Valuations at Stanford Endowment

The school’s investment office shared in their latest report that they are investing in fewer fund managers.

SMC [Stanford Management Company] primarily relies on carefully chosen external partners to select individual securities, allowing Stanford to benefit from specialized knowledge in asset classes that reward superior active management. While our partners pursue a range of investment strategies, all share a common belief in fundamental investment that incorporates exhaustive quantitative and qualitative research on specific and analyzable opportunities. This discipline fosters a value-sensitive and contrarian approach, which aligns well with Stanford’s long-term focus. Our partners appreciate the importance of Stanford’s mission, demonstrate a clear fiduciary mindset, and exercise consideration for human and environmental welfare.

Beginning in mid-2015, SMC initiated an effort to consolidate and upgrade its external partner roster to enhance performance relative to benchmark results. Our efforts include building fewer, more substantial positions with partners that demonstrate superior investment judgment, thorough processes, sound ethics, and a strong alignment of interests with the University. A concentrated set of investment partners brings the additional benefit of more frequent communication, leading to more fruitful and trustful partnerships. A better understanding of our partners’ work allows us to invest with conviction and contrarianism.

Stanford University Investment Report 2019, Stanford Management Company

With new private equity funds generating 29.3% in the last four years, it’s working.

Expressed in terms of net asset value, our work to concentrate and upgrade the portfolio has proceeded steadily and had impacted roughly 60% of the Merged Pool as of June 30, 2019. The performance arising from this work has been strong in all asset classes. Active partners have materially outperformed inactive, or liquidating, partners over the last four years. For example, new partners that invest in global public equities have generated an 11.3% net internal rate of return over the last four years, handsomely outperforming similarly timed cash flows invested in the MSCI All-Country World Index. New partners that invest in private equity have generated an astonishing 29.3% net IRR over the last four years, not only far outpacing relevant indices, but also exiting the typical “J-curve” period for illiquid fund investments early and strongly.

In the middle of the report they discuss an often overlooked topic.

Relatively little is said about the underlying valuation of financial assets, yet valuation is usually the most important variable for a disciplined, long-term investor to consider.

No single valuation measure captures all relevant information. In fact, it is often prudent to weigh several metrics, and to think carefully about what they measure. For example, book value may be a good descriptor for an asset-heavy business, like a bank, but can be a poor one for a business with significant intangible assets, like a technology company. Similarly, a high return-on-equity can signal strength and sustainability for a company with low levels of leverage, but may not mean nearly as much for a company laden with debt. Skillful investors consider several valuation metrics when analyzing an asset from the bottom up and apply different weights to each depending upon the nature of the business and their confidence in the accuracy of the measurement.

You pay high prices, expect low returns.

While valuation plays little role in short-term investment outcomes, it is a powerful determinant of outcomes over long periods. The reason is intuitive: when you pay a high price for an asset, you usually expect subsequent value increases to be less than if you had paid a low price. This is as true for financial assets like stocks and bonds as it is for houses.

Said differently, valuations of financial assets tend to be “mean reverting.” That is, they return to long-run average levels from periods of over or undervaluation.

All prices eventually revert to the mean, you just don’t know when.

Valuations can deviate meaningfully from long-term averages and remain elevated or depressed for extended periods of time. Reversion occurs in different speeds at different times for a variety of complex and probably unknowable reasons, and investors that expect it to occur like clockwork can be greatly disappointed. Despite the unpredictability of its timing, however, mean reversion is a powerful feature of long-term investment, and careful investors know a healthy dose of contrarianism helps maintain the desired balance between risk and return in their portfolios over time. As the great economist John Maynard Keynes observed, “The central principle of investment is to go contrary to the general opinion, on the grounds that if everyone agrees about its merit, the investment is inevitably too dear and therefore unattractive.”

That’s why you must have time on your side when investing.

Oak tree at the Dish at Stanford.
Photo by Peter Gonzalez on Unsplash

Post by Marcelino Pantoja