Broyhill Letter Highlights XII: Passive Investing

This is the twelfth piece in our Broyhill Letter Highlight series, highlighting our thoughts on passive investing over the years.  You can access other posts in the series here.

For those who would like to revisit our letters in full, we will also be gradually sharing them to our Research Studio throughout the series.

XII: Passive Investing

The market has always been good at reallocating capital from the careful to the careless. Lots of people lose lots of money when sensible expectations become senseless. It would seem that, over time, investors have become increasingly senseless as return expectations have steadily increased year after year alongside rising equity markets. Seemingly, the higher equity markets go, the greater returns investors expect. That's just not how this works.

The consensus believes that the greatest risk comes not from holding stocks, but from not holding enough of them. Passive investing and momentum investing are the primary manifestations of this belief. During the later stages of a bull market, they are one and the same. Artificially high demand for a small group of stocks benefits speculators in the bubble they help create.

Passive investing has removed any hint of price discovery from the markets, and today’s factor models are almost completely devoid of fundamental analysis. As a result, when investors do start to pull their money from passive funds, the subsequent rotation from momentum to value will likely be furious and frantic.

Market regimes evolve over a long enough timeframe that widespread beliefs become engrained in conventional wisdom. As a result, the consensus clamors to buy the winners of the prior regime. Those beliefs are reinforced again and again, making them even more difficult to change. They become so engrained that many investors simply cannot believe that sky-high profit margins and stratospheric valuations won’t return and be sustained indefinitely.

Value’s excess performance vanishes occasionally—often for longer than we’d like. But, these short-term cycles of underperformance are what ultimately ensure value’s long-term outperformance.

Similar concerns are raised during every cycle. And yet, each period of underperformance has been followed by exceptional outperformance.

We think value investing is a decent bet in a world full of bad bets. There is value hiding in plain sight. It just requires the patience, discipline, and willingness to stand apart from the crowd. Remember. It's not what you look at that matters. It's what you see.

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