The Forcing Function for All Assets & the Price-Insensitive Buyer

I hope my recent notes have given you a flavor of what to expect from 'long form' Paulo. It is now time for the CloudBear to put up the paywall for future posts. I believe that a more private forum will give me the latitude to discuss trade expressions and ideas more freely (not financial advice obviously!!). I also plan to be active in the Substack chat that I have set up for paid subscribers.

I am excited about writing with people who value this, and hope that many of you will join me there!

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Summary of today’s note:

• In our financialized US economy with increasingly indexed securities markets, capital appreciation and alpha require a forcing function: the price-insensitive buyer.

• This is true not just for Value/Smallcap equities, but all assets.

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I recently went back and listened to one of my favorite podcast episodes of the past year: David Einhorn on Patrick O’Shaughnessy’s Invest Like the Best in March 2023 (link). I had originally expected the traditional HF manager mea culpa for several years of weak performance. Instead, I found David’s interview to be a thoughtful introspection of how his value approach which had worked so well in the 1990s and 2000s not only stopped working with the advent of ZIRP/QE, but instead punished him for not recognizing and adapting to the mechanics of relentless inflows to Passive participants whose price-insensitive buying reflexively compounded Size and Momentum factors dressed up as alpha.

Since Covid, I believed an inflationary, higher-vol environment in rates — with a rise in term premium, cost of carry for assets, and cost of funding for balance sheets — would serve as the rock against which Passive’s trend would break, and the pendulum would start to swing back to the sort of Active management that rewarded in the inflationary 1960s and 70s… an environment where the return profile of buy-and-hold flattened as economic and market cycle wavelengths shortened while amplitudes expanded…a time when you would cut exposure in half if a position doubled in a few months despite every internal voice screaming “let your sitting do the work”…and then when the same security later halved you would triple the size…an era when portfolio management and sizing added far more alpha than security selection in performance attribution.

Despite the changing inflation regime since Covid, the Value factor still seems unable to generate significant outperformance (chart per @JayKaeppel on Twitter):

The thought finally crossed my mind: regulators and policymakers set out to turn the banking system into a utility after 2008, and they succeeded. More recently they have set out to turn asset management into a utility — and they are succeeding. They want this. This works for them. Because when everybody earns a similar mediocre portfolio return with no catastrophic down years like 2008, then nobody complains, so no policymaker or regulator’s job is at risk. The result is an oligopoly on the sellside among investment banks, and a growing oligopsony on the buyside among asset managers. I remember 15 years ago thinking the 80/20 rule applied for allocations to hedge fund managers, where 80c of every dollar went to funds running over $5 billion. Today it’s more like 95/5, and the threshold is $10+ billion. Oligopsony indeed.

Covid and the subsequent fiscal and monetary responses seem to have only accelerated these trends rather than reversing them. Scary thought: what if these trends persist for another few years? What if we need to see Passive own 60% or 70% of market caps before the trend exhausts itself? Why not 80%? What if all of US banking consolidates into 4 giants like Canada, Australia, and Brazil? What if HF pods consolidate into a handful of managers each running $200+ billion in capital? What if the Top 15 buyside long only accounts become Big 3? Perhaps we assume “no way, this can’t possibly continue” because deep down we know a financial system concentrated in the hands of so few means many angry plebes (isn’t this what Bidenomics and 7% deficits are supposed to be all about addressing? Fiscal = plebe inflation vs Monetary = asset inflation as my friend

Le Shrub

likes to say).

But what is actually going to reverse such trends? What “mean” do value purists really think we are going to magically revert to when all that matters is investment flow on the margin (and the central bank liquidity which propels that flow)? What active value manager will have any capital left to buy cheap securities when Passive finally flips from inflow to outflow as Boomer sales weigh on assets? Worse: what if Boomer selling results in outflows from BOTH Passive and Active managers, resulting in both styles hitting the offer? Nearly everyone seems to assume that because the rise of Passive resulted in the decline of Active, then the decline of Passive will result in a recovery for Active… but what if both suffer net redemptions? Given the financialization of the economy, if a stock market decline finally pushes CEOs to fire a few million people, and that unemployment crushes 401k/Target Date passive inflows, this does not conversely generate inflows for Value and Small! Both Passive & Active lose!

With this backdrop, it is simply not enough for active managers to buy woefully cheap public equities in the cyclical value / smallcap / commodity / EM space and wait for Mr Market to magically come to his senses about valuation. Nobody is coming to save you. Everyone is just trying to survive and stay in business.

