I’ve been reading investors letters by Steven Bregman for years (Horizon Kinetics). I admire his original thinking as he highlights many effects of the long bull market in passive funds or indexation.

Although it is hard to think about where we are in the indexation bull market, I think it is very interesting to hear Mr. Bregman talk about what indexation means, and will mean, for stock-picking.

For those that are not familiar to the Horizon Kinetics letters, I encourage you to take a look at some of the idiosyncratic stock picks they did.

For that we need to get into the plumbing of indexation.

Key takeaways

  • float adjusted market cap: index ETF’s changed the simple market cap weighted rule when they became more popular. For example, benchmark owner S&P changed to float-adjusted weighting, which weighs every stock by the valuation of the float, or the piece of the business that is held by the general public
    • Implications
      • Insiders selling create mechanical (=motivated) buying pressure from index funds, while studies have shown that companies with less insider ownership underperform (I believe the sweet spot to be around 50% insider ownership in a regression)
      • Insiders buying or companies buying their own shares fast such as the uber cannibals make index funds motivated sellers, while these companies outperform
        • TC Comment: if we assume that the fundamental performance of these outperformance stays identical vis-à-vis a scenario where no index funds exist to create selling pressure, this means that, ceteris paribus, the insider and uber cannibals anomaly is expected to become bigger over time by virtue of a lower entry price
  • Automatic bid: as long as capital flows into index funds, stocks that are currently most weighted in passive funds (such as mega caps and FANGs) are expected to get more automatic bids. If not, they are subject to the marginal buyers (e.g. active investors supposedly not interested in FANG stocks at the current price levels)
    • Bregman compares anticipating the tech bubble versus the index bubble with a fishing boat observing incoming waves from a storm versus a fishing boat getting lifted by the overall higher water level from a tsunami, not very visible until it hits the shores
    • Passive indexation is not equally pervasive in the stock market. This imbalance exists not only because of the market-cap rule, but also because there are sector and country specific ETFs offerings that create differences depending on ETF buyers’ current preferences with respect to total stock supply
      • Geography
        • Bregman cites Norway as an under-indexed country.
      • Sector:
        • Bregman cites the shipping sector as an example of an under-indexed sector
      • TC Comment: while the reasons are not discussed (for shipping this could be because it is in a down cycle and unpopular right at the time that most money is flowing into indexation), I took this phenomenon as an input in my checklist item of “Why the mispricing might exist” before buying Wilh. Wilhelmsen Holding (WWIB) in Aug. ‘16 a Norwegian shipping company
      • Bregman mentions Siem Industries in Norway. Having looked into the company a bit we found there are only a couple of hundred shareholders for this >1B USD market cap company. Illiquidity is clearly a barrier for indexing.

Illiquidity in stocks, acting as a deterrent of index funds, and institutions in general, is known as a big driver of returns. I will do a separate post on the topic.