Investment Strategy essay
M u l t i - M a n a g e r P o r t f o l i o A r c h i t e c t s SM
Rip Currents
Stewart R. Massey
Founding Partner & Chief Investment Officer
973-525-1000
[email protected]
September 8, 2010
Here on the east coast the last weeks of August and early September brought hot humid weather.
Families from the Carolinas to Maine headed to the beach to enjoy the ocean breezes and a refreshing
dip in the surf. The sea looks inviting in the waning days of summer but underneath the surface lay
dangerous rip currents caused by a series of hurricanes moving northward far offshore.
Markets are acting a bit like the ocean now. The tide comes in on bits of good news (“better”
economic data, strong corporate earnings, encouraging policy statements) and out on discouraging
news (“bad” economic data, macro concerns, the negative bias of the media). The riptide this kind of
market creates is volatility. Volatility creates short term aversion to risk, equities in particular. Nobody
wants to go for a swim. They are happy to stay on the beach (fixed income and cash) and wait until the
danger passes.
When our sons were younger we would wait for low tide and comb the beaches of Bay Head for
sea glass. For the uninitiated, sea glass has been tumbled and smoothed by the waves, water and sand,
creating smooth, frosted shards of glass. Most sea glass comes from discarded bottles and jars. The
most common color is white. Periodically we would find brown and green pieces. The rare find,
however, was the elusive piece of blue sea glass. They usually appeared after the ocean was roiled by a
storm or rip current. This discarded junk that nobody wanted created beautiful little gems. We’ve had
dishes and bottles of them decorating the house for more than 20 years. They bring back many fond
memories. I can’t help but think that today’s tumultuous times may be creating pieces of blue sea glass
on the financial shores in the form of risk assets.
We’re not stock pickers at Massey Quick. We leave that up to people much smarter than we are.
One of our managers has recently built a sizeable position in Cisco. Let’s dig a little deeper to understand
why. Cisco is a global leader in the design and manufacturing of Internet Protocol (IP) based networking
and other products to the IT industry. Applications include IP networks for mobile, data, voice, video
applications, switching systems, IP phones and home network management software. They also have
subsidiaries that address high growth businesses like network and content security, web security,
building systems to manage energy efficiency and so on. You get the picture. These are classic growth
businesses. I would imagine the company has quite a bit of earnings leverage when capital spending
picks up. The following is a five year price chart for Cisco’s common shares.
Massey, Quick & Co., LLC
360 Mount Kemble Avenue | Morristown, NJ 07960 | www.masseyquick.com
Courtesy of bigcharts.com
On August 11, 2010, Cisco reported fourth quarter results. Here are a few data points:

Quarterly revenues were up 27% year over year

Quarterly earnings per share were up 79% year over year

Cash flow in the fourth quarter was $3.1 billion, up over 50% year over year.

The company had $39.9 billion of cash on the balance sheet at the end of the quarter.

