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One More Thought: Recession Risk

In our Annual Letter to investors we highlighted the collapse in the long-end curve as an indication of a maturing economic cycle (chart below):

Long End Curve

Our friends at Variant Perception, recently shared a similar perspective:

A yield curve inversion has predicted every US recession since 1945, with only one false positive, in 1966 (although the false positive preceded a downturn in industrial production and a 25% decline in the DJIA).  If you were a castaway on a desert island and you could only take one economic indicator with you, then you would take the yield curve.  Last year, not one major economy’s yield curve steepened, and the pattern is continuing into this year.

Developed Yield CurvesIt’s worth noting that this is not simply a developed world phenomenon.  Yield curves around the world are signalling a synchronized global slow down. Per Variant Perception:

Almost all major yield curves have flattened over the last 50 weeks.  This is despite many central banks cutting or being in easing mode to try to combat falling inflation.  When longer-term yields are falling relative to shorter-term yields, it is normally a signal that the economy as a whole wants to borrow less, and that the economy is slowing.  Yield curves today are telling us global growth will slow in 2015.  There is only a small recession risk at the moment, but continued flattening of yield curves would be a warning sign that things are due to get worse.

Emerging Yield Curves

In addition to collapsing yield curves, global earnings momentum has slumped in recent months. While the energy sector has been a key source of these downgrades, revisions in US forecasts last month were the worst since the 2009 financial crisis.  As illustrated below, the six month decline in forward earnings estimates is normally associated with a recession.

SG Earnings Momentum

A few last points to ponder compliments of Andrew Lapthorne at Societe Generale:

It is fair to say that the consensus does not expect a US recession any time soon. As such the recent drop in consensus earnings expectations is being dismissed by many as attributable to weak energy prices and the translation effects of a stronger US dollar – two factors that will ultimately lead to cheaper prices in the US and a greater disposable income for consumers worldwide.

That may indeed be the case, but the counter-evidence is certainly mounting up. For one, if global economic acceleration was on the cards, why have 20 central banks cut interest rates already in 2015? Why have the economic surprise indicators fallen away, and why are most other countries also seeing major earnings downgrades – surely they should benefit from higher US dollar translation effects?

Posted in Macro.

Quick Thoughts on Portfolio Strategy

Although many schools in North Carolina were closed multiple days this week due to snow, ice and dangerous driving conditions (never-mind that the roads have been blacktop all week), some of us still managed to brave the weather and get a few things done in Lenoir. Those things included preparing for BMC Fund Investment Committee and Board of Director meetings which wrapped up yesterday.  Below are a few excerpts from those presentations to provide a sense of how we are positioned in the current market:

Expected returns remain very compressed across asset classes today. As a result we continue to hold short-term reserves in cash and equivalents which provide an option on tomorrow’s opportunity set.


Our fixed income allocation today remains below normal as yields have been forced lower due to the zero interest rate policy of major central banks. This chart shows the expected real returns on offer from various fixed income sectors. Note that outside of emerging markets, most bonds are priced to return about nothing for the next ten years. The exception, at least on these numbers, would appear to be EM, but given the elevated macro risks in emerging market economies today, we are not interested in stretching for yield here.

The speed of the rise in emerging market debt since the financial crisis has been extraordinary.  China’s private sector external debt has risen from a mere $140 billion in 2008 to $1.2 trillion today. In aggregate, emerging market private sector external debt levels are as high as they were before the Asian crises in 1997-1998. The odds of the dollar carry trade unwinding as emerging market growth slows are not immaterial.

RA Bond Returns

We are finding value in other segments of the bond market. The high yield market has had a rough few months. Much (not all) of this can be linked to the sell off in oil.

High Yield

If we step back and look at the long term trend in high yield bond spreads we can see that the recent sell-off has created a pretty nice opportunity as these bonds are now priced at a healthy premium to treasuries. While we are nowhere near the levels we say in 2008 – which was a “once in a generation” event – high yield bonds are now trading at levels on par with what we saw in the wake of the tech bubble.

HY Spreads

And while spreads have spiked in recent months, default rates remain low. It’s safe to say that defaults will rise in the quarters ahead, particularly given the stress in the energy sector, but we think there is enough value in the rest of the sector today to warrant greater attention.


