Spuds Powell on Fear, Confirmation Bias and the Modern Media

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In football, it's often said that the best offense is a good defense. Spuds Powell, who played football for Cornell University, subscribes to that philosophy too, as an advisor. Spuds is managing director at Kayne Anderson Rudnick, which manages $65 billion in client assets. In 2008, when the S&P 500 fell 38%, Spuds' typical portfolio was down just 20%. Beginning as an advisor at Kayne in 2004, Spuds has been named Barron's top-ranked RIA for 4 of the past 5 years. This is Greg Bartolis, editor-in-chief of Barron's Wealth and Asset Management Group. Join me now for a discussion with Spuds, who will discuss the appeal of alternative investments as well as the importance of investor psychology. Spuds, welcome.

Thank you, Greg. I'm happy to participate in the program.

Thank you so much for joining us. So let's first start on a high level for those who might not be familiar with your firm. Uh, what, what kinds of clients do you typically serve?

Most of my clients are either approaching retirement or are in retirement and at a stage of life where they've worked very hard to accumulate a significant amount of wealth and are much more focused on protecting what they have during difficult markets so that they can enjoy everything else that life has to offer. My average client has about $12 million invested with us and the average age of the clients I work with is 64.

And your firm is based in Los Angeles?

We're based in Los Angeles. We were founded in 1984 as a family office on behalf of a self-made multi-billionaire by the name of John Anderson who also happens to be the benefactor for UCLA's business school, the Anderson School of Management.

You often preach the virtues and act accordingly of defensive investing and planning. What's your take on the market right now? I mean, despite the recent sell-off, we're still, what, 3%, 4%, 5% from an all-time high. Interest rates are rising but still historically low. Give me your overall take on the market and how you're positioning clients.

Generally speaking, we continue to feel pretty optimistic about the outlook for both the economy and the equity markets. As is always the case, there are risks out there and there are opportunities out there. The risks that we lose sleep over these days would be the risk of high inflation lasting longer than anticipated, the risk that taxes are increased by more than the market anticipates, the risk that COVID could take another turn for the worst and shut down parts of the economy. You know, there will undoubtedly be some drama leading up to our good friends in Washington agreeing to increase the debt ceiling limit. But generally speaking, we think the probability of at least most of those risks unfolding is relatively low. You know, we're in the camp that predicts that high inflation is temporary. And once the global supply chains catch up with the increase in demand, that inflation will stabilize and start to pull backwards. We fully expect taxes to rise, but given the relative balance in Congress between the two political parties and the fact that there are a couple of moderate Democrats, we expect the infrastructure bill to be less costly than anticipated and As a result, we think the tax reform will be less extreme than some fear. And our expectation is that thanks to the success of the vaccinations and their distribution, the risk of COVID taking a meaningful turn for the, for the worse is relatively low. And I guess more importantly, on the positive side, we feel like the trend of what I call revenge spending will continue. You know, after a year to a year and a half of everyone being cooped up at home thanks to the virus, people are now out traveling again and they're having weddings again and they're going to sporting events and music events again, and Broadway has reopened. And, and then because of that, there's been this massive increase in consumer spending, and we think that trend is going to continue for the foreseeable future. And as more people spend more money, it means that more businesses can sell more goods and services, and ultimately that translates into healthy corporate profits, which bodes well for the stock market. The other thing we feel encouraged about is there is a massive amount of cash sitting on the sidelines. You know, throughout last year, given all the uncertainty around COVID and how long it would take to eradicate the virus, business executives sat on cash, private equity managers sat on cash, and individuals built up cash balances. Today, given the success of the vaccinations and the high likelihood that there is a light at the end of the COVID tunnel, we're finding now that businesses are starting to deploy their cash. They're using it to hire people and invest in capital expenditures. Private equity managers are putting their cash to work and using it to acquire businesses. And individuals who are realizing that their cash generates a 0% rate of return are highly motivated to put that cash to work somewhere. We think that too bodes well for both the economy and the stock market.

