Rational Reflections Dec 2023

RATIONAL REFLECTIONS

By Bell Institutional

What can you expect from Bell Rational Reflections?

By reading Rational Reflections, it is our goal that readers will be able to walk away with a greater feel and understanding of the thought process that goes into the creation of investment portfolios at Bell. Throughout this series, we will attempt to cover a variety of topics on a continuous basis that hopefully readers will find interesting. Such topics will include, but are not limited to, the following:

• Thoughts and reactions to current news items, with an emphasis on how the news fits into our broader understanding of the investment landscape and secular outlook.

• Highlights and valuations of particular companies, many of which will be in our internally managed strategies.

• Central themes in our investing process and how they change along the way.

Investment Philosophy and Process

Simplicity is the ultimate sophistication

Occam’s razor states that among competing hypotheses, the hypothesis with the fewest assumptions should be selected. This mental model is useful because it enables one to separate the long-term signal from the shortterm noise, aiding a measured approach to investment decisions. Conversely, complexity often paves the way for errors and negative surprises. While this might seem counterintuitive, studies have shown that intelligent people are naturally drawn to more complex solutions. This intelligence can inadvertently lead to self-deception by fostering the belief of possessing all the answers. At Bell, we believe that mistaking predictions for knowledge, underestimating risks and overestimating control over future events is a good way to experience a negative surprise.

“If you can’t explain it simply, you don’t understand it well enough.” – Albert Einstein

Don’t panic over sensationalism

Investing is really quite simple: seek the greatest value for the least risk. However, it is very easy to become sidetracked by news headlines or succumb to the moods of Mr. Market¹. Successful investors remain calm in the face of market volatility while avoiding panic and emotional decision-making. A long-term perspective reduces the urge to overreact to short-term fluctuations. Things are rarely as bad or as great as they seem!

We believe that market timing is no substitute for a successful long-term investment strategy. As long as our theses are still intact and our underlying holdings still reflect said theses, there are typically no moves to be made. We focus on making fewer and better decisions.

First principles of thinking

The best way to answer a difficult question is to break it down into smaller, simpler questions that can be answered reliably. Boiling problems down to their fundamental truths (deconstructing) and then reasoning up from there (reconstructing) enables us to look at the world from the perspective of physics. This type of reasoning removes complexity from the decision-making process so that we are better able to focus on the most important aspects that pertain to the decision at hand.

Analysis Synthesis

Challenge

New Idea

First Principles

An example of first principles thinking in our investment and analysis process is how we approach equity valuation. We take the broad question of “what is company X worth?” and break it down into smaller questions that are much easier to answer. We boil down a company’s prospects into our fundamental truth that valuation is dependent on three main factors: 1) growth, 2) reinvestment needs and 3) risk.

Source: Morgan Housel

What is the intrinsic value of a stock?

Drivers of Value:

1.

3.

Value of Equity

Be humble and mentally flexible

Successful investing requires humility and adopting mental flexibility. When the facts change, being willing and able to change beliefs is crucial. One of the great aspects of investing is that if you get something wrong, you always have the opportunity to change it. Refusing to change an opinion, just because it is yours, is nothing more than hubris. Check your ego at the door.

We are acutely aware that we will never be 100% correct. Along this vein, forecasting is an inherent part of investing. However, it is important to recognize its limitations. Forecasts have one of two outcomes: lucky or wrong. Instead of explicitly relying on predictions and “putting all of our eggs in one basket,” we focus on building a resilient and diversified portfolio that can weather various market conditions.

Hold down costs and let compounding work to the benefit of the portfolio

Compounding occurs when investment gains are allowed to generate further investment gains. The longer money compounds, the faster it grows, which leads to an exponential effect on investment returns. Lower fees mean more of an investor’s gains can be reinvested, leaving compounding as uninterrupted as possible. As shown below, even small differences in costs can accumulate significantly over time.

Equity Thesis

Our current equity thesis revolves around two central beliefs: 1) U.S. market leadership is likely to continue for the foreseeable future and 2) the technology sector will continue to revolutionize the global economy.

