One last rant before we get back to business after the long weekend. Sitting here Sunday morning with coffee and iPad in hand (if anyone else has had wi-fi issues with an iPad mini, PLEASE let me know) and came across a number of free digital issues of various publications. I don’t subscribe to the New Yorker regularly but have enjoyed the occasional read at the dentist office and thought this was a natural follow-up to yesterday’s rant:
Irony is cheap, not painless. One well-established fact is that polarization in Congress maps onto one measure better than any other