Earlier, you mentioned a number of concerns. Are these all, in your estimation, factored in by the market, or do you think some of this is not in the market?

Some of it is priced in the market. It wouldn't be any surprise to the market if and when we learn that taxes are going up. You know, it wouldn't be a huge surprise to the market if we learned that inflation remains higher for longer than anticipated. It wouldn't be shocking to the market if we got more sort of scary news coming out of China. Wouldn't be shocking to the market if the negotiations around the infrastructure bill got more heated or drawn out longer. So a lot of that is priced in the market. But as I said, the risk is that the outcome of some of those issues is worse than the market anticipates.

Right. I mean, the inflation being higher for longer, the whole transitory discussion seems to be increasingly seen as, well, not transitory unless you define it with a broader time horizon. I mean, you see that a little bit manifested into markets now. Some of the traditional inflation hedges, whether real or not, precious metals have been rising more, TIPS have been doing well, real estate. So do you have a best/worst case scenario or just Maybe by mid-year things lifting or?

Our expectation— Well, first, we acknowledge, as I think the Fed has, that the transitory nature of higher inflation has lasted longer than anticipated and probably will last longer than expected going forward. Our best guess though is that the backlog in the global supply chains will have sort of caught up with the, the, the consumer demand that exists now within a year, um, maybe as soon as 6 months. Between now and then, we will probably see a little bit of a bumpy ride when it comes to inflation and the impact that that might have on, on, uh, you know, businesses' input costs. Um, you know, there's always the risk that with longer-term higher inflation interest rates trend upward in a meaningful way, which could be very painful, particularly in light of the amount of debt that we have in Washington. But our prediction now is that within a year, the backlog in supply will have been addressed and resolved. And once there's more balance between supply and demand, we expect that, you know, thanks largely to technology, and the reality that we live in more of a globalized economy than ever before, inflation will stabilize and start to pull back. The reality is that we can now buy goods that are manufactured anywhere in the world. And thanks to that global competition for our spending dollars, we feel like there's sort of a lid on inflation. There are technologies like Amazon as an example Travelocity would be another good example where you can go to a website and instantly compare the prices of, in the case of something like Travelocity, airline tickets, hotel rooms, rental cars. And again, because of that broader competition, we expect inflation to remain in line as we look out into the foreseeable future.

Tell me about alternatives and your firm. I know historically you've often allocated more, certainly than many other wealth managers. What are you doing with alts today?

We have always been big proponents of allocating a portion of at least most of our clients' assets to a variety of different alternative investments. One of the very few things I can guarantee people is there will be times where the stock market performs poorly. There will be times where the bond market performs poorly. And so our philosophy has always been that in order to generate the best risk-adjusted performance on behalf of our clients, it makes sense to allocate a portion of their wealth to strategies that can perform well when either the stock market or the bond market misbehaves. So generally speaking, we're big proponents of the enhanced diversification that alternative investments bring to the table.

I read an interview from 2017 and you said it that at the time an average of about 10% of client portfolios were allocated to alts and sometimes even as high as 25%. Is that about the same for today or are the numbers perhaps a little bit different?

The numbers are similar today. However, the types of alternative investments we are allocating our clients' capital towards differ now than from back then. To us, we sort of categorize alternative investments into two buckets, those that are really geared primarily towards improving performance, and then those that are really geared primarily towards reducing risk. And today we're focusing a higher percentage of our clients' alternative investment exposure towards alternative investments that are risk reducers and also generating attractive income.

And what would be some examples of that?

