May 2021
IN THIS ISSUE
When bad news is good news
Robin Hood vs Buffett
Short interest in SPY is spiking
Inflation is rising
High-Quality Shareholders
Stock splits are mathematical non-events that change nothing about a company’s fundamentals. Twice as many outstanding shares multiplied by half the share price clearly preserves the company’s total market capitalization.
But sometimes stock splits are not mathematical non-events! Despite the advent of fractional shares, potential increases in demand exist at lower share prices due to the wider base of investors who can “afford” those shares. It’s taken many years, but I finally learned to control my convulsions when students ask the inane “I’m a poor college student, which penny stocks should I buy?”
Warren Buffett famously opposes stock splits, the consequence of which is Berkshire Hathaway’s roughly $430,000 price per Class A share. Sure, the Class B shares have a much lower per share price (with even further diluted voting rights) to accommodate shareholders who don’t have a spare $430,000. But Buffett clearly prefers the higher share price rather than the increased demand, whereas Tesla and Apple both split their stocks last year to reduce their share prices. Why?
Lawrence Cunningham, the all-things-Buffett author, researcher, and director of the aptly-named Quality Shareholders Initiative at George Washington University, has the answer - Quality Shareholders:
Both of these companies [Tesla and Apple] recently split their stock in order to cut share price. They apparently are trying to attract shareholders who will also be customers. But while that might be good product marketing, it is definitely bad investor stewardship: Stock splits degrade a company’s shareholder quality.
Managers and investors alike should care about which shareholders grace a company’s shareholder list. At companies brimming with transient shareholders, managers bend toward a short-term focus, while those dominated by indexers get shareholder proposals and votes aligning with prevailing social and political fashions.
Some companies attract a greater proportion than others of patient and focused shareholders — what Warren Buffett has dubbed “high-quality shareholders” (QSs for short). While all public companies have transients and indexers among their shareholders, those with a higher density of QSs get longer strategic runways that are associated with superior performance.
There you go. Tesla and Apple find value in attracting retail customers as shareholders. Berkshire Hathaway finds value in attracting patient, financially secure “high-quality shareholders”, a good proxy of which is the ability to buy a $430,000 security. Importantly, QSs who do not sell on minor declines give latitude for corporate management teams to focus on long term performance.
Surely many companies are jealous of Berkshire Hathaway’s QS base. Just imagine ordinary companies making 50,000 to 1 reverse stock splits to price out non-high-quality shareholders - that would be interesting!
In a related piece titled Warren Buffett knows these are the best investors to follow with your own money, Cunningham delves into the mechanics of the performance premium:
Today’s conventional wisdom, and much research, suggests that “active” funds underperform the market after fees on average. Top fund performance doesn’t persist and while some investment managers are skilled, few deliver on that value for customers after fees. But the QS group, both patient and focused, proves an exception, as this group’s members do tend to persistently outperform after fees.
Being long-term, QSs offset the short-term preferences of transient shareholders. A high density of QSs, with their characteristic patience, helps managers operate strategically, with a long-term outlook. Such effects can percolate throughout a company. If less pressure comes from shareholders to produce short-term results, then directors, officers, employees, suppliers, partners and others can operate in the same way.
Second, companies attract QS and repel transient shareholders by avoiding quarterly earnings guidance and conference calls in favor of a longer-term focus. They adopt, publish, and discuss honest long-term performance metrics, such as economic profit and return on invested capital, in lieu of popular fixations such as earning per share.
Above all, companies commit to what QS value most: effective capital allocation. This refers to a simple but elusive idea that treats every corporate dollar as an investment put to its best use, whether organic or acquired growth, debt reduction, dividends or share buybacks.
Yes, yes, those are the goods! Finding ways to repel transient traders and passive indexers while attracting high-quality shareholders, that’s how to grease the wheels of outperformance. Forget what’s popular or “normal”; having very expensive per-share prices, restricting redemption rights, not issuing quarterly earnings guidance, and various other structures fuel the outperformance that most investors ironically seek.
Which brings us to the volatile price swings this month in Ark Invest’s ETFs. Here’s CNBC’s Maggie Fitzgerald in Cathie Wood’s Ark Innovation ETF is down 10% this week, nearing new low for the year:
Nearly $770 million has left Ark Innovation in the last week. Ark Invest — including its five core ETFs — has lost about $1.1 billion in investor dollars in the past seven days, according to FactSet.
Ark Innovation is more than 32% off its high in February of 2021 after which the ETF spiraled on concerns about rising interest rates.
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[Ark Invest’s Founder, CEO, and CIO Cathie] Wood is steadfast in her long-term investing philosophy and takes advantage of the volatility to double down on her highest conviction picks. Ark Invest’s chief operating officer, Tom Staudt, has told CNBC that Ark’s “long-term focus allows us to buy if a name has been hit for short-term reasons or sell if a name is up on short-term exuberance.”