U.S. market leadership persists

We believe that U.S. market leadership is likely to persist for the foreseeable future. This belief stems from the United States being the champion of capitalism. Capitalism has a number of advantages including encouraging efficient production, facilitating economic growth, rewarding innovation and offering social and financial freedom to citizens. This is in contrast to what happens in societies that lean more toward socialism, where government intervention is more prevalent. As government intervention increases, it leads to inefficiencies, mounting waste and stifled innovation.

In reality, most capitalist countries operate under a mixed economy in which the government intervenes to provide certain regulations and impose taxes. We believe government intervenes less in the United States.

A good metaphor for capitalism is Adam Smith’s “invisible hand.” The invisible hand describes the mechanisms through which beneficial social and economic outcomes arise from the accumulated selfinterested actions of individuals, none of whom intends to bring about such outcomes. Follow the incentives, and you will likely find the outcome.

The largest and most important companies in the world are from the United States. We believe a large driver of this is due to the fact that the technology sector in the United States is only lightly regulated and therefore does not suffer from regulatory capture as much as something like healthcare and big pharma. A two-person start-up in a garage can work!

The technology sector continues to revolutionize the global economy

We believe that tech dominance is something that is structural in nature, not temporary. The nature of business has fundamentally changed as the economy has shifted from the 20th to the 21st century. The internet is the most profound invention in human history and has turned the economy from the 20th century, described by supply-side economics and capital-intensive businesses, on its head. Due to the internet, companies are now able to deliver the marginal (digital) good effectively for free. The main focus for the most successful companies is now the user experience, which leads to network effects and winnertake-all or winner-take-most economies. The largest and most successful technology companies, uniquely enabled by zero marginal costs, are dominant by virtue of user preference driving suppliers onto their platforms, creating a virtuous cycle.

Network effects

The most successful companies are those that enjoy massive network effects. A network effect is a phenomenon whereby the value of a good or service is increased as its number of users increases. The internet is a perfect example. Initially, there were few users on the internet since it was of little value and content was limited. However, as more users gained internet access, they produced more content, information and services. More users led to more content/information, which led to more users accessing said content, which in turn led to more content being produced. Rinse and repeat. This illustrates the shift to demand-side economics from supply-side.

What about antitrust?

Source: LinkedIn

Traditionally, antitrust was built on the assumption that market consolidation leads to higher prices for customers. As a company grows to an outsized scale, it can artificially raise prices due to the elimination of competition. Consumers have limited options, leading to no alternative for purchasing goods. However, when it comes to Big Tech, it is not clear what there is to investigate. The reality contradicts traditional thinking: on the internet, with zero marginal costs in serving new customers and no transaction costs in scalability, the largest companies serve customers most effectively, leveraging demand into power over supply. Consumers choose to use these goods/services by choice, not out of necessity. If the user experience isn’t the best (in terms of cost or usability), customers and suppliers are free to move to a different provider. However, they do not do so because no better solution exists. Therefore, breaking up these large companies through antitrust laws is likely to erode consumer experience and value.

It's noteworthy that the FTC, led by Chairperson Lina Khan, continues attempting to break up Big Tech unsuccessfully.

Cutting the bloat

Since the Financial Crisis in September 2008, the market can generally be described as one of continuously falling interest rates and rising stock prices. When interest rates fall, the cost of capital falls. When the cost of capital falls, the hurdle rate falls, leading to more speculative projects and the rise of more speculative companies. In this environment, many companies became complacent, displaying characteristics like overhiring, wasteful capital allocation and lack of discipline. An example of over-hiring is epitomized in young individuals working at large tech firms, showcasing "a day in the life" TikTok videos that demonstrate minimal productivity throughout the day. If the market rewards a company despite bad behavior, that bad behavior will persist.

Fast forward to the present with higher interest rates that are likely to be “higher than we like for longer than we want.” Consequently, there's a necessity to become financially fit and reduce corporate bloat. Many companies have faced declining stock prices over the past 18 months due to a lack of cost controls.

Large-cap tech companies, despite their positives, have also become complacent. However, it is our belief that these companies are stronger than even they perceived they were.