Well, let's see, we have a couple of different strategies that are providing— they're credit strategies that are providing first lien loans. You know, one instance, these are first trustee loans to home builders. If you think about a homebuilder who wants to buy an old dilapidated property, knock it down, build a big brand new home, and sell it. Before the great financial crisis of 2008, these homebuilders could borrow money from banks. But with all the regulations now imposed on banks and the changes that have taken place in the traditional banking sector, Banks really are either not in that business or are unable to kind of turn around these loans as quickly as home builders would like. So we partner with a firm that has sort of looked at that as an opportunity and is now in the business of providing these first-trustee loans. It's a strategy that's yielding about 7% per year with a risk profile that's a lot closer to the traditional bond market than, say, the traditional equity markets. And then there's another strategy that we offer that's providing privately structured loans to small and medium-sized businesses. In many cases, these are privately held businesses. And it's sort of got a similar mandate where it's yielding about 7% to 7.5% per year. The loans are all short-term in nature, which helps keep risk to a minimum. As I mentioned, they're first lien loans, which helps keep risk to a minimum. It's a way for clients to generate really healthy income at a time when interest rates are at historically low levels and do so with a strategy that has a risk profile that's quite a bit lower than the broader stock market.

Let's talk about equities. Where do you see opportunity and what kind of stocks do you look for?

As you implied in your introduction, Greg, Our first priority has always been and always will be playing great defense during lousy markets. Our clients hire us first and foremost to protect their capital during recessions and bear markets, and thankfully, we're great at it. When it comes to the equity markets, in order to achieve that goal of playing great defense, we've always focused on a bottoms-up approach towards equity selection. We, we manage concentrated portfolios typically of about 25 to 35 individual stocks, and we limit our clients' investments to companies that tend to have either no debt or very little debt, companies that tend to be very profitable and have proven to consistently grow their earnings through good times and bad. We focus on businesses that are generating a significant amount of cash flow. Uh, we put a lot of time and effort and energy into identifying what the competitive market advantages of each one of those companies are, what has enabled them to become sort of the clear dominant players in their industry, and most importantly, whether or not they'll be able to maintain those clearly defined competitive market advantages.

And how does pricing power play a role given that with inflation and also maybe balance sheets, to what extent, if any, does that play a role?

Pricing power plays a big role. We looked at the different ways that businesses are able to fend off their competition. Businesses that have strong pricing power are in a much stronger position than those that don't. Other factors that we will consider would be things like a business's brand. Companies that have very strong brands are obviously able to to have what Warren Buffett often describes as a moat around their business that prevents their competition from picking up market share.

I wanted to pivot now. I listened to a podcast you did that had a really interesting part where you clearly expressed a real fascination with behavioral finance and I think in your own words, the impact of modern media on investor psychology. Um, it's a little bit open-ended question, but just tell me what you— what, you know, captures your imagination on this topic.

I'm, I'm totally fascinated, intrigued by the psychology behind investing and what motivates investment decision-making. When it comes to the media, in my opinion, the media has changed. You know, unlike decades ago when we all had to rely upon a relatively shortlists of news sources. Today, thanks to the internet, there are hundreds of media outlets, if not thousands, that are all fighting for our attention. And I think the media has learned that, that fear sells. And so there are many examples throughout the course of every day of, of, uh, you know, news being delivered in such a way that it's feeding on our fears and our insecurities and our anxieties. And, um, I find that that unfortunately tends to infect or affect investors' judgment and decision-making. Um, you know, when you turn on the nightly news, you hear typically about a lot of scary stories and bad things that are happening and scenarios that may unfold that could create lots of problems and challenges. You don't hear nearly as much about good things that are happening and positive scenarios that might unfold. And I think the impact from an investment point of view is investors and people in general tend to respond more strongly to scary news than they do to positive news. And I've always felt that the greatest mistake investors can make is the mistake of letting their emotions in this case fear, influence their judgment. And so I've always advised my clients to take what they hear in the news with a healthy grain of salt.

Yeah, it's interesting. I mean, certainly the news industry in broad strokes, it thrives on conflict and tension. It's the old story, if you build a building, you know, building comes down, that's news. Or another older saying, if it bleeds, it leads. And that's a little more in the tabloid realm, But there's certainly truth to that, and certainly fear is an easy and quick way to get people's attention and to viscerally engage them. However, there is one interesting exception to this, which is the— well, at least amongst cryptocurrency adherents, there is actually the absence of fear. There's almost an invincibility and inevitability about it. And it's a very bifurcated worldview. You have the true believers and then a lot of people You see Jamie Dimon, etc., who are the naysayers. So that's kind of an interesting sub-universe within the correct larger universe you just described, I think, of the media ecosystem and the financial markets.

