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Don’t Ask The Barber If You Need A Haircut

The bulls are quick to cite a dozen or so reasons why the ratio of Market Capitalization to GDP is not an effective valuation indicator – the economy has evolved over time; an increasing share of earnings are sourced from abroad; the components of the S&P have changed dramatically over the years; blah, blah, blah.

At the end of the day, the unfortunate truth is that the folks who take issue with this particular valuation yardstick are the same folks who benefit from telling investors to expect continued double-digit returns from stocks. Don’t ask a barber if you need a haircut.

We are all too quick to trust the experts. We are all influenced by incentives, so much so that if you hope for something enough, you can start to believe it. But sticking your head in the sand won’t change the fact that the chart below, compliments of Hussman Funds, is one of the best valuation indicators in terms of predictive ability.

Posted in Valuation.


Joel Greenblatt on Value Investing

I recently re-read Greenblatt’s Little Book That Beats The Market to prepare for a presentation to Jacob’s Fork Middle School on investing (see slides here).  This book is just as valuable for educated investors as it is for sixth graders.

For more serious investors, I’d highly recommend a weekend at the library studying Greenblatt’s Special Situations class notes, available here. If that doesn’t tickle your fancy, here are A Dozen Things I’ve Learned from Joel Greenblatt about Value Investing, compliments of 25iq:

  1. One of the greatest stock market writers and thinkers, Benjamin Graham, put it this way. Imagine that you are partners in the ownership of a business with a crazy guy named Mr. Market. Mr. Market is subject to wild mood swings. Each day he offers to buy your share of the business or sell you his share of the business at a particular price. Mr. Market always leaves the decision completely to you, and every day you have three choices. You can sell your shares to Mr. Market at his stated price, you can buy Mr. Market’s shares at that same price, or you can do nothing. Sometimes Mr. Market is in such a good mood that he names a price that is much higher than the true worth of the business. On those days, it would probably make sense for you to sell Mr. Market your share of the business. On other days, he is in such a poor mood that he names a very low price for the business. On those days, you might want to take advantage of Mr. Market’s crazy offer to sell you shares at such a low price and to buy Mr. Market’s share of the business. If the price named by Mr. Market is neither very high nor extraordinarily low relative to the value of the business, you might very logically choose to do nothing.
  2. Buying good businesses at bargain prices is the secret to making lots of money. Look down, not up, when making your initial investment decision. If you don’t lose money, most of the remaining alternatives are good ones.
  3. Choosing individual stocks without any idea of what you’re looking for is like running through a dynamite factory with a burning match. You may live, but you’re still an idiot. Most people don’t (and shouldn’t) invest by buying stocks and holding them for only one month. Besides the huge amount of time, transaction costs, and tax expenses involved, this is essentially a trading strategy, not really a practical long-term investment strategy.
  4. Periods of underperformance make value investing difficult – and, for some professionals, impractical to implement.
  5. Companies that achieve a high return on capital are likely to have a special advantage of some kind. That special advantage keeps competitors from destroying the ability to earn above-average profits.
  6. You have to know what you know – Your Circle of Competence. The idea behind the Circle of Competence is so simple it is embarrassing to say it out loud: when you do not know what you are doing, it is riskier than when you do know what you are doing.
  7. Remember, it’s the quality of your ideas not the quantity that will result in the big money.
  8. There is no sense diluting your best ideas or favorite situations by continuing to work your way down a list of attractive opportunities.
  9. Even finding one good opportunity a month is far more than you should need or want. Warren Buffett has a few thoughts on this point: “We don’t get paid for activity, just for being right. As to how long we’ll wait, we’ll wait indefinitely.”
  10. If you are going to be a very concentrated investor, you should not use leverage. You can’t leverage because you need to live through the downturns and that is incredibly important. Charlie Munger: “I’ve seen more people fail because of liquor and leverage – leverage being borrowed money.”
  11. The odds of anyone calling you on the phone with good investment advice are about the same as winning the Lotto without buying a ticket. To be a successful value investor of any kind requires actual work. And since work is necessarily involved, many people will try to avoid it, since that is human nature. Relying on people who call you on the phone with investment advice to avoid work, doesn’t, ahem, work.
  12. Almost everyone should have a significant portion of their assets in stocks. But here it comes – few people should put ALL their money in stocks. Whether you choose to place 90% of your assets or 40% of your assets in stocks should be based largely on how much pain you can take on the downside.