In recent years the company has repurchased 3.1 billion shares of stock at an average price of
$20.70.
During the conference call to review fourth quarter results, Cisco’s CEO stated that "We are seeing
a large number of mixed signals in both the market and from our customers' expectations, and we think
the words 'unusual uncertainty' are an accurate description of what is occurring." The stock dropped
from 24 to 21 the following morning and traded under $20 per share on August 31st.
Granted, we are going through a period of economic uncertainty, but this type of reaction is
typical of the short term thinking that currently dominates the market. If we see evidence of a weak
recovery can Cisco trade back to the August 7, 2010 price of $25 per share (roughly a 20% return)? If we
see evidence of a moderate recovery in the next few years can Cisco trade back to the 52 week high of
$27.74 per share (a 32% return on capital)? Again, we’re not stock pickers, but these are the types of
companies are managers are compelled to buy at these levels. For purposes of full disclosure my wife
owns Cisco in her IRA and my children own it in their trusts.
Conviction, Frustration, Conviction
Over the past ten weeks, our manager research team, my partners and I have visited with well
over a dozen equity managers. As we reflect back on all of these meetings, three strong themes
emerged:
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September 2010
1. The managers each had strong conviction about the stocks in their portfolios. They believed
they had the fundamentals right and the long term prospects for their portfolios were highly
promising.
2. They were frustrated that the market was not rewarding them for good fundamental
research. Correlations between individual stocks were high as a result of the macro driven
moves in the market. “Good” companies and “bad” companies were trading in lockstep.
3. They all believed that when the macro forces diminished, their deep fundamental analysis
would produce good outcomes in the portfolio as the market rewarded the “good” and
punished the “bad”.
When correlations between individual stocks and sectors are high it is extremely difficult for long
term investors to make money. As mentioned previously, the market doesn’t make a distinction
between the share prices of companies with strong fundamentals and weak fundamentals. Since all of
our managers have an investment process steeped in deep fundamental research, it has been hard for
them to add value. This, coupled with extreme volatility makes for frustrating results.
The following chart illustrates the correlation between individual stocks in the Russell 1000 Index
between 1950 and 2010.
Source: Barclays Capital Quantitative Equity Strategies
With cross correlations at an all time high, it is an extraordinarily difficult time for managers who
rely on fundamental research to add value above and beyond their benchmark. Long/short managers
suffer even more as their longs and shorts move in the same direction despite the vast difference in
quality between their positions.
Our belief is that these forces will wane as we move further away from the financial crisis and
toward economic recovery, however shallow it may be. Have patience. Try not to focus on the short
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September 2010
term. Think in terms of your true investment time horizon, whether it is five, seven or ten years. The
following quotes from several of our core managers speak volumes.
“One of the hardest things to do in investing is to be patient, but it can also be the most
rewarding. A fundamental tenet to what we do is to deploy capital in a way that
maximizes return relative to risk. The hard part is that returns don’t simply show up on a
linear basis when you deploy capital. Sometimes good investments take years to work,
often incurring losses before eventual positive returns. Having a certain amount of
patience is critical to investment success.”
“Given the uncertain environment, one would think high quality companies would be
trading at a greater than typical premium to the market. However, in many cases the
opposite seems to be true, as these stocks are trading at little or no premium to
businesses with much more economic risk. This should help create a rich opportunity set.”
“My experience has been that prolonged periods in which company fundamentals and
valuation become irrelevant are typically followed by periods during which there is great
opportunity for micro-focused long/short stock pickers….I expect this current environment
will lead to a similar period where valuation imbalances are ultimately corrected.”
It’s All About Confidence – Follow The Money
There is no shortage of cash out there. The 500 largest U.S. corporations are currently holding
over $1 trillion on their balance sheets. This excludes companies in the financial sector. Corporate cash
as a percentage of the market value of the S&P 500 hasn’t been this high in over 50 years. Fixed income
mutual funds continue to rake in assets. $351.3 billion was invested in fixed income funds in 2009. Over
$150 billion has been directed to bond funds in 2010. Equity mutual funds have experienced net
outflows for the past three years. The marginal seller of equities is gone. After three years of outflows,
who is out there that hasn’t already sold stocks to de-risk their portfolios?
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September 2010
Why are corporations hoarding cash? Why are investors moving away from stocks into fixed
income? It’s all about confidence. The financial crisis left investors bruised and wary of risk assets (bonds
are risk assets, but more on that topic later). The confusion over the unwritten provisions of the health
care bill, the financial regulation bill and an uncertain tax policy is making business cautious and hesitant
to invest in new plant, equipment and technology. Many would argue the current administration is
“anti-business”. For the same reasons, the consumer is hunkered down. Individuals with investment
capital are thinking more about return of capital than return on capital. This is one of the reasons that
returns on fixed income instruments are exceedingly low. People are chasing yield.
A change in sentiment could begin to move cash into risk assets. If one were to paint a positive
scenario for the coming months it would include:

More positive data points that the economy is recovering. We saw a brief glimpse of this on
September 1st when it was announced that growth in American and Chinese manufacturing
was better than expected. The S&P 500 climbed 2.8% that day.

The extension of the Bush tax cuts to all Americans. The November elections will be hard
fought. Incumbents need to go back to their constituents on a positive note that doesn’t
include pork barrel projects.

Less anti-business rhetoric coming out of Washington. Bashing corporate America will keep
confidence low and delay capital investment that will start bringing jobs back to the economy.
The Fed can inject immense amounts of liquidity into the economy but that won’t create
borrowing or spending.
In short, we need a series of events that will begin to bring confidence back to the boardroom and
to consumers.
Money flows are momentum based. We are looking at two key data points to help us understand
a return to confidence. The first is mutual fund flows. When confidence begins to increase we expect
money will move away from fixed income instruments into equities. The “first movers” will likely be
mega cap blue chip companies with global business footprints. If these companies have a history of
paying and increasing a moderate to generous dividend, all the better. It has been interesting to watch
our dividend oriented managers over the past several months. They have been performing far better
than their benchmarks. The following table depicts returns for these managers for June, July and August
versus the S&P 500 index.
Manager “A”
June 2010
(1.59)
July 2010
7.99
Manager “B”
(3.02)
8.06
Manager “C”
(2.20)
7.10
S&P 500
(5.23)
7.01
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August 2010
(4.51)
September 2010
I believe these returns are a first indication that funds are flowing into high quality blue chip
companies with yields higher than 10 year Treasury bonds (2.70%). These companies are viewed as
lower risk investments when compared to the broad market. Over time, money will move further out
the risk curve.
The second indicator we are watching is corporate merger and acquisition activity. An old friend of
mine is a highly ranked securities analyst that covers the major investment banks. His conversations with
senior M&A professionals indicate that the deals are stacked to the ceiling. Once corporate America
regains some confidence, expect to see a plethora of acquisitions. Activity has picked up in the summer
months. This will help our multi-strat managers with exposure to risk arbitrage. Major deals included:

BHP Billiton’s bid to buy Potash Corporation for $39 billion

Goldcorps bid to buy Andean Resources for $3.4 billion.

