The results are in: The TenStocks at Covestor portfolio ended the year up 30.1% (net of advisory fees). This compares favorably to the S&P 500 Index (SPX), which closed 2012 up 13.4%.
As usual with a concentrated portfolio, 2012 proved to be another bumpy ride. We came out of the gate fast in Q1, faded in Q2 and Q3, and then finished strong in Q4. Overall, we consider it a good performance.
Now we turn our efforts to the task of producing alpha (performance in excess of the market) in 2013. Alpha is an important performance metric. We believe it’s a measure of how much value a manager is bringing to the table.
Alpha generated over a one-year period doesn’t mean much in our opinion, but if you can find a manager who has a record of consistently producing alpha over a five- or ten-year time frame, we believe that manager may be worth a closer look.
Covestor recently asked us what our favorite stocks were for 2013. We mentioned Aveo Pharmaceuticals (AVEO) and Bank of America (BAC). We believe Aveo’s investigational RCC drug, Tivozanib, will be approved by the FDA later in the year.
Bank of America (BAC) has been one of our largest positions for some time, currently making up 20% of the portfolio. In our opinion, this stock was universally despised and shunned by the market for the last few years, but staged an impressive price recovery in 2012 and finished the year up over 100%.
We believe there’s more to come from BAC this year with a possible mix of buybacks, dividend hikes and more price appreciation. However, as BAC regains popularity and is no longer a dirty word at cocktail parties, we believe it will be time for us to edge closer to the exit.
Indeed, seeing CNBC’s Jim Cramer turn bullish on the stock this month with an $18 price target gives us pause, as does Christopher Whalen’s recent conversion to Bank of America’s bright side.
As recently as October 17, 2012, a mere three months ago, Mr. Whalen said on Bloomberg TV that BAC was ‘literally disintegrating’. Yet by January 9, 2013 Mr. Whalen’s crystal ball had undergone a sea change of clarity and was forecasting in this Bloomberg interview (at 6.20 minutes) that BAC would reach book value of over $20 a share.
We are not particularly comforted to witness what some people consider two prescient luminaries of the financial media convert to our point of view. We do hope, of course, that they are right, but for us, their very presence on our side of the ship rings the first faint bells of caution.
Unpredictable event risk is another caution for us in 2013. As outlined, event risk is ever present even when overlooked and unpriced. We have the latest display of US government incompetence coming down the pike with the debt-ceiling talks and more arguing, denying and can-kicking of what we believe to be inevitable.
There’s Syria, Mali, viral health epidemics, the ongoing, unsolved Eurozone crisis and other possible X factors all lurking and waiting to influence markets. We believe those who fail to price in the unexpected are likely to pay for the omission.
Another cautionary note, in our opinion, is the growth of margin leverage at brokerages and hedge funds. We think the policies of the FED encourage the very risk-taking that got the world into this collective economic mess in the first place.
According to Bloomberg, hedge fund borrowing to juice returns is at the highest level since 2004. This chart of margin debt at NYSE member firms shows steady upward growth in leverage as market players increase exposure (and risk) to equities.
Interactive Brokers, popular with a favorite of hedge funds and traders, reported that at the end of December 2012, margin loan balances were 40% higher than a year ago. In an effort to cap this renewed increase in Fed-pumped risk, Interactive Brokers has raised initial margin rates on a wide swath of small-cap names.
Again, we believe that when everyone moves to the same side of the boat, one should move to the other side and make sure one is standing close to the lifejackets. What we are trying to say here is that despite the lack of what we consider viable alternatives (except maybe buying a house close to Disneyworld) we are a little cooler about the market than we were in late 2012 bc (before Cramer).
In our opinion, a sharpish eye will notice that elevated market pricing and the resurgence of risk-taking and leverage is a product of artificially manipulated interest rates inspired, conjured and distorted by Fed Chairman Ben Bernanke and his merry band of global money printers.
Which—if we allow ourselves a brief moment to wallow in a bit more doom and gloom—brings us to the sum of all fears: It’s $639 trillion and counting. That’s close to the amount of interest rate derivatives outstanding today.
For a quick glimpse of the ultimate insanity of this elephant in the room, cast your eye here or here. Have you ever heard of a ‘range accrual swap’? How about a ‘power reverse dual currency note’? Or a Bermuda swaption?
The global interest rate derivative market is the ultimate mother of invention. If it blows, we may all be living a Life of Pi. Knowing exactly when to seek safe harbor is never easy. Getting the timing right is close to impossible without a fair degree of luck.
And anyway, a ship that remains in port may be safe, but it will never get anywhere and that’s not what ships are built for. With all this in mind, we maintain the course we have set for ourselves in 2013, but we did think it wise to put a reef in the main and keep a close eye on the weather.
So, we looked at the portfolio to see what and where we could trim to reduce market exposure. The one name we owned trading closest to our estimate of fair value was Berkshire Hathaway (BRK.B). We have just sold it.
Letting Mr. Buffett and Mr. Munger go is not an easy decision. We are respectful admirers of both of them. We’ve made the pilgrimage to Omaha. We’ve eaten steak and hash browns at Gorats. Just having Berkshire Hathaway in the portfolio adds a certain prestige and credibility, in our opinion.
We think it’s like having the Mona Lisa in your private collection. But unfortunately, the truth is that time rolls on for both of them. We expect some downward pressure with any health concerns. But really, we just wanted to trim our market risk a bit and Warren and Charlie were at the front of the line in our view.
Lest anyone think we suffer from perpetual pessimism, this might be a good time to borrow some words from Warren himself: ‘In order to finish first you first have to finish.’ We quoted this piece of simple wisdom in this May 2011 Covestor commentary.
Our emphasis is on survivability and risk management. That’s not to say we don’t have significant portfolio price drops from time to time, including periods of underperformance—we do. But we also believe that if we don’t always run scared and always attempt to make our mistakes on the side of caution, the portfolio will recover, especially if we have packed it with what we see as discounted value, and are unafraid to raise cash during good times and brave enough to be a buyer during bad times. With all that said, we sail out into 2013 and we’ll see what it brings us.
The investments discussed are held in client accounts as of December 31, 2012. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable.
