top of page

Excerpt 2019 letter

“Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future.” [Warren Buffett]

The markets seem increasingly irrational to me. Here are a few other worrying trends I am seeing:

  1. Capital is chasing bonds, even though cash yields no longer compensate for the risk

  2. Low (negative) yields are driving markets more than the operating earnings of underlying companies

  3. Passive/index investing has overtaken active investing

  4. Many retail and institutional investors are underweight public equities

Capital chasing negative yields: In the course of 2019, the price of some European treasuries with long durations rose by more than 40%, despite trading at negative yields. In other words, these “safe” instruments guaranteed an annual loss of up to 1% if held to maturity, and potentially much more if they re-rated back to more sane levels. While investors were able to book strong paper gains on tremendous amounts of capital, they are now at risk of suffering substantial paper losses if the tide turns. It’s difficult to comprehend that there are billions of euros chasing negative yields when solid companies are trading at less than 10 (or even 20 times) earnings. Unfortunately, regulated institutional investors such as pension funds and insurance companies are forced to invest into supposedly “safe” fixed income instruments at any price, even if it no longer makes sense to do so.

Index investing creates its own vicious cycle: Being charged to hold cash is increasingly driving investors to buy blue-chip and momentum stocks, causing a rally in household names such as McDonald’s and Nestle, or Facebook and Tesla. This trend is being reinforced by the increasing number of index buyers, who are commonly forced to buy the largest and most popular companies in the market. The longer and the more forcefully the current environment pushes already expensive stocks higher, the more investors become distracted by capital flows rather than focusing on the earnings and balance sheets of the businesses they invest in. For example, McDonald’s share price has doubled over the last five years. While it is undeniably a solid, large and mature business, neither its value nor its earnings stream has changed much in this time. What has changed is the market’s perception of the company, a perception largely fueled by inflows.

That said, not all companies and asset classes have benefitted from these flows of capital. Even during the rally, some shares were subject to dramatic volatility and irrational undervaluation. I am seeing a growing divergence between what’s in favor and neglected, unloved and overlooked businesses. Some of iolite’s best investments over the last few years were shares that had fallen out of favor and were subsequently pushed out of an index (triggering forced selling) but then either re-entered the index after a period of recovery (triggering forced buying) or were acquired.

Investors avoiding public equities: What’s true for stocks is also true for asset classes. It seems that many market participants I speak to have almost written off public markets as their clients want to avoid volatility. Instead, they prefer private market or real estate investments, as these investments are not subject to a daily mark (i.e. daily price swings). There was a time when public companies traded at higher multiples compared to their private peers because of the “liquidity premium”. These days, investors’ preference for smooth — albeit often untested — returns has led to a situation in which private companies frequently trade at much higher valuations relative to their public peers.

Thoughts on: “how flawed are index funds?”

Index investing may have been a great idea once, and it is still a cost-efficient way to diversify equity investments. However, it is also increasingly becoming a systemic risk now that the majority of market participants are index investors. Let’s just quickly look at how flawed index investing can be.

The MSCI World Index is the broadest and arguably most complete measure of global equity markets. However, five U.S. technology stocks now make up 11% of this index’s value. Is this justified?

The global market is very large: there are more than 50,000 listed stocks easily available to the average investor. More than 7 billion people in the world need food, electricity, building products, transportation, and banking services. In this century, we will likely see China’s economy grow larger than those of the U.S. and Europe combined. The growth in Asia, Africa and Latin America could lift an additional 2 billion people out of poverty by 2050. By comparison, the population of the U.S. is 330 million and that of Europe 740 million. How is this outlook currently being reflected in the world’s broadest stock market index? Looking at the average Chinese or Indian consumer — how much of the dollars a person spends go to Apple, Microsoft, and Amazon? Is a bet on the MSCI World Index really the best way to participate in the world’s economic development?