I would agree with that.

Yeah, I would agree with that. And also, it's interesting to your point, let's say in decades past, the gatekeepers were a select few, and now with the internet, It's kind of like everyone could find their own tribe or see the version of reality that best conforms or reflects their own worldview, be it with investing or any other aspect of life. So it's the whole echo chamber aspect as well. And then things increasingly seem up for debate, and I guess maybe that more broadly reflects society's increasing reluctance to agree on many things which might in the past have been reflexively accepted as truth or something resembling it.

I agree with that. And I think getting back to the conversation about behavioral finance, one of the things that I think you've alluded to is how much easier it is now than ever before for investors to fall into the trap of confirmation bias, you know, where they, they limit the information they gather, you know, maybe the news outlets they, they, they listen to, to those that are, are confirming their own sort of pre-existing biases, as opposed to, you know, having an open mind and, and, and being on the receiving end of unbiased and objective news and information.

Does this make it harder as an advisor, um, given that investors are more exposed to, you know, emotional voices saying do this, do that? I mean, do you get more calls, let's say, from clients where you kind of have to talk them off the ledge, if you will, uh, as opposed to years past when there was less information bombarding them from every direction?

Absolutely, absolutely. And I think it, you know, the, the challenges that investors face, and therefore the challenges that I face as I strive to be the voice of reason for investors, is twofold. First, because of the competition within the media and the media's commitment to doing whatever it can to try to attract attention. And as we've discussed, in many cases, fear sells. Combined with the advancement of modern-day technology and the reality that everyone races around with a smartphone in our pocket, and as a result, we all have access to news 24 hours a day, um, it just sort of focuses people on short-term information and the latest scary headline. You know, 20, 30 years ago, if you saw on sort of the ticker tape of a news channel, something that said breaking news, it was legitimately breaking news. You know, something very significant happened somewhere in the world. Today you see reference to breaking news all day, every day. And so I think it's the combination of the influence that the media has on our, um, sort of fears and anxieties, combined with the fact that we all have access to the news all day every day creates lots of challenges for me as a wealth advisor.

What's one of the biggest mistakes that you see investors do when it comes to, I guess, letting their emotions get in the way of doing what they should do?

Yeah, the biggest mistake, and it's such an obvious mistake that, you know, that people should be well aware of if they're going to invest in risky asset classes, is the mistake of panicking and, and letting that fear influence their investment decision-making. And, and I am reminded of how common it is to be inclined to make that mistake on a— certainly on a weekly, if not a daily basis. And I find it very amazing because when I look across my client base, you know, they're— everyone is very financially successful The vast majority of my clients are very well educated. They're very sophisticated people. These are people who have lived through several economic cycles. These are people who have lived through, you know, several bear markets. In many cases, these are people who have built and sold successful businesses. You know, you think that these would be the last people in the world who would fall into the trap of, of letting their fear influence their investment judgment. And yet, I see examples of people doing just that all the time. And the common line I often hear from some of these same people is, well, this time is different. I can't tell you how many times I've heard that. And my response to that is always, well, of course this time is different. Every economic downturn is different. Every bear market is different. Every Every trigger for sort of noise in the stock market is different, and that's okay. But at the end of the day, the stock market has proven for a long, long time to be extremely resilient. Every single time the stock market has ever sold off, it's always recovered and gone on to set new record highs. Um, you know, reality typically is not nearly as dire or as scary as the media would imply. Short-term performance, whether it's unusually good or unusually poor, really shouldn't matter. At the end of the day, if you're going to invest in the equity markets, you've got to embrace the reality that they will be volatile. But again, the good days over time tend to far outweigh the bad. The last thing in the world you want to do is panic after a temporary sell-off in equities sell those stocks, lock in those losses, and inevitably miss out on the ensuing rebound.