Our investment in Third Avenue Credit is well positioned to capitalize on opportunities in stressed and distressed credits. Unlike traditional high yields funds, Third Avenue can invest up and down the capital structure and is not limited to owning an index-like portfolio. The average price of its bonds today is 75 cents and the fund yields over 10% with minimal interest rate risk. The portfolio’s duration is under two years.

Third Avenue

In GMO’s most recent quarterly letter, Ben Inker recommended investors “Ditch the Good, Buy the Bad & the Ugly.” The argument was essentially that all the good news was priced into US stocks, so despite a relatively healthy economy, expected returns at home are well below average. US equities are represented here by the large red circles at the bottom of the chart, priced to provide returns similar to cash with a lot more volatility for the next decade.

Inker’s recommendation was that investing where the valuations are lower has been a far better strategy historically, and, despite all of the worrying features of the economic environment outside of the U.S. today, investing in the various bad and ugly places in the world is going to wind up far more rewarding than the admittedly good-looking U.S. This is illustrated well here.Equity Returns

And while international diversification acted like an anchor on portfolio returns last year, equity market performance YTD has been a much different story.

Russian Twists

Last year was a particularly challenging one for active management. GMO discussed our challenges in a recent white paper. A few excerpts below:

Between 80% and 90% of active U.S. equity managers underperformed their benchmark last year, making it one of the worst years for active management in the recent past. Those particularly prone to hyperbole will use this as a clarion call to further embrace passive management and rid themselves of their active managers. After all, if only 1 in 10 active managers can actually generate alpha, why would investors bother with the time, headache, or cost of active managers? Not so fast …

It is incredibly important to avoid extrapolating short-term results. Just because active management in general has been through a difficult period, it does not necessarily follow that what is past is prologue. In today’s increasingly short-term-oriented investment culture, winning stock pickers are deemed to have exhibited superior foresight and brilliance while the losers have suddenly become idiots and are often shown the door.

Reality is something quite different. In any given year, there can be a substantial amount of luck involved in outperforming a benchmark. Over a longer horizon, we think it is easier to make the determination between skill and luck.

As you look across your roster of equity managers, there will be a myriad of explanations as to the reasons for poor performance. Some of those explanations will be valid and others will sound much more, um, creative. But for active management as a whole, 2014 was a year when forces were aligned in such a way as to make it an especially difficult environment for active managers to outperform. U.S. equities trounced non-U.S. equities, large cap stocks trounced small cap stocks, and equities trounced cash. That was a lot of trouncing going on. And, sure enough, active management was trounced. But you cannot let the results of 2014 dictate the outcome of any debate on the merits of active investing versus passive investing. Extrapolating a short-term trend into the future can be a very difficult way to compound wealth.

There are merits to passive investing. But there are also merits to active investing. Active management allows for the continuous assessment of the state of the market and to make intentional choices about how best to take advantage of opportunities and mitigate risk. Passive management precludes the ability to add value in this way.

If you did appropriate due diligence and the people, philosophy, and process of your investment manager has not changed, the short-term pain you are feeling may simply be due to the ebb and flow of style. Reacting to the short-term pain of underperformance and locking in a loss may feel good but can be very costly. It is unlikely that 2015 will result in the same performance for active managers as 2014. It is certainly possible, but we think it is unlikely.

Active Management

We couldn’t agree with the authors more. “Investors are much better served by focusing on their investment philosophy and process than by responding to short-term results and headlines.”

Posted in Portfolio Strategy.

Bust A Move: Tap Dancing to Work

Success is getting what you want, happiness is wanting what you get. Warren Buffett has said that he won the ovarian lottery the day he was born.  He “tap dances to work every day” because he works with people he loves and loves what he does.  So do we. We have fun each day because we love our work. Having too much fun can give the impression that you aren’t serious. But best we can tell, there is no correlation between appearing to be serious and actually being good at what you do. Because we love our work, our minds are always in gear. Because we are having fun, we are always engaged. As our “Other Loeb” puts it: “When your idea of fun means working to understand how companies prosper and why they are mispriced, being an investor is the best job in the world.”