3G Capital to acquire Burger King Holdings for $3.3 billion

3M to acquire Cogent for $953 million

First Niagra Financial to acquire NewAlliance for $1.5 billion

Intel to acquire McAfee for $7.68 billion

MasterCard to acquire DataCash Group for $520 million

Dell to acquire 3Par for $1.15 billion

Rank Group to acquire Pactiv for $6 billion

AON to acquire Hewitt Associates for $4.9 billion

Tyco to acquire ADC Telecom for $1.25 billion

Noble to acquire Frontier Drilling for $2.16 billion
As confidence returns corporations will buy other companies, repurchase their own shares and
eventually revive capital spending. We’re not saying this is a short term process. We’re looking out over
the next several years. But this type of activity is good for stock prices.
The Bond Bubble
In my previous investment strategy piece (go to www.masseyquick.com and search under
“Investment Strategy Essays” on the home page) interest rates and fixed income were discussed at
length. Our thoughts haven’t changed. In summary:

We believe interest rates are near a cyclical low. Treasury bonds, the benchmark for all fixed
income securities, are currently pricing in a double dip recession. We are not in that camp.

Over the next five years, medium to long duration fixed income may be the most
disappointing asset class.

Portfolios should be constructed with short maturities.

Portfolios should be professionally managed. Individuals or their brokers don’t have the
capacity to conduct in depth credit research, particularly in municipal bonds.

Don’t take from principal in your fixed income portfolio to meet income needs. Take an
endowment like total return approach harvesting interest, dividends and capital gains.
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September 2010
There is tremendous concern in the markets about municipal credit risk. Municipal bond yields as
a percentage of treasury yields have climbed steadily throughout the recent sovereign debt crisis as
broad attention has been given to local and state budget predicaments.
Courtesy of Samson Capital Advisors
When the baby is thrown out with the bathwater, hire a professional to sort it out for you. Active
fixed income management with a strong emphasis on credit research is the best bargain in town.
Beachcombing
Market volatility and high correlation isn’t over. We’ve been bruised. It takes time to heal. The
current market environment is a breeding ground for short term thinking. Short term thinking is a
breeding ground for long term opportunity. This essay assumes a minimum investment horizon of three
years. Over the next six to twelve months opportunities will arise to re-risk portfolios. Would we jump in
with both feet tomorrow? No. I was discussing this concept with a client last week and he asked me to
define the term “re-risk.” While recognizing that each client is unique and that each of their objectives
are different, here are the general themes:

Slowly decrease fixed income allocations.

Increase equity allocations in portfolios starting with large cap blue chip dividend growth
managers.

Move away from low beta long/short equity managers to higher beta long biased long/short
equity managers.

Allocate more capital to risk arbitrage managers that benefit from merger and acquisition
activity.
Granted, these are baby steps. We’re not in the double dip camp, but recognize these fears will
bring out the tide and expose opportunities. It’s frightening to buy assets when the general consensus is
selling them. Taking a long term view is so important now. Hopefully, we’ll end up with a pocket full of
blue sea glass.
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September 2010
Buy
Sell
Large Cap Dividend Growth Equities
Long/Short Equity
Long Biased Strategies
Risk Arbitrage Managers
Distressed Credit Managers
Long/Short Credit Managers
(Capital Structure Arbitrage)
Blue Chip Growth Equities
Medium to Long Duration Bonds
High Yield Bonds
Cash
Massey Quick currently advises on $1.6 billion of assets for wealthy individuals and families,
endowments and foundations. Thank you for your continued confidence in our team. Please feel free to
call 973‐525‐1000 or email us with any questions or comments you may have. Our web address is
www.masseyquick.com.
[email protected]
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IMPORTANT DISCLOSURES
This letter is being furnished on a confidential basis to the recipient for discussion purposes only and is not
intended as investment advice. This letter is not to be transmitted in whole or in part without the prior consent of
Massey, Quick & Co. LLC (Massey Quick). Massey Quick makes no express or implied representation or warranty
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herein does not purport to be complete and is subject to change.
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September 2010