There is really only one solution to the Value/Small problem — one which Mag7 Tech Bros inadvertently stumbled upon in the aftermath of 2008: you need a price insensitive bid. Credit to the Tech Bros…their magic formula of cheapening labor costs by paying less salary while issuing enormous stock-based compensation on the backs of shareholders who didn’t appreciate the dilution also resulted in optically outsized operating margins (ex-SBC of course), which kept investors from selling (look at the margins and growth! High quality!!). Cashflows were then deployed into enormous buybacks to neutralize the SBC dilution. So long as cashflow grew, shareholders seemed to benefit from a tax-efficient return of capital. Little cashflow? Raise debt to buy back equity. Hell, raise debt despite growing cashflow and buy back even more. Debt was basically free for a decade anyway.

The stock buyback created a price-insensitive bid which competed with price-insensitive Passive to propel Momentum and Size into the grotesque Mag7 = 30% of S&P situation we have today. But this is not your dad’s 1999 mania-driven market concentration — this is something else entirely.

It was the price-insensitive nature of these buyback and passive flows that served as the forcing function for capital appreciation and excess returns… your decade-long alpha laid bare in 2023 for all to see.

Pivoting for a moment: how can it be that commodities remain near historic nominal and inflation-adjusted lows vs US equities, despite chronic underinvestment, supply disruptions, and cost inflation of the past few years? Commodities have many reasons to attract capital, especially now that most company managements are prioritizing shareholder returns over capex and volume growth. Supply constraints abound. Yet nothing changes. You have oil inventories drawing counter-seasonally in Q1 (something I can’t recall seeing this aggressively), time spreads firming, healthy crack spreads reflecting a tightening physical market… and the oil price simply does not react. On the contrary: last week an Al Jazeera headline about a possible Israel-Hamas ceasefire took $2 of geopolitical risk premium out that I didn’t realize was still in the price — on fake news. Of course, once the report was denied, that premium did not get priced back. Classic “a market that does not rally on bullish news is not bullish,” I suppose.

You may recall my recent post on commodity Rolling Crackups (here). Many commodities have languished around marginal cost and below AISC while underinvestment becomes more severe, with little consequence to market pricing…and then out of nowhere thermal coal exploded, or nickel, or Henry Hub gas, or uranium.

The forcing function in commodities is also the price-insensitive buyer, only here it’s not a corporate buyback or passive ETF, but a player who needs the physical when it simply is no longer available. It seems commodity prices need to wait around until everybody knows that everybody knows there is a shortage, and then bang…the gap between screen price and demand destruction (or substitution) can be huge. But eventually the move ends, often while the voices in one’s head are still screaming “let your sitting do the work!” Pigs get slaughtered.

At lunch this week, a fixed income specialist friend commented to me how all the fundamentals he had learned for pricing rates over his career made no difference to his P&L in recent years. Rather, his success has been largely a function of understanding arcana around the TGA and the Fed, and identifying the price-insensitive buyers (Fed via QE, banks/insurers with their regulatory constraints, foreign central banks) or sellers (Treasury, Fed via QT). Determining which player is the largest and most motivated at any moment has been his key to alpha.

There it is again: the forcing function of the price-insensitive buyer.

Who can possibly deny that over the past few years the vast majority (if not all) of alpha was harvested by interpreting positioning and sentiment to frontrun flows, rather than tracking fundamentals?

The point is this: 4x Ebitda will become 3x, 2x, 1x… The only solution to non-Mag7 and especially Value/Smallcap equity underperformance is for managements to introduce a price-insensitive buyer — the corporate buyback — to offset relentless price-insensitive Active redemption sales that weigh on their share price. FCF yields of 15%+ mean nothing if they don’t translate to shareholder returns…but not just any return. Dividends are useless in this fight. My buddy Kuppy got into buybacks vs dividends here a few months ago, and is completely on point.

The problem is that while commodity company managements have finally gotten religion on capital discipline, most (with a few exceptions) have not gotten hip to SBC. As Charlie Munger famously said: “show me the incentive and I’ll show you the outcome.” Maybe it’s time senior managements in value/smallcap got in on the SBC management enrichment scheme, take a salary cut to preserve margin while cutting capex to the bone, and pour all their FCF into relentless buybacks. One day the float tightens past a tipping point, and the forcing function wins.

No invisible pool of Active money will magically wake up one day and realize Smallcap/Value/Commodities are valuable. In a financialized world where flows determine performance and value counts for little, the forcing function is the presence of the price-insensitive buyer. Without him or her, the cheap will stay cheap…and get cheaper.

The few active shareholders might want to think about forcing this issue with management teams before there is nobody left to care.

Yours sincerely,

Paulo aka Cloudbear