Google’s Chairman Eric Schmidt warns that if you’re working your butt off without deriving any enjoyment, something’s probably wrong. We’d say something is definitely wrong! Part of the fun is derived from success. But a lot of it comes the old fashioned way – laughing, joking and the occasional prank! Culture is a critical component to long-term success.  Many companies try to manufacture Fun with a capital “F” which is just not quite the same.  This excerpt from How Google Works should demonstrate our point. Enjoy.

Most companies try to manufacture Fun, with a capital F. As in: We are having the annual company picnic/holiday-party/off-site on Friday. There will be Fun music. There will be Fun prizes. There will be a Fun contest of some sort that will embarrass some of your coworkers. There will be Fun face painting/clowns/fortune-tellers. There will be Fun food (but no Fun alcohol). You will go. You will have Fun.
There’s a problem with these Fun events: They aren’t fun. This doesn’t have to be the case. There’s nothing wrong with organized company events, as long as they are done with flair. In fact, it’s not hard to throw a fun company party. The formula is exactly the same as fun weddings: great people (and you did hire great people, didn’t you?) + great music + great food and drink. While the fun factor can be endangered by those guests who are congenitally unfun (Aunt Barbara from Boca Raton, Craig from accounting), there’s nothing a good ’80s cover band and a fine brew can’t fix. Everyone’s fun when they’re dancing to Billy Idol and swigging an Anchor Steam.

Then there are group or company off-sites. These are often justified as “team building” events that will help the group learn how to work together better. You go to the ropes course or chef’s class, take a personality test or solve a group problem, and just like that you will coalesce into a fine-tuned machine. Or not.

Here’s our idea for off-sites: Forget “team building” and have fun. Jonathan’s criteria for his excursions included doing outdoor group activities (weather permitting) in a new place far enough from the office to feel like a real trip, but still doable in a day, and providing an experience that people couldn’t or wouldn’t have on their own. These rules have led Jonathan to take his teams on trips all over Northern California: to Muir Woods, Pinnacles National Park, Año Nuevo to see the famous elephant seals, and the Santa Cruz Beach Boardwalk.

These events don’t cost much—fun can be cheap (Fun, usually not). The price of admission to Larry and Sergey’s roller hockey games in Google’s early days was nothing more than a stick, a pair of skates, and the willingness to be hip-checked by a founder. Sheryl Sandberg ran a book club for her sales team that was so popular in our India office that every single person participated. Eric led the entire Seoul team in dancing “Gangnam Style” with Korean pop star PSY, who had come by the office for a visit. (Eric doesn’t adhere to Satchel Paige’s advice to “dance like nobody’s watching.” When you’re a leader, everyone is watching, so it doesn’t matter that you dance poorly, it matters that you dance.)

Jonathan once made a bet with head of marketing Cindy McCaffrey on whose team would have higher participation in the company’s annual employee feedback survey, Googlegeist. The loser had to wash the winner’s car. When Jonathan lost, Cindy rented a stretch Hummer, caked it in as much mud as possible (to this day we don’t know how), and then gathered her team so they could watch Jonathan wash the behemoth SUV and pelt him with water balloons while he was at it.

Another time, Jonathan got the company basketball court built by bringing in a couple of hoop sets and challenging a few engineering teams to see who could put them together first. Some of these guys didn’t know a dunk from a dongle, but they knew an engineering challenge when they saw it.
A fun culture is a creative, successful one.  Fun comes from everywhere as opposed to Fun – it can not be engineered.  It’s just fun and only happens in the right environment with the right people.  It’s impossible to have too much fun. The more you have, the better the odds you’re doing something right. I’m not much for tap dancing, but I have been known to bust a move if the mood hits me.



Posted in Process, Quotes.