Wood’s other ETFs also experienced intense selling pressure on Thursday. The Ark Next Generation ETF lost 2.75%, bringing its week-to-date losses to more than 9%. The Ark Genomic Revolution ETF and the Ark Autonomous Technology and Robotics ETF fell 2.7% and 0.3%, respectively. The pair are down 10.2% and 4.4% this week alone. The Ark Fintech Innovation ETF dropped 2%, bringing its losses for the week to more than 6.5%.
Ark Invest is not exactly Berkshire Hathaway. There is the obvious ETF structure that promotes frequent trading, and Ark’s concentration in the tech space tends not to attract the patient Berkshire Hathaway types of shareholders. Now Wood just needs to attract QSs who won’t flip in and out of her ETFs.
Otherwise though, executing on a long-term investment strategy that prepares for and takes advantage of volatility-induced opportunities for outperformance is a familiar approach around here, one that we call “thinking in Likelyhoods”.
The Four Ds
Speaking of flipping, I first learned about “the four Ds” in the context of flipping real estate. You know those shows: Flip This House, Flip That House, Flip or Flop, Flipping <<enter city name here>>.
Opportunities arise from dislocations in housing prices among sellers who often experience one or more of “the four Ds”: Death, Divorce, Disaster, or Disease. Sellers sometimes need to sell quickly and are willing to accept lower offers to resolve the impact of the “D”. Flippers swoop in, buy distressed properties on-the-cheap, restore value to the property, then sell at hopefully a significant profit for their few weeks or months of work.
Flippers seek to profit from the work of correcting inefficiencies in market prices. How? They manage their portfolios strategically, prepare in advance with “dry powder” cash-in-hand, and pounce when opportunities arise.
So which of The Four Ds sank Archegos Capital Management? Divorce, I suppose. Credit Suisse (and other lenders) married Bill Hwang for money but then asked for a divorce by way of margin calls.
Who were the flippers seeking to profit from the Divorce and correct the inefficiency? George Soros, for one, Soros Bought Up Stocks Linked to Bill Hwang’s Archegos Implosion:
Billionaire George Soros’s investment firm snapped up shares of ViacomCBS, Discovery and Baidu as they were being sold off in massive blocks during the collapse of Bill Hwang’s Archegos Capital Management.
Soros Fund Management bought $194 million of ViacomCBS Inc., Baidu Inc. stock valued at $77 million, as well $46 million of Vipshop Holdings Ltd. and $34 million of Tencent Music Entertainment Group during the first quarter, according to a regulatory filing released Friday. A person familiar with the fund’s trading said the company didn’t hold the shares prior to Archegos’s implosion.
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“When there’s a dislocation, we’re prepared to not just double down but triple down when the facts and circumstances support that,” [CIO Dawn Fitzpatrick], 51, said in a “Front Row” interview on Bloomberg TV.
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The 13F filing provides one of the first examples of how a hedge fund attempted to capitalize on the distressed remains of Archegos. It also offers an insight into Soros’s investment firm, which is run by Chief Investment Officer Dawn Fitzpatrick.
Here we go! Soros Fund Management did not own the shares prior to Archegos, they just swooped in on the Divorce-induced selloff to take advantage of distressed share prices. Maybe Soros had been eyeing these shares prior to Archegos, or maybe not? But the profit potential may be there, as Divorce-induced selling is distinctly different from changes-in-business-fundamentals-induced selling.
But were the share prices actually distressed? For the record, the implosion happened March 26th. Here are the share prices on January 4th a few months before the imposion, March 19th the week before the implosion, and March 31st just after the implosion:
Source: Interactive Brokers, Likely Capital Management
Who knows what will happen, especially given the new world of meme stocks, diamond hands, and rockets, gosh stock picking is a rough way to invest. We will find out soon enough, so set your calendar reminders to check these share prices in a few months. But given that Archegos’s trading volume was a significant explanatory factor in the magnitude of share price increases, one might reasonably expect the post-implosion prices to settle back toward pre-implosion prices, perhaps prior to the Archegos-induced price increases from roughly January through mid-March. If that’s the case, Soros Fund Management might not get the post-Divorce flippable recovery that they were expecting.
ONE MORE THING…
When bad news is good news: Dow jumps more than 200 points to another record as investors look past big jobs miss
Robinhood vs. Buffett: When you are called out for promoting stock picking, do not reply by framing day trading as “taking control of financial lives”. The data are clear on these outcomes. Broker Robinhood upbraids Buffett over casino comparison
Short interest in SPY is spiking. Watch this space: SPDR S&P 500 ETF (SPY) Short Interest Climbs to Highest Level of 2021
Inflation is rising: “...economists are trying to remind the world of a key couple of facts: Inflation is often a byproduct of economic growth and is likely temporary.” Someone tell them they forgot to capitalize Likely. Investors are worried about inflation data, but economists see it as a sign of temporary growth
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