistically, most of the work of diversification is accomplished after the first dozen non-correlated investments. So it is good to have a dozen and slightly better to have two dozen. Beyond that, it is hard for me to know all that I should. Typically, I speak with each member of the board and management, their lawyers, bankers, and auditors, their customers, competitors, vendors, as well as their regulators. I read all of the relevant primary source documents and go over them with the firms' principals down to each footnote. I run out of time after keeping up with a few dozen firms.
(AC): Between Eugene Fama winning this year's Nobel Prize in Economics and the growing popularity of factor-based index funds, what are the chances a stock picker like yourself can reasonably offer alpha above and beyond a value-tilted index of the sort indexers like Research Affiliates have had so much success within recent years?
(CDM): So far so good, but I have only been investing for about 25 years, so these are still only early results.
I used to have some investments in casinos and at the time I was told that the breakdown of customers is approximately 94% that are not advantage players and know that they are not, 1% are advantage players and another 5% that are not advantage players but think that they are. Incidentally, that last five percent are far and away the most lucrative for the house. They get treated extremely well in terms of meals, drinks, and suites. I would not be surprised if the breakdown of capital market investors is similar. The most important thing is for non-advantage players to invest only passively.
How should one invest passively? There is no shame in simply investing in SPDRs, but I prefer equal weighted S&P ETFs (RSP), dividend weighted ETFs (DTD) and Joel Greenblatt's various fundamentally weighted mutual funds. These are all ways to avoid the problem of owning more and more of something just because it becomes more expensive, which strikes me as a** backwards.
(AC): What advice would you give to a 'do-it-yourself' investor looking at opportunities in the present environment?
(CDM): I would recommend saving a lot and spending little, which takes an enormous burden off of security selection. Get to the point as early as possible when you don't have to do anything. Then, when opportunities cross your desk, you can look at them with a certain indifference until you see one that is mispriced by a wide margin. The market itself creates all of the pressure that you need and then some. You don't want any additional pressure to be actively busy all of the time.
Want a simple test for determining whether a given environment is ripe for long opportunities or short opportunities? It is my Sotheby's (BID)/ Loews (L) test. BID is where rich people spend their excess liquidity. High BID share prices indicate a decent likelihood that the capital markets are also pretty well picked over in terms of bargains on the long side, such as is the case today. Loews is run by a team of brilliant asset allocators who are at the pinnacle of the value investing tradition - they buy low and sell high whether it is at the corporate or security level; they are honest money makers for their shareholders and they don't care if anyone notices. They act like owners because they are large owners. What premium to NAV do assets run by the Tisch family deserve? I can't calculate it precisely, but it would be a substantial one. So, from time to time when I can buy more L shares at a substantial discount to NAV, as was the case in the financial crisis, then I determine that Mr. Market has lost his marbles and I look for additional such bargains.
(AC): Any additional considerations you'd like to share with readers as they ponder their investing strategy in 2014 and beyond?
(CDM): There's more to life than money. But there's not more to investing than money.
Before you invest in anything, understand the process and mechanics by which the money is made and that money is returned to you. Investing should involve keeping your money safe and getting an adequate return. Anything else that you might crave - excitement, a connection to something cool, validation, ego - should be satisfied elsewhere.
Having a joyful, satisfying life outside of capital markets is helpful to investing. What do you love other than the market? That is a question that should have a readily available answer. Once you have done all of the sensible things to do, then stop. While you are living the rest of your life, you are protecting your money from doing all of your bad ideas simply because you finished doing the good ones. Get away from Bloomberg, get out of the office, get outdoors, and get to the people you love and love to be with.
Disclosure: Chris DeMuth, Jr. is a portfolio manager at Rangeley Capital, a partnership that invests with a margin of safety by buying securities at deep discounts to their intrinsic value and unlocking that value through corporate events. In order to maximize total returns for our partners, we reserve the right to make investment decisions regarding any security without further notification except where such notification is required by law. As indicated in SEC filings, I am long over 5% of both OBAF and OSHC. As indicated in a separate article on IPO, I am short IPO.
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