What I’ve learned from Warren Buffett

This year is the 50th anniversary of Warren Buffett taking control of Berkshire Hathaway. “He has provided generations of investors with a great gift. Many, including me, have had our horizons expanded, our assumptions challenged, and our decision-making improved through an understanding of the lessons of Warren Buffett.”  More on what Seth Klarman has learned from Buffett below, compliments of the Financial Times:

  1. Value investing works. Buy bargains.
  2. Quality matters, in businesses and in people. Better-quality businesses are more likely to grow and compound cash flow; low-quality businesses often erode and even superior managers, who are difficult to identify, attract, and retain, may not be enough to save them. Always partner with highly capable managers whose interests are aligned with yours.
  3. There is no need to overly diversify. Invest like you have a single, lifetime “punch card” with only 20 punches, so make each one count. Look broadly for opportunity, which can be found globally and in unexpected industries and structures.
  4. Consistency and patience are crucial. Most investors are their own worst enemies. Endurance enables compounding.
  5. Risk is not the same as volatility; risk results from overpaying or overestimating a company’s prospects. Prices fluctuate more than value; price volatility can drive opportunity. Sacrifice some upside as necessary to protect on the downside.
  6. Unprecedented events occur with some regularity, so be prepared.
  7. You can make some investment mistakes and still thrive.
  8. Holding cash in the absence of opportunity makes sense.
  9. Favour substance over form. It doesn’t matter if an investment is public or private, fractional or full ownership, or in debt, preferred shares, or common equity.
  10. Candour is essential. It’s important to acknowledge mistakes, act decisively, and learn from them. Good writing clarifies your own thinking and that of your fellow shareholders.
  11. To the extent possible, find and retain like-minded shareholders (and for investment managers, investors) to liberate yourself from short-term performance pressures.
  12. Do what you love, and you’ll never work a day in your life.

The true genius of Buffett is his ability to take incredibly complex subjects and knock them down to the basics in a manner so simple you can’t help but wonder what was so complicated in the first place.  Anyone that has sat in a room listening to Charlie and Warren can appreciate this.  In some ways, they are just playing a different game than the rest of us.


Posted in Guru Focus, Process.

Are You Smarter Than a 7th Grader?

My wife’s 7th grade class is currently learning about percentage change so the math teacher at Jacob’s Fork Middle School has the students following stocks to demonstrate rates of return.  She asked me to come in this week and give a presentation to the kids about investing in the stock market. This was probably the most challenging presentation I’ve ever done.  But definitely the most fun!

Our presentation is embedded below. Links to each video are included in the speaker notes (it’s the only way I could figure out how to include both).  And don’t worry.  We clipped the last minute of the John Oliver video during the presentation to exclude Radio Shack’s “message” to America.  Even I have some boundaries!

Are You Smarter Than a 7th Grader (Notes)

Posted in Process.

Saving Accounts for Charlie

A random tip for Sunday evening for those looking to earn more than zero on their savings accounts.  Assuming people still have savings accounts?

Screen Shot 2015-02-08 at 6.59.47 PM

Posted in Portfolio Strategy.


In May 2013 we published our research on Hospira (HSP) concluding with some suggestive commentary around the value the company might represent to a potential suitor:

Conventional wisdom in the investment banking world would suggest that once a high quality operating segment is spun-off from a larger conglomerate, it is only logical that it be reacquired years down the road. Academic research suggests that conventional wisdom may be on to something as spin-offs are five times more likely to find themselves the target of an acquisition. Coincidentally, Hospira recently implemented a “Change in Control” document for CEO Michael Ball and other named executives which is set to expire in 2015. We would note that most of Mr. Ball’s options are struck around $35 per share, so he has plenty of incentive to consider a “change in control.” At the same time, many large global pharmaceutical companies, struggling for growth, are building out generic portfolios to drive future profits as blockbuster drugs come off patent.

We believe Hospira would be a particularly good fit for many of these businesses looking to acquire a large share of an attractive market at a bite size which could be easily swallowed. If Hospira can’t fix their problems themselves, it’s likely that other, bigger fish have noticed that the problems are fixable. In recent years, the average price paid for similar companies has ranged from 11x to 14x EBITDA. Using the midpoint of this valuation and applying it to our estimate of normalized EBITDA, would value the deal at $13.8 billion, or $83 per diluted share – more than 150% above current levels.

