Why ETF “Herd Investors” Will Always Get Burned

Just when I suspect one of America’s greatest investors might be digging through my mail… I become convinced he’s doing it.

Howard Marks of Oaktree Capital lambasted index investing in his latest investor letter. In this, we’re 1,000% agreed: Indexing is a silly, dangerous waste of time (unless you want sub-3% returns… minus fees).

An eagle eye for warding off popular con games like indexing is just one of the reasons Marks is worth about $1.9 billion. Clearly, he knows a thing or two about grabbing unreasonably high returns.

He warned his readers about another return-sapping scheme out there on Wall Street.

It’s one I’ve compared to buying a “ticket on the Hindenburg” and thinking you signed up for a walking tour of the Chicago Botanic Garden.

This is worth a second look – because Marks is actually pointing us toward a much, much more profitable way to invest.

It’s an approach I’ve mastered and profited immensely with for years – and so can you…

ETFs Are the Primary Weapon in Wall Street’s Con Arsenal

Initially, exchange-traded funds (ETFs) focused on indexes that provided low-cost, liquid asset allocation choices to investors – not the worst idea in the world – but we have blown way past that stage.

Now the ETF market is huge, worth $4 trillion as of the start of 2018. In today’s market environment, if you have an idea that falls anywhere between really dumb and ingenious, odds are someone has already constituted an ETF to exploit it.

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These ETFs are made even more exploitative by the fact that Vanguard, BlackRock, and other money managers heavily market them to the public via FOX News and Facebook.

The advertising is great, the sales pitch is excellent, and by and large, they’re expertly crafted to make investors feel very comfortable in the herd.

That’s the public image. The reality is that ETFs represent just about everything that’s wrong with the market.

For instance, in his latest, Marks talks about (among many other things) the distorting impact ETFs on all-important valuations.

He notes how the surging popularity of passive investments like ETFs will obviously bring more cash into index-listed stocks like Apple Inc. (Nasdaq: AAPL) and Johnson & Johnson (NYSE: JNJ) than other stocks.

This could bode poorly for those other stocks that aren’t all over the news every hour of the day, since investors may foolishly pull money out of those and pour it into the indexed “rock star” companies.

Mark summarized the problem with his letter’s most standout line: “It seems obvious that this can cause the stocks in the indices to appreciate relative to non-index stocks for reasons other than fundamental ones” [emphasis mine].

Make no mistake: if stocks are appreciating to high valuations for any reasons “other than fundamental ones,” it’s a surefire sign of a bad investment.

It’s true that the indexes and sector replication portfolios contain very few bargain stocks right now. It can be frustrating, especially if you’re a stock cheapskate like me.

But, as I’ll show you, it also sets the stage for the next sell-off. Or, as I like to call them, “portfolio creation events.”

Marks’s memo lays out the case for why passive investors, i.e., “the herd,” can actually open opportunities for the value-focused loons like us: “Can you picture a world in which nobody’s studying companies or assessing their stocks’ fair value? I’d gladly be the only investor working in that world.”

I sure as hell would, too, while the herd buys stocks without considering the underlying business all while pushing valuations to levels quickly becoming unsustainable.

What Goes Up… Comes Down Hard on Passive Investors

No matter how Wall Street may try to disguise the risk of equity ownership by creating whacky new ETFs, a stock will always – always, always, always – represent ownership in that business and eventually reflect the value of the business.

It bears repeating: When you own a stock, you own a business, and it’s imperative you understand that business – and its value – inside and out.

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This fundamental truth, which should be the basis from which all stock-buying proceeds, is completely obscured in the ETF sector.

This murky path has brought members of the herd to a pretty dangerous place, although its one we can ultimately use to our advantage.

See, ETF owners, thus bamboozled, simply don’t know how to react properly to any market – whether it be bull, bear, sideways, or in circles.

Even worse, they cannot react to these changes which can come on fast.

For instance, Marks talks about the high-yield bond ETFs. It’s much easier to buy a high-yield ETF than it is to assemble your own individual bond portfolio.

Now, I’m here to tell you: In bad markets, I’ve seen even the popular bond issues of the day go “No Bid,” which means there was no buyer – at any price.

If the high-yield bond ETFs cannot sell bonds, then they cannot honor excessive redemptions. And then the share price of that high-yield bond ETF will collapse to… $0.00.

Also consider the First Trust Nasdaq ABA Community Bank ETF (Nasdaq: QABA).

This ETF owns hundreds of small community banks, many of which are thinly traded.

Now, we all know I love a good community bank; some have tripled my money.

So what’s the problem?

Well, the problem is this: If a good community bank is like the Mona Lisa, then a community bank ETF is more like Frankenstein’s monster.

Those thinly traded shares are a potential time bomb for the ETF fund managers who own dozens and dozens.

If, for whatever reason, the fund enters panic-selling mode, then the prices of the underlying banks will crater as the fund managers desperately seek buyers to meet redemption requests.

Dozens of ETFs own a lot of small-cap stocks that will get crushed if fear enters the herd – and the marketplace.

Some herd members may be sitting back right now thinking their portfolio is bulletproof, since it contains index ETFs with large-cap stocks.

“Surely these fantastic stocks will find buyers even in the worst market, so there is no need to worry.”

As someone who has 40 years in the markets under his belt, I’ve seen a lot of tombstones with that very epitaph (hastily) scrawled on.

And Mr. Marks, despite having about a decade on me in the markets and using his words a bit more eloquently, says pretty much the same thing.

He notes, “It’s not clear where index funds and ETFs will find buyers for their over-weighted, highly appreciated holdings if they have to sell in a crunch. In this way, appreciation that was driven by passive buying is likely to eventually turn out to be rotational, not perpetual.”

This tells us exactly what side we want to be on…

How to Profit When the Herd Gets Slaughtered

So, someone will eventually buy those “fantastic stocks” the rapidly cratering ETF holds, but you better consider who those buyers are – and the prices they like to pay.

Those buyers will be some very experienced “last-resort” types – real cheapskates, too, like… Michael Price, Carl Icahn, Seth Klarman, and… yours truly.

How cheap are we? Unreasonably cheap.

Here’s what we like to see on the price tag while we’re kickin’ the tires…

Right now, the median earnings before interest and taxes (EBIT) to enterprise value (EV) for S&P 500 companies is 17.2. None of us are even vaguely interested in those companies until that number plunges into the single digits.

The median P/E is 21, and, again, we all want a single-digit number, give or take a decimal place or two.

The median price-to-book is almost 2, and we want less than 1.

If these metrics show anything, it’s that there are vast chasms of space between current market valuations and the valuations that cold-blooded buyers like me pounce on.

That’s a far distance to fall.

So, if the herd wants to own ETFs, by all means, let them keep buying. Because eventually, they will provide the Mother of All Buying Opportunities (MOABO) when even the biggest, most stalwart stocks see their prices crater.

The trick, folks, is to not be in the herd. I want to get you in the mindset, so that you begin to think of yourself as a buyer of last resort.

You don’t have to be a billionaire, like Carl Icahn, but you can absolutely, positively swing and hit in that league. I’m not a billionaire, either.

You’ll be in great company – rich, too.

Start to see stock ownership for what it really is: Business ownership. Make sure you understand the company, its business model, and (importantly) its market value before you buy an (unreasonably cheap) stock.

Don’t worry; I’ll help you with the research. I love to do it – I’m at the point where I do it for fun.

I’ll help you become a patient-aggressive type, like me, who prefers unreasonably undervalued companies that trade miles outside the indexes.

Believe me, we’ll always have buying opportunities, no matter what the markets are doing.

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