Never Confuse a Good Investment Manager with a Bull Market

One of the most important lessons for investors is this: never confuse a good investment manager with a bull market. It’s easy to attribute success to skill when markets are soaring, but the true test of an investment manager’s capabilities lies in navigating downturns and maintaining performance in turbulent times. This phrase, central to the SMARTCAP investment philosophy, highlights a critical distinction between luck in favorable market conditions and skill in enduring through volatility while identifying and acting on mispriced opportunities.

In this blog, we’ll delve into the essence of what makes a great investment manager, particularly in volatile markets, and why it’s crucial to recognize that success in a bull market does not necessarily translate to enduring expertise.

Understanding Market Cycles: Bulls, Bears, and Everything in Between

Markets are cyclical by nature. The bulls—the extended periods of market growth—and the bears—downturns and corrections—are inevitable phases that investors will face. During bull markets, asset prices rise, confidence surges, and investors may feel as though they can’t miss. The perception of risk diminishes, and even less sophisticated investors can achieve positive returns by simply being part of the market.

However, a bull market can create a false sense of security. Investors and managers alike may believe that their decisions are purely a reflection of skill rather than external market forces. When everything is going up, it’s easy to look smart. But in a bear market, the strategies that have been propping up portfolios come under pressure, and mistakes are magnified. This is when the real value of a skilled investment manager becomes evident.

What We Are Paid For: Recognizing Mispriced Markets and Managing Through the Volatility of Time

 At the heart of successful investing is recognizing mispriced markets and enduring through volatility. These two pillars are the foundation of the SMARTCAP investment philosophy and should be at the forefront of any investor’s mind when evaluating managers.

1. Recognizing Mispriced Markets: Great investment managers possess the ability to identify when assets are mispriced, whether undervalued or overvalued. During periods of market exuberance, such as a bull market, this skill is critical. A good manager doesn’t get swept up in the excitement of rising prices; instead, they evaluate whether the underlying value justifies the market price. In the long term, this discernment ensures that an investment portfolio remains robust, regardless of short-term price movements.
2. Managing Through the Volatility of Time: Investment is a marathon, not a sprint. Volatility is a fact of life, and managing through the volatility of time is what separates the best managers from the rest. Staying invested, not panicking during downturns, and keeping a cool head while making decisions are key traits of successful investors. In contrast, less experienced managers may be tempted to time the market, often exiting during the worst possible moments and re-entering too late.

As Howard Marks of Oaktree Capital often says, "You can’t predict the market, but you can prepare for it." Preparation, in this context, means ensuring that your portfolio is structured to endure through volatility without needing to make drastic changes at the worst times.

 The Pitfalls of Bull Market Thinking

 In a bull market, many managers are lulled into a false sense of security. However, there are numerous pitfalls that come with this type of thinking, and they are often the root causes of major losses during downturns. Let’s explore a few common mistakes:

1. High Leverage: Managers may be tempted to use high leverage to amplify returns when markets are rising. In a bull market, this strategy can seem brilliant, producing outsized gains. However, when the market turns, leverage can quickly become a double-edged sword, amplifying losses just as easily as it amplified gains.
2. Short-Term Debt and Lack of Hedging: Over-reliance on short-term debt can create liquidity problems during a downturn. Managers who fail to hedge their risks, such as by locking in fixed rates on debt or using swaps, may find themselves exposed when market conditions change unexpectedly. The 2008 financial crisis offers many examples of institutions that ignored these risks, resulting in severe losses.
3. Chasing Yield: Bull markets often lead to yield-chasing behavior, where managers seek higher returns by investing in riskier assets. When those assets are overvalued, the downside potential is significant. The temptation to chase the next big return can result in a portfolio filled with ticking time bombs, ready to implode during the next downturn.
4. Ignoring Market Signals: During periods of market exuberance, it’s easy to ignore warning signs. Managers who focus too much on recent success may fail to see shifts in fundamentals, leading to mistimed investments and significant losses when the market corrects.

 Less Losers, The Winners Will Take Care of Themselves

 The key to long-term investment success is not chasing every winner but avoiding the biggest losers. "Less losers, the winners will take care of themselves," is a phrase that encapsulates this philosophy perfectly.