This week, Pfizer agreed to acquire Hospira for $15.2 billion, roughly $90 per share. It’s been quite a nice ride for HSP shareholders from the lows below $30 in early 2013. Of course, we hopped off this ride a bit too early as the stock quickly rallied toward our base case estimation of fair value. We often invest in securities where we see substantial optionality above and beyond our conservative estimate of net worth, but we rarely depend on that upside to drive performance. We underwrite each investment to our base case, leaving plenty on the table for positive surprises while focusing most of our attention on what could go wrong to ensure we are comfortable taking the associated downside risk. We are often scaling out of positions as they increase toward our estimate of fair value as expected returns decline from higher prices. From time to time, we may miss out on the occasional home run delivered by a slow-growth slugger with a huge cash hoard, but over time, proceeds reinvested in businesses trading at wider discounts to net worth have offered much more attractive expected returns. In any case, we certainly hope a few of our “less-disciplined” friends held on for the full ride here!

HSP Napkin

Posted in Security Analysis.

Smart Creative

One of my New Year’s resolutions is to read a book per week in 2015.  So far, so good, with the help of Kindle audio and a recent road trip north. I don’t plan on posting each book, but will share a few excerpts readers may enjoy.

How Google Works by Eric Schmidt and Jonathan Rosenberg is full of colorful lessons for entrepreneurs and investors. We don’t own the stock today, but would welcome the opportunity to partner with Google’s “smart creatives” at the right price. Relative to the traditional “knowledge worker” Googlers represent a different type of employee. In the author’s words:

They are not confined to specific tasks. They are not limited in their access to the company’s information and computing power. They are not averse to taking risks, nor are they punished or held back in any way when those risky initiatives fail. They are not hemmed in by role definitions or organizational structures; in fact, they are encouraged to exercise their own ideas. They don’t keep quiet when they disagree with something. They get bored easily and shift jobs a lot. They are multidimensional, usually combining technical depth with business savvy and creative flair. In other words, they are not knowledge workers, at least not in the traditional sense.

They are a new kind of animal, a type we call a “smart creative,” and they are the key to achieving success in the Internet Century. The defining characteristic of today’s successful companies is the ability to continually deliver great products. And the only way to do that is to attract smart creatives and create an environment where they can succeed at scale. And who, exactly, is this smart creative? A smart creative has deep technical knowledge in how to use the tools of her trade, and plenty of hands-on experience. In our industry, that means she is most likely a computer scientist, or at least understands the tenets and structure of the systems behind the magic you see on your screens every day. But in other industries she may be a doctor, designer, scientist, filmmaker, engineer, chef, or mathematician.

  • She is an expert in doing. She doesn’t just design concepts, she builds prototypes.
  • She is analytically smart. She is comfortable with data and can use it to make decisions. She also understands its fallacies and is wary of endless analysis. Let data decide, she believes, but don’t let it take over.
  • She is business smart. She sees a direct line from technical expertise to product excellence to business success, and understands the value of all three.
  • She is competitive smart. Her stock-in-trade starts with innovation, but it also includes a lot of work. She is driven to be great, and that doesn’t happen 9-to-5.
  • She is user smart. No matter the industry, she understands her product from the user or consumer’s perspective better than almost anyone. We call her a “power user,” not just casual but almost obsessive in her interest. She is the automotive designer who spends her weekends fixing up that ’69 GTO, the architect who can’t stop redesigning her house.
  • She is her own focus group, alpha tester, and guinea pig. A smart creative is a fire-hose of new ideas that are genuinely new. Her perspective is different from yours or ours. It’s even occasionally different from her own perspective, for a smart creative can play the perspective chameleon when she needs to.
  • She is curious creative. She is always questioning, never satisfied with the status quo, seeing problems to solve everywhere and thinking that she is just the person to solve them. She can be overbearing.
  • She is risky creative. She is not afraid to fail, because she believes that in failure there is usually something valuable she can salvage. Either that, or she is just so damn confident she knows that even in the event that she does fail, she can pick herself up and get it right the next time around.
  • She is self-directed creative. She doesn’t wait to be told what to do and sometimes ignores direction if she doesn’t agree with it. She takes action based on her own initiative, which is considerable.
  • She is open creative. She freely collaborates, and judges ideas and analyses on their merits and not their provenance. If she were into needlepoint, she would sew a pillow that said, “If I give you a penny, then you’re a penny richer and I’m a penny poorer, but if I give you an idea, then you will have a new idea but I’ll have it too.” Then she would figure out a way to make the pillow fly around the room and shoot lasers.
  • She is thorough creative. She is always on and can recite the details, not because she studies and memorizes, but because she knows them. They are her details.
  • She is communicative creative. She is funny and expresses herself with flair and even charisma, either one-to-one or one-to-many.