I have been to Africa many times. It is a huge, diverse and fascinating continent, with a growing and rapidly developing population as well as an abundance of natural resources. Africa’s population of 1.3 billion is spread over more than 50 countries. Total GDP is USD 2.2 trillion, with GDP per capita of USD 1,700 vs USD 62,000 in the U.S. or USD 2,000 in India. Buying the MSCI Frontier Markets Africa Index should be a great way to benefit from the almost inevitable growth of the African continent over the next few decades. However, a closer look at the index reveals that just five companies make up nearly 50% of the index, among them two telecom companies and three banks. This is hardly where innovation and the bulk of the growth is to be expected. Sadly, it also means that these behemoths have easy access to capital, while more innovative and growth-relevant smaller businesses may struggle to raise capital.

Vietnam is one of the fastest growing and most promising economies in Asia. The Vietnamese stock market consists of a broad and interesting blend of small businesses. However, an index investor would put 70% of his capital into just 5 companies: essentially a couple of large and highly valued real estate developers and holding companies.

From these quick three examples, it should be obvious that index funds cannot be the last word in investing. Moreover, if most of the world’s capital is being managed passively (or by artificial intelligence), this means nobody is holding management accountable any longer. After all, who will fire an underperforming or corrupt manager if nobody exercises the ownership rights their shares represent? There will also be less capital actively supporting uneconomic but vital breakthroughs in science and engineering. As other people have stated before me: “Passive investing is worse than Marxism.” Even if most active investors underperform the market, and even if most investors may not know how to operate a business — their voices hold boards and management teams accountable.

Thoughts on how to “beat” the market

I want to come back to my investment in Jumbo Interactive, as it is such a good example of what I do, and of the growing opportunity set I see. Selling Jumbo and recycling the proceeds into other, more attractively priced opportunities allowed iolite to sell high and buy low. I often use volatility to my advantage — this has been one of the key drivers of my success since I started investing.

When I started buying shares of Jumbo Interactive, they were trading at AUD 1.20 and I thought they were worth about AUD 3.00 to 4.00. After I had already invested a significant amount of managed assets into the company, Jumbo was de-listed from an index, which triggered forced selling. The shares subsequently dropped to almost AUD 0.60.

Suffering a 50% quotational loss in just a few months is frightening. I kept asking myself: “Am I the patsy at the poker table? What do I not see?” I repeatedly tested my investment thesis but always came to the same conclusion: the company is undervalued. Yet the share price continued to fall.

You cannot force market participants to suddenly fall in love with a stock. In the case of Jumbo, index investors were forced to sell, a few smaller mutual funds were selling to preserve their portfolios (“window dressing” as no one likes to show a portfolio of apparent losers) and many retail investors were selling because of fear, to generate tax losses, or because they had given up. I felt like the only one buying; I started spreading my investment thesis, but interest was muted. Apparently, nobody wanted to catch a falling knife. I kept buying … and it did feel very lonely.

Many investors I speak to take a rising share price as a positive indicator, and a falling share price as a reason to be concerned, a signal for more issues down the road. The growing community of quantitative investors tends to fall into a similar trap: many models I have seen are just betting on a continuation of a trend.

Soon after Jumbo’s business’ recovery became obvious, the shares started to recover. New investors jumped on board as the rising share price made the stock look “safer” to own. Eventually, Jumbo was re-listed in the index, triggering forced buying. More people eager to ride the wave jumped on board. Supported by positive operational news, the shares quickly ascended to AUD 20, and Jumbo had turned into an Australian unicorn (a start-up company with a market cap larger than AUD 1 billion).

Whatever business issues and risks investors had seen before were forgotten. Instead, an increasing number of research notes promoted the company’s growth prospects and analysts kept upping their value estimates. Unfortunately, some of the early turnaround investors had sold too early, as they were aware of the risks. They failed to capture the momentum, and unfortunately missed out on a few unexpected rewards along the way. I have often been in this category myself, but thankfully not in this case.

My decision to the sell the position mid-year is no judgement about the quality of the company or its management team. On the contrary — I would love to fully own Jumbo, and I sold purely based on valuation. Who knows, perhaps the market will offer iolite another opportunity to buy into this great company further down the road.

Why am I telling this story? Why do I keep telling this story? It’s because I think there always was and always will be a profitable niche for an active manager. While the growing pools of passively managed capital are improving the odds for the active manager, tapping the opportunity requires a certain skillset and state of mind, and every investor is only as good as the capital available to him.

Recent Posts

See All


Commenting has been turned off.
bottom of page