January 2014 Investor Letter

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Below is a letter that is written monthly for the benefit of Avondale Asset Management’s clients. It is reproduced here for informational purposes for the readers of this blog.  If you are interested in receiving this letter monthly by email, sign up here.

Dear Investors,

2013 was the 5th best year in the history of the S&P 500. The index climbed by a spectacular 29.6% and broke the 30% barrier when including dividends. There aren’t enough superlatives to describe the year that US equities enjoyed. A 30% year is a truly rare event.

We fell short of matching the S&P’s advance, but against that lofty benchmark we definitely weren’t alone. Given the fact that the S&P climbed in almost a straight line last year, the slightest bit of conservatism including diversification away from US equities ensured underperformance relative to the equity index. Other asset classes didn’t perform nearly as well as US equities last year, so owning anything else proved to be a drag.

Traditionally conservative investments fared worst of all in 2013: fixed income markets generally lost value as interest rates rose, and gold fell by about as much as the S&P gained, down a painful 27%. Meanwhile, even many investments that are supposed to provide some extra return in favorable economic environments couldn’t keep up with the S&P 500’s gain. Global equities outside of the US only rose by about two thirds as much as US equities, and emerging market equities actually fell last year.

Because of this, very few investors with a broad absolute return focus really did as well as the S&P 500 did in 2013. Most individuals don’t hold all of their wealth in concentrated exposure to US stocks. In fact, according to Federal Reserve data, US households in aggregate held only 53% of their financial savings in equities at the beginning of 2013. The rest was split among cash, bonds and other financial assets. Mathematically, if the 53% of American households’ portfolio that’s invested in stocks was up by 30%, but the rest of the portfolio was flat or negative, it implies that the average American earned somewhere in the vicinity of a 16% return on their savings in 2013. This is perhaps a fairer barometer of how American savings portfolios performed last year.

Given our broad focus, this is a reasonable benchmark for us as well, but it isn’t perfect. Aside from this Fed benchmark, hedge fund returns and asset allocation benchmarks are also decent yardsticks because they capture how investors fared when faced with the larger set of decisions inherent to managing a complete (not segmented) pool of capital. According to the HFRX index, the average hedge fund gained about 6.7% in 2013. In comparison, asset allocation benchmarks ranged from a 3% gain for a “conservative” investor to 24% for an “aggressive” investor. These benchmarks have their own flaws as well though.

In my opinion, the best way to judge our performance, and the way that I benchmark myself is based on the following absolute spectrum: a return of less than 1% is a failure, 5% is adequate, 8% is strong, 10%+ is great and 20%+ is spectacular. Each year I aim for spectacular returns, but we will not always hit our target. I look at the S&P 500 as a long term target which I aim to beat over time, but our performance should only tangentially be measured in relation to the S&P 500 and never in any single year.

With that in mind, I think that we did very well in 2013. I’m proudest of the fact that we came into the year with a favorable view of equities and maintained that view for the majority of the year. I don’t believe that there is such a thing as a “passive” investment allocation and so the heavy allocation to equities at the beginning of 2013 was a very active and conscious decision based on our assessment of the environment. In 2013 by luck or by skill our heavy investment in equities turned out to be a prescient decision.

Still, even with the right outlook, we admittedly did not eclipse return levels I think we reasonably could have hit. This is because as the year progressed I began to sense that the risk/reward equation shifted out of favor of stocks and therefore we have been selling. I did not expect the S&P 500 to end the year at 1850 until it was too late to pivot into position to benefit. We left potential returns on the table because of this, but I’m not sure whether I would classify this as a mistake per se. The decisions that were made were made with a multi-year time horizon, and so we gave up some near term returns in order to ensure that we could return safely to shore before a storm came in.

As a result of these sales though, we enter 2014 holding a LOT of cash. I don’t know what the S&P 500 will do this year, but it is my job to give us the best shot of finishing the year somewhere along the return spectrum that I outlined above. I think that this heavy cash position gives us the best opportunity to achieve that.

Based on my analysis of valuation, the economic cycle and statistical patterns, I think that there is a greater than average likelihood that the S&P 500 will generate a low single digit or negative return in 2014. I have written before that the only reason to be materially bullish at this time is if you believe that we are in the midst of a “generational” bull market like those seen in the late 1990s and late 1920s. I don’t think that we are, but it’s worth noting that each of those bull markets had significant draw downs in the later innings of their historic runs. In 1926, the Dow fell by 17% when the Fed began to raise interest rates in an easy money environment. In 1998 the S&P 500 fell by 19% surrounding the LTCM blowup. Taking the midpoint of those two declines, an 18% drop from here would send the S&P back to 1515, nearly wiping out all of 2013’s gains.

Our heavy cash position gives us the opportunity to take advantage if the market falls back to these more reasonable levels. I still believe that 1650 represents the high end of fair value for the index, and 1450 marks a reasonable level to be buying as long as earnings maintain their current trajectory. If the index started to fall towards those levels though, it’s likely that the market would overcorrect, as it is prone to do. To me, the opposite side of 1850 is 1150. Today we so far from these levels that they are almost unimaginable, but 1850 was also unimaginable at the start of 2013.

If I am completely wrong, however, and the market does repeat 2013’s rally, our portfolios are still reasonably positioned to hit the 5% “adequate” return threshold. If 2014 repeats 2013 though, I hesitate to ponder what 2015 would look like. At these valuation levels every point that is added to the index is a point that is likely to be taken back from it when the market eventually falls.

In some ways a further rise would make our job easier since it would mean that the market would be even more unbalanced and prone to a negative break. I would feel more comfortable making money shorting the market at such levels, something I have been reluctant to do as of yet. Shorting is not an action I prefer to take since short selling is almost certainly a long term loser. The natural tendency of markets is to rise over time, so I prefer to operate under the philosophy “if you don’t like something, don’t buy it.” However, if the markets become that disjointed from reality, the potential reward does start to outweigh the otherwise unfavorable risk.

One of the most difficult things about being an investor with a long term perspective is that sometimes the long term takes a long time to unfold. I am fully prepared to wait for years to commit significant amounts of capital back to work if that’s what it takes, but even if it takes years until we see another “fat pitch,” it will still be my duty to generate returns along the spectrum outlined above in the near term. For now though, we may just have to live with “adequate” 5% returns rather than “spectacular” 20% ones. The market will do what it does, and we will position ourselves to benefit over the long term either way.

Cheers to a happy and healthy 2014!

Scott Krisiloff, CFA