*Per employee figures are annualized for comparison

This is showcased by cost-cutting campaigns having no negative effects on top-line revenues. In fact, reduced employee headcounts have led to increased sales and greater efficiency. For instance, Meta Platforms has reduced headcount by over 20,000 since Q4 2022. The result: revenues continue to rise while efficiency is improving to all-time levels.

While cost-cutting measures are becoming more common, there's still a long way to go. We believe that corporate bloat is still prevalent, but that executives are now discovering that reducing workforce size doesn't produce the ill effects originally feared. We anticipate continued cost-cutting and efficiency efforts in the near term. However, once the excess is trimmed, real cost-cutting may be necessary.

Fixed income

Fixed income (bond) investing, like stock investing, requires a disciplined approach. However, there are also some differences. While equity investments offer partial ownership of issuing companies without guaranteeing returns, fixed income securities promise fixed cash flows at specific future dates. Assuming a fixed income security is held to maturity and delivers payments as expected, investors already know their return.

Our key tenets include:

• Preserve principal and know what you own

• Walk, don’t run

Focus on income and avoid defaults

• Focus on what works

• Opportunistic allocation

Avoid overcomplicating investment strategies. Much of fixed income investing boils down to investing in attractive securities with a high likelihood of debt repayment.

Conducting in-depth credit analysis enables us to prioritize income-generating and interest-bearing bonds, emphasizing consistent payments of both income and principal. Understanding what we own helps us make more informed decisions and avoid unnecessary risks.

Walk, don’t run

Patience is a virtue in investing. Similar to equity investing, fixed income investors can become shortsighted and focus on short-term fluctuations. Forecasts predicting the near future in a world of random events are akin to a coin toss. In no case are they accurate enough to consistently add value in a manner that outperforms a stable investment strategy. Successful investing looks beyond daily noise, maintaining focus on long-term goals.

With that in mind, avoiding unnecessary turnover is a focus. High amounts of turnover and excessive trading often lead to higher transaction costs and increased friction that detracts from return performance. When making allocation changes, a gradual approach is adopted. Walk, don't run – give decisions time to play out and make adjustments only as needed, preferably with cash flow and maturity roll rather than outright buy/sell transactions.

Focus on what works and repeat

The world of investing can be overwhelming with a plethora of options and strategies. However, successful investing often follows a simple mantra: focus on what works and repeat. Identifying effective investment approaches and sticking to them leads to long-term success, allowing incremental gains to accumulate over time.

Opportunistic allocation

Take advantage of opportunities in the market by making opportunistic allocations. This may involve exploring investments in municipal bonds, corporate bonds, mortgage-backed securities, asset-backed securities and non-index assets. Understanding yield curve placement allows for strategic positioning to capture incremental yield while managing risk through diversification.

Conclusion

At Bell, we prioritize simplicity over complexity. Successful investing doesn't involve chasing trends or reacting impulsively to market noise. By adhering to our investing philosophy and process, we believe we can navigate financial market complexities, constructing robust portfolios capable of withstanding the test of time. Our conclusion remains clear: An investment strategy with the least number of unknown variables has the highest probability of success.

VP/Portfolio Manager

Fargo jbancroft@bell.bank

Jordan Bancroft, CFA, CAIA

End notes

¹Mr. Market is an imaginary investor devised by Benjamin Graham in his book, The Intelligent Investor. Mr. Market is an investor prone to erratic swings of pessimism and optimism. These swings in behavior lead to buying when the price is high and selling when the price is low.

Disclosures

This communication reflects the personal opinions, viewpoints and analyses of the Bell Institutional Investment Management (BIIM) employees providing such comments and should not be regarded as a description of advisory services provided by BIIM or performance returns of any BIIM client.

The views reflected are subject to change at any time without notice. Nothing in this communication constitutes investment advice, performance data or any recommendation that any particular security, portfolio of securities, transaction or investment strategy is suitable for any specific person.

Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. BIIM manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.

Investing and wealth management products are: Not FDIC Insured | No Bank Guarantee | May Lose Value | Not A Deposit | Not Insured by Any Federal Government Agency