Here’s why:

1. Focus on Downside Protection: Skilled investment managers prioritize downside risk management. This means focusing on avoiding catastrophic losses rather than constantly swinging for home runs. Every portfolio will have winners and losers, but minimizing the impact of the losers is what ensures steady, long-term performance.
2. Locking in Good Deals: Once a manager identifies a strong investment opportunity, they lock in favorable terms. This could mean securing long-term, fixed-rate debt when interest rates are low or buying assets at a discount during periods of market turmoil. Importantly, they don’t try to make an already good deal better by taking on unnecessary risks.
3. Stability to Seize Opportunities: A stable portfolio allows managers to remain focused and capitalize on opportunities when the market presents them. When a downturn hits, those with stable portfolios have the liquidity and flexibility to acquire distressed assets at bargain prices, while those who took on too much risk are left scrambling to survive.

At SMARTCAP, we’ve never underwritten deals with the expectation that they’ll be home runs. Instead, our most successful projects often start as singles or doubles where we can leverage a market need or favorable timing when presented. One such example was our acquisition of 12 acres of land to develop three industrial buildings totaling 230,000-square-feet. We purchased the land for $2.6 million, but as we were constructing the first 100,000 square feet, a tenant with specific requirements approached us. We sold half the land to them for $5.6 million, turning what was initially a $2.6 million cost into a negative land basis.

Not only did this create immediate value, but due to the capital accounting structure, we were able to return the proceeds from the sale back to our investors without triggering taxes. On top of that, because this project was in an Opportunity Zone, we’ll also benefit from a step-up in tax basis when we eventually sell the asset, eliminating capital gains.

The key takeaway here is that you can't plan for these grand slam deals—but by staying focused, managing investments strategically, and keeping a stable portfolio, you create the opportunity for them to happen. Successful investment management isn't about chasing home runs; it’s about not losing. Great managers understand that and stay patient, positioning themselves to take advantage of opportunities when they arise.

Offense vs. Defense: Knowing When to Strike and When to Hold Back

A balanced investment strategy requires knowing when to play offense and when to play defense. Both strategies have their place, and a good manager knows when to switch between them.

1. Offense: In periods of strong market growth early in a broader market cycle, it may be appropriate to take on more risk. This could mean increasing leverage or focusing on higher-return opportunities, knowing that the market has the wind at your back. However, even in offensive mode, it’s critical to maintain a margin of safety to protect against unforeseen shocks. Remember, if you are playing offense, you have less room for error. 
2. Defense: Defensive strategies become crucial when the market is late in its cycle, and risks are higher. This involves reducing leverage, focusing on cash flow, and making conservative investments that prioritize capital preservation. A defensive stance allows managers to endure market downturns without taking significant losses, preserving capital for future opportunities. A stable platform allows a manager to focus on value when the markets turn. 

How to Avoid the Pitfalls: Learning from Mistakes

The pitfalls of investing are numerous, but they are also predictable. By regularly reviewing past mistakes and identifying common risks, investment managers can avoid repeating errors.

1. Stay Humble: Success in a bull market does not make you infallible. Just because you were successful doesn’t mean you were right. It’s critical to assess your successes with the same scrutiny as your failures and make adjustments accordingly.
2. Focus on Fundamentals: Straying from fundamental analysis is often the root cause of mistakes. When you understand the intrinsic value of an asset and make decisions based on sound analysis, you’re less likely to get caught up in market hype.
3. Don’t Get Greedy: A key characteristic of successful managers is knowing when to walk away from a deal, even if it looks tempting. If you have a good deal, lock it in. Don’t risk losing it by trying to squeeze out an extra percentage point of return.

Adding Value/Alpha: The Long-Term Approach

 In conclusion, adding value in investing doesn’t come from chasing short-term gains or relying on market exuberance. It comes from making disciplined, strategic decisions that prioritize long-term success over immediate gratification. By seeing value when others don’t, investing in downturns, and being patient through market cycles, investment managers can generate alpha that lasts.

So, the next time you hear someone boasting about their success in a rising market, remember: never confuse a good investment manager with a bull market. True skill lies in recognizing value, managing risks, and staying disciplined in the face of volatility—bull market or not.