Everybody Goes Surfing

“If you are in a surfing competition, the key thing is to take the right wave and ride it safely, which means don’t bump into people riding the same wave. It also means you have to kick out before the wave hurts you, and then go back and ride another wave. There are two types of errors you can make. The first error is never taking a wave because it is not perfect, which is the equivalent of staying in cash. Staying in cash, with a negative real rate, eats away at your principal. The other mistake is to take a wave that is too crowded and you are not able to get off it safely. For the past few years, we all have been riding the central-bank liquidity wave, and as investors we need to figure out how to safely continue to do that, because it is a very crowded wave. So if there are any signs of weakening, there will be a lot of people rushing to the door, as we saw last May and June.

“We are trying to focus on those parts of the liquidity wave that are more robustly anchored. So I spoke about shorter-dated debt in certain sectors. Second, there are sectors that are not being embraced because of liquidity issues. So I mentioned certain municipals and certain emerging-market bonds, especially in local currency. We are also focusing on companies that have very solid balance sheets and are generating a ton of cash, because they are giving that back to the equity investors. So, dividend-paying companies likely to increase their share buybacks are attractive.”

Friends may wonder if the above quote came from a certain colleague who recently traded the luxury of Zegna in NY for the warmth and flexibility of QuickSilver in LA.  While we are sure this particular CIO, has plenty of advice on riding the big swells on the horizon (click graphic below for official soundtrack), the words of wisdom above came from PIMCO’s Mohamed El-Erian in a recent interview with Barron’s.


For our part, we are inclined to agree with Mr. El-Erian on most counts.  Waves are getting very crowded these days, but we still see pockets of value in short-duration, off-the-run credit and in municipals.  The risk of spiraling currency crises keeps us on the defensive with regard to emerging markets, but we main comfortable with our exposure to the emerging market consumer, predominantly through investments in the developed world’s Global Gorillas.  We would highlight one additional factor working in favor of many of those high-quality, dividend-paying companies – increased activism.

Poor performance at some of America’s largest corporations has driven a number of restless shareholders to rock the boat. Whatever the reason, it appears that institutional investors are supporting activists more and that boards are more open to “conversations”  about enhancing shareholder value.  Bottom Line: We have detected the emergence of an underlying theme threaded across a number of positions in our equity portfolios – Quality With A Catalyst.  We believe investors will be well served over the years by identifying these high quality franchises which stand to benefit from the tailwind of active shareholders who serve as a catalyst for value-realization.

Value investors are always on the look out for catalysts. While buying assets at a discount from underlying value is the defining characteristic of value investing, the partial or total realization of underlying value through a catalyst is an important means of generating profits. Furthermore, the presence of a catalyst serves to reduce risk. If the gap between price and underlying value is likely to be closed quickly, the probability of losing money due to market fluctuations or adverse business developments is reduced. In the absence of a catalyst, however, underlying value could erode; conversely, the gap between price and value could widen with the vagaries of the market. Owning securities with catalysts for value realization is therefore an important way for investors to reduce the risk within their portfolios, augmenting the margin of safety achieved by investing at a discount from underlying value.

Catalysts that bring about total value realization are, of course, optimal. Nevertheless, catalysts for partial value realization serve two important purposes. First, they do help to realize underlying value, sometimes by placing it directly into the hands of shareholders such as through a recapitalization or spin-off and other times by reducing the discount between price and underlying value, such as through a share buyback. Second, a company that takes action resulting in the partial realization of underlying value for shareholders serves notice that management is shareholder oriented and may pursue additional value-realization strategies in the future.

– Margin of Safety by Seth Klarman