Yeah, you know what, what you just said reminds me of a quote by Jack Bogle of Vanguard, formerly Vanguard, who evoked the famous saying, you know, don't just stand there, do something. And he turned it on its head, saying when it comes to investing, if there's a market meltdown, You know, don't do something, just stand there. Yeah, so yeah, it's very, very apt.

I've often used an analogy with clients that I find to be helpful. If investors in the stock market took the same sort of mental approach towards stocks that they did if they invested in real estate, they'd be much more successful investors. And what I mean by that is For, for, um, if somebody were to buy, uh, an investment property, the expectation I'm sure that they would have would be that over the course of a, of an extended period of time, you know, maybe 10 or 20 years, the value of that property would appreciate quite nicely. And in the meantime, they would benefit from some sort of monthly rental income or cash flow. And because it's real estate, they're unable to track the daily fluctuations and the value of that property. If stock investors took that same approach and they didn't pay attention to the daily fluctuations and the value of that equity, and they focus more on a longer-term investment time horizon, and they focus more on, you know, the dividend income they're able to generate in the meantime, disregarded sort of the noise of the world, then they would end up being much more successful long-term investors.

Yeah, very true. Very true. I think that the more times they compulsively look, the more chances are that they may, you know, lose sight of their ultimate long-term plan. We're almost out of time. Just wanted to ask you one final question, and this relates to something more actionable that listeners can act upon, and this involves alts. So I'm sure many advisors have clients who are— most of their money is wrapped up in stocks and bonds and maybe some REITs or what have you. But for advisors who think it makes a lot more sense for clients to have more exposure to alts, what's an effective way for them often to get buy-in from clients who otherwise might be a little bit reluctant because they're not sure how comfortable they are with them? And granted, all kinds of Alts are all different. There's no monolithic alt, but any general advice you might have on that count?

Yeah, Greg, there are two things that come to mind. First, as I mentioned earlier, I think it's important to remind investors that there will be times where the stock market and the bond market perform poorly and point out to them that to the extent that they can invest a portion of their wealth in other types of investments that can do well when that's happening, is a good thing. The second sort of strategy that I use is to fully acknowledge that there are many examples of alternative investments out there that are not good investments. There are lots and lots of alternative investments that are very expensive. That are illiquid. You know, they have complicated tax reporting. In many cases, they're really not that transparent. You really aren't able to look under the hood and get a good sense for what the underlying investments in that strategy are. And I think if you proactively acknowledge that but point out that despite the fact that there are so many less than optimal alternative investment options available in the marketplace, there are exceptions and there are great opportunities out there to put capital work in alternative investments that have reasonable fees and, and, uh, and that, that are generating really compelling results and, and, and have an investment sort of strategy that will do an effective job of expanding diversification and lowering risk. And, and as I mentioned earlier in our conversation today, generating really attractive income in a world where the traditional bond market is providing less income than just about ever before. But I think it's by acknowledging that there are bad apples in the basket and that our job as wealth advisors is to identify the good apples in the basket that tends to create more open-mindedness about alternative investments.

Sounds like sensible advice. Thank you so much for joining us.

It's my pleasure. I have enjoyed visiting with you, Greg.

Excellent. Thank you so much again. My guest has been Spuds Powell, Managing Director at Kayne Anderson Rudnick. If you like this podcast, please share it far and wide, and to hear others, go to Barrons.com/podcasts.

This podcast was brought to you by Wells Fargo Advisors. Looking for a firm your clients can't outgrow? Wells Fargo Advisors offers financial advisors full balance sheet solutions with wealth planning, investment products, banking, and lending that meet the needs of affluent to ultra-high net worth clients. Build your practice your way and on your schedule with independent and employee model options designed to meet your needs today and tomorrow. Learn more at joinwfadvisors.com.