Not every smart creative has all of these characteristics, in fact very few of them do. But they all must possess business savvy, technical knowledge, creative energy, and a hands-on approach to getting things done. Those are the fundamentals.

Perhaps the best thing about smart creatives is that they are everywhere. We have worked with plenty of smart creatives who boast computer science degrees from elite universities, but plenty more who don’t. In fact, smart creatives can be found in every city, in every school, in every class and demographic, and in most businesses, nonprofits, and government organizations: the ambitious ones of all ages who are eager (and able) to use the tools of technology to do a lot more. Their common characteristic is that they work hard and are willing to question the status quo and attack things differently.

We aren’t computer scientists. We aren’t building self-driving cars or launching balloons into space to deliver internet to the world. But we do know quite a few smart creatives that work hard to question the status quo right here in Lenoir (in addition to those actually working at the Google Data Center). And we’re always looking for more.


Posted in Security Analysis.

Chart of the Day: Fracking Downgrades

The US economy likely grew at its fastest rate since the start of the expansion in 2009, yet earnings forecasts are now falling at the fastest pace since 2009.  The catalyst: fracking oil prices.

Fracking Downgrades

While all eyes remain on European deflation, don’t be surprised to see US headline inflation post a negative print in the coming quarters. The implications for global yields and asset prices could be significant.

Posted in Macro.

Selling Sex, Seduction & Immigrants

Chrysler and the U.S. auto industry have been on the mend since the financial crisis (see Imported From Detroit).  Europe’s economy, on the other hand, has remained stagnant. As a result, Fiat announced its return to U.S. with the Fiat 500. Although the brand has remained popular in foreign markets like Latin America and Europe, it has been effectively dead in America since Tony’s Departure in the 1980’s. Initial efforts to revive the brand proved challenging. Fiat lacked a broad-based marketing strategy, received mixed reactions and generated little buzz. Until Francois was handed the keys to the brand.

Francois has set the tone and style of Fiat’s U.S. marketing ever since. “We have a small car selling in a niche segment, so we can’t pitch it here the way we pitch a mainstream brand in Europe,” François explained to AdWeek. “We cannot pitch it as a car you need, but as a car you want. It’s not a commodity, not mainstream. It’s a great design. It is cool. The language is youth, fun, trendy.”

Fiat’s return to the US was kicked off in style with Immigrants (above) – a 2012 commercial featuring Fiats driving from Italy to New York. The brand’s origins played into subsequent ads. Francois took it one step further with Italian Invasion (below), marked by ample cleavage and espresso.

In addition to television spots, Fiat has gone digital to reach a younger audience with content that “sometimes does not fit network standards and practices.” Leveraging this Italian flare, Francois created the Seduction series, (my personal favorite for soon to be obvious reasons). Seduction (below) made its debut at the 2011 Los Angeles Auto Show on a shoestring budget and was then posted to the brand’s YouTube site.

Without having ever been aired on television or cable networks, the montage reached 20 million views. Social media is stoking Fiat brands, in conjunction with partnerships with celebrities like Dr. Dre, Ziggy Pop, Zac Brown and Lenny Kravitz.

The commercial first aired on television during the 2012 NFL Championship Game. Seduction cast the Romanian Supermodel, Catrinel Menghia, as the scorching personification of a Fiat 500 Abarth and illustrates what happens the first time an average guy encounters one. The spot ends with the message, “The Fiat 500 Abarth. You’ll never forget the first time you see one.”

For the follow-up, Topless, a scorpion pinches off Menghia’s bikini strap with its pincers as she’s innocently sunbathing on the beach. Selling cars based solely on gas mileage and safety features can fall flat per Francois, “and the last thing you want to do is sell a commodity. We’re selling sex. We’re selling passion. Make people lust after the product.”

It would appear that Francois is getting the job done. The entire 2012 run of the Fiat 500 Abarth sold out despite expended production.  Sex sells.

Posted in Security Analysis.

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