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Portfolio > Portfolio Construction

Passive Investing May Be Nearing ‘Dangerous’ Levels: Portfolio Manager

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It’s never been more important than today to construct a portfolio that does not look like the index, according to Larry Pitkowsky, co-founder of GoodHaven Capital Management.

Pitkowsky co-founded GoodHaven Capital Management, a registered investment advisor providing investment management services to individuals, institutions and other clients, in 2011. He is the co-managing partner and co-portfolio manager of GoodHaven along with Keith Trauner.

Prior to forming GoodHaven, Larry was affiliated with Fairholme Capital Management, and from 1999 through 2008, he held a variety of roles at Fairholme, including analyst and portfolio manager.

Pitkowsky sat down with ThinkAdvisor to discuss GoodHaven’s investment philosophies.

 “If people want an index-like portfolio, there’s lots of very inexpensive ways to have an index-like portfolio,” he said.

But, he added, to get a different result in the market over time, “you need to look different.”

It’s vital to look less like the index (not more) given that passive and index funds don’t consider valuation when buying, according to Pitkowsky.

The flood of money over the past few years to passive has been “dramatic,” as Pitkowsky called it.

Passive funds are taking market share from active managers at an accelerating pace. Active funds experienced significant net outflows in 2016, losing more than $340 billion of assets. Passive funds benefited, gaining more than $500 billion in net inflows. 

The flows into passive investing may be approaching “dangerous” levels, according to Pitkowsky.

“You can never tell when something that seems excessive will change,” he said. “However, without lobbing any complete criticism against passive, we would say it would seem to us that accelerating that move in the last couple years seems potentially dangerous to us.”

Pitkowsky is hesitant about a move into an asset class that is “trading amongst its highest valuation point at any time except for the dot-com bubble.”

“What concerns us — first, as citizens and observers —is that an acceleration into passive over the last couple years … at a time when the market averages are at high levels by any measure,” Pitkowsky explained. “The S&P at 19x earnings, the highest price-to-sales ratio since the dot-com bubble. Highest price-to-EBITDA ratio since the dot-com bubble.”

This is why Pitkowsky recommends that investors who are concerned about risk and downside should be looking for portfolios that are much more attractively priced than the index.

One way Pitkowsky has been able to manage a portfolio that differs from the index is by using fear and negative headlines as places to look for opportunity.

“If you want to earn above average returns over time with less risk, you often have to look for mispriced securities, and to look for mispriced securities you need to look where there is some unpopularity, and then you have to be right,” he said.

In the past, Pitkowsky has benefited from buying in areas with negative headlines and misplaced opportunities, like energy and mining.

“We have a few holdings in the energy area, which were strong contributors to our results in 2016 when we were up 20%,” he told ThinkAdvisor. “That sector has been weak lately and we feel we’re getting another opportunity there.”

Pitkowsky called the energy sector “the worst performing secor year to date” in the market, with many of the stocks trading at the levels they did when oil was $30.

“The most interesting thing about our energy investments is it is in no way predicated on­­ our ability to predict the price of oil or gas, which we don’t think we know how to do,” Pitkowsky said. “It’s about finding a couple of well-managed companies that are low-cost operators with talented people running the company.”

Pitkowsky continues to hunt steals, and carefully choose a small number of significantly undervalued companies — most often, these are strong and enduring businesses run by exceptional owners or managers.

Purchasing bargains minimizes risk, but also forces managers to look into situations where there is fear, misunderstanding or disinterest. Bargains also provide a margin of safety, according to Pitkowsky.

“We need something that we feel is a bargain to protect against the unknown and to have us earn a better rate of return,” he said.

He gave the example of driving over a bridge to explain the need for bargains in a portfolio.

“We’d never want to drive over a bridge that could handle a 30,000-pound vehicle in a vehicle that weighed 29,000 pounds,” he said. “Not enough margin of safety. We feel the same way about investing in securities.”

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