The full article (and several others on the site) are worth a read and available here. His Lessons from Howard Marks are excellent as well.

lemonade

Posted in Letters & Links, Valuation.


Quote of the Day: The Prince

“I have not found among my possessions anything which I hold more dear than, or value so much as, the knowledge of the actions of great men, acquired by long experience in contemporary affairs, and a continued study of antiquity.”

“A wise man ought always to follow the paths beaten by great men. Let him act like the clever archers who, designing to hit the mark which yet appears too far distant, and knowing the limits to which the strength of their bow attains, take aim much higher than the mark, not to reach by their strength or arrow to so great a height, but to be able with the aid of so high an aim to hit the mark they wish to reach.”

– Niccolò Machiavelli

The Prince

 

Posted in Quotes.


Sam’s Rules for Building a Business

This year’s book challenge continues with Sam Walton: Made In America. Here are Sam’s Rules for Building a Business:

RULE 1: COMMIT to your business. Believe in it more than anybody else. I think I overcame every single one of my personal shortcomings by the sheer passion I brought to my work. I don’t know if you’re born with this kind of passion, or if you can learn it. But I do know you need it. If you love your work, you’ll be out there every day trying to do it the best you possibly can, and pretty soon everybody around will catch the passion from you—like a fever.

RULE 2: SHARE your profits with all your associates and treat them as partners. In turn, they will treat you as a partner, and together you will all perform beyond your wildest expectations. Remain a corporation and retain control if you like, but behave as a servant leader in a partnership. Encourage your associates to hold a stake in the company. Offer discounted stock and grant them stock for their retirement. It’s the single best thing we ever did.

RULE 3: MOTIVATE your partners. Money and ownership alone aren’t enough. Constantly, day by day, think of new and more interesting ways to motivate and challenge your partners. Set high goals, encourage competition, and then keep score. Make bets with outrageous payoffs. If things get stale, cross-pollinate; have managers switch jobs with one another to stay challenged. Keep everybody guessing as to what your next trick is going to be. Don’t become too predictable.

RULE 4: COMMUNICATE everything you possibly can to your partners. The more they know, the more they’ll understand. The more they understand, the more they’ll care. Once they care, there’s no stopping them. If you don’t trust your associates to know what’s going on, they’ll know you don’t really consider them partners. Information is power, and the gain you get from empowering your associates more than offsets the risk of informing your competitors.

RULE 5: APPRECIATE everything your associates do for the business. A paycheck and a stock option will buy one kind of loyalty. But all of us like to be told how much somebody appreciates what we do for them. We like to hear it often, and especially when we have done something we’re really proud of. Nothing else can quite substitute for a few well-chosen, well-timed, sincere words of praise. They’re absolutely free—and worth a fortune.

RULE 6: CELEBRATE your successes. Find some humor in your failures. Don’t take yourself so seriously. Loosen up, and everybody around you will loosen up. Have fun. Show enthusiasm—always. When all else fails, put on a costume and sing a silly song. Then make everybody else sing with you. Don’t do a hula on Wall Street. It’s been done. Think up your own stunt. All of this is more important, and more fun, than you think, and it really fools the competition. “Why should we take those cornballs at Wal-Mart seriously?”

RULE 7: LISTEN to everyone in your company. And figure out ways to get them talking. The folks on the front lines—the ones who actually talk to the customer—are the only ones who really know what’s going on out there. You’d better find out what they know. This really is what total quality is all about. To push responsibility down in your organization, and to force good ideas to bubble up within it, you must listen to what your associates are trying to tell you.

RULE 8: EXCEED your customers’ expectations. If you do, they’ll come back over and over. Give them what they want—and a little more. Let them know you appreciate them. Make good on all your mistakes, and don’t make excuses—apologize. Stand behind everything you do. The two most important words I ever wrote were on that first Wal-Mart sign: “Satisfaction Guaranteed.” They’re still up there, and they have made all the difference.

RULE 9: CONTROL your expenses better than your competition. This is where you can always find the competitive advantage. For twenty-five years running—long before Wal-Mart was known as the nation’s largest retailer—we ranked number one in our industry for the lowest ratio of expenses to sales. You can make a lot of different mistakes and still recover if you run an efficient operation. Or you can be brilliant and still go out of business if you’re too inefficient.

RULE 10: SWIM upstream. Go the other way. Ignore the conventional wisdom. If everybody else is doing it one way, there’s a good chance you can find your niche by going in exactly the opposite direction. But be prepared for a lot of folks to wave you down and tell you you’re headed the wrong way. I guess in all my years, what I heard more often than anything was: a town of less than 50,000 population cannot support a discount store for very long.

About a week or so after reading Sam Walton’s biography, SeaWorld named Joel Manby new CEO.  We don’t know him personally but after stalking researching him all night after the announcement, we are confident he is the right man for the job. The market would appear to agree as the announcement drove shares of SEAS 5% higher the following day.

Over the past decade, Manby has served as President and CEO of Herschend Enterprises, the largest privately-owned theme park operator in the states.  During his tenure, he has expanded the company from 6 to 26 properties while more than doubling EBITDA and cash flow. After spending an evening reading Manby’s own book on leadership, Joel Manby’s 7 Principles appear to have more than a few things in common with “Sam’s Rules” outlined above.

Manby, who was featured in one of the first episodes of Undercover Boss,  has stated that a number of Herschend’s programs have roots at Walmart. If those programs have even a fraction of the impact at SeaWorld, investors should have a nice ride in front of them. Lucca and I will report back on the potential at Seaworld after a visit to Orlando next weekend.  The Pavese household has been suffering somewhat of a Nemo obsession in recent weeks so we are hoping we have some luck Finding Dory.

darla1

Posted in Letters & Links, Security Analysis.


The Longest Post War Bull Market

A few more thoughts on recognizing where we are in the cycle, illustrated by SG:

The US has now “enjoyed” its longest bull market since WWII.  Over this period, the S&P gained over 200%, making it the third-strongest six-year run since 1900. The two others, 1929 and 1999, did not end well.

Longest Bull

This has also been one of the longest periods not to have seen a 10% correction, according to SG. The current 800 trading days was only exceeded in 1999 and 2007 ?. Those periods did not end well either.

Corrections

Posted in Portfolio Strategy.


Billion Dollar Fools Games

“There are many well-documented examples of complacency in today’s global capital markets, but one particular alarm, too often overlooked by investors, has been persistently ringing louder. Investor’s insatiable appetite for higher yielding, lower quality debt is the driving force behind the current buyout boom in which private-equity firms gobble up corporate stock and finance the acquisition with heaps of new debt. But as the domestic equity markets cheer the surge in leveraged buyouts, and the size of announced deals gets larger with each passing Merger Monday, the fundamental wisdom behind each deal gets smaller.”

There is nothing permanent except change. While the above quote may be just as relevant today, it was first written in the inaugural edition of the Broyhill Letter published in January 2007. The rest, as they say, is history.

Bull markets have a way of sucking everyone in at the top, as Seth Klarman noted in his most recent annual letter. “Today, stocks and bonds are both in favor; tomorrow, and without notice, this could change. Markets, like hemlines, will rise and fall. The current flavor of the month can turn sour. It is that “turning sour” that can happen rather quickly . . . the problem is, when the market reaches the top of a mountain is when certain groups of investors jump in.”

As illustrated in the chart below, those “certain groups” do not exclude companies themselves. My good friend Nik Modi at RBC recently highlighted the number of billion dollar deals in a research note updating his views on the 2015 Consumer Outlook.  Nik believes: “There is an opportunity for investors to take advantage of the stepped up special situations activity we began to see in the back half of 2014.” His best ideas include ENR, where the company’s personal care businesses could be taken out, post-spin. Apparently there are at least a few other guys who still see value in batteries. Note: Buffett’s Berkshire Hathaway buys P&G’s Duracell.

Nik does excellent work on the consumer space and has been spot on with ENR over the years (for what it’s worth, he also had one of the best three-point shots on our high school team despite giving up at least a good foot in height). Unfortunately for us, he was also spot on with his bearish AVP call which we ignored (better luck next time Nik).

That being said, we do tend to agree with his bullish outlook on the opportunity set in special situations. Energizer’s Form 10 is on my desk and on our on-deck list. We are still finding pockets of value in this market although those pockets are getting shallower and often filled with a ball of lint rather than the pleasant surprise that comes with finding a crumpled up dollar bill.  In other words, investment decisions cannot be made in isolation. As a result, investments must be made in the context of economic, credit and sentiment cycles all of which are getting long in the tooth as we discussed here. Surging buyouts are yet another cyclical indicator.

History has shown time and again that buybacks and acquisitions are extremely procyclical. Both can be excellent, if not imperfect, measures of corporate sentiment. With activist war chests larger than ever and the velocity of 13D filings only outdone by Hillary’s personal emails, it’s easy to justify paying a high price for a security on the basis that someone else will come along and offer a still higher price for the same investment. But this doesn’t change the name of the game. Selling to a “greater fool” is still a fools game.  The chart below shows the last three times “billion dollar fools” showed up in force. We saw this in 2000.  We saw this in 2007.  And we are seeing it today.  Don’t be a fool.

M&A Deals Over $1 Billion

2015-03-12 14_55_08-HPC_Beverages_and_Tobacco2015-03-12.pdf - Adobe Reader

Posted in Macro, Portfolio Strategy.


Nowhere to Run

GMO Forecasts

 

Posted in Valuation.


Luck of the Irish

Promising investments can come from anywhere. There are no patents on investment ideas. The only common factor in our search for fifty cent dollars is the thrill of the hunt. Often, some of our best ideas are sourced from within the existing portfolio. This may entail less of a “hunt” but can be even more fun and just as rewarding.

Last year, we committed significant resources to understanding the opportunity set in European real estate and presented our investment thesis on Kennedy Wilson (KW) at ValueX in June.  In that presentation, Around the World with Kennedy Wilson, we illustrated the positive fundamentals underpinning the Irish real estate market, where KW enjoyed first mover advantage.

Luck of the Irish

In that presentation, we explained that cap rates had come down, but relative to local interest rates, spreads remained very attractive. Commercial property prices and rents fell 60-70% during the crisis. Both had rebounded, but Irish property was coming off of a very low base.

The real opportunity was on the supply side or lack thereof.  There had not been a single crane on the Dublin skyline since 2006-2007. Construction completely dried up. At the same time, demand for prime real estate was soaring. Prior periods of declining rents in Dublin (illustrated above) had historically been followed by mulitple up years.  After such a dramatic fall, we suggested last year’s move was just the beginning.

We’ve since made a second investment in the space, focused specifically on Dublin real estate. A crashing euro masked strengthening fundamentals for a while, but it appears the market has begun to get it right.

GRN

To put this story in perspective, CBRE’s 2015 Irish Commerical Real Estate Outlook demonstrates the recovery taking place as does Jones Lang LaSalle’s Dublin Office Market Review and Outlook 2015.  A few highlights:

Availability of prime office space across Dublin declined by over 40% last year. The Grade A vacancy rate in Dublin 2/4 at year-end was 2.0% – you read that right – 2.0% vacancy.  Overall vacancies are forecast to drop further.

No new space was delivered last year. And no new space is expected to be delivered this year.  Consequently, supply shortages have pushed prime rents in the region more than 28% higher during the year.

Prime headline rents in the district have increased to about €45 per square foot. CBRE expects rents to rise by as much as 22% in 2015 to €55 per square foot.

Prime City Rents

Prime Office yields stood at 5.0% at year-end. CBRE is looking for another 50 bps of yield compression in 2015. Probably not a stretch if rates continue on their current path. The Irish 10 Year currently yields less than 1%. Treasuries over 2% not looking so bad all of a sudden.

Irish 10 Year

With 95% of Green’s portfolio based in Dublin and an investment yield north of 6% today, we think the potential upside from rental growth and cap rate compression remains significant.  And perhaps the strongest indication yet of Ireland’s recovery:

The volume of transactional activity in the Dublin pub sector during 2014 exceeded all expectations. In total, more than 38 Dublin pubs sold during the last 12 months with a further 19 under contract at year-end. With considerable deleveraging still to occur and the underlying economic recovery boosting consumer sentiment and in turn the pub trade, strong volumes of transactional activity are expected to be witnessed in the pub sector again in 2015. 

Publicans

Posted in Macro, Security Analysis.


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.

GMO

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.

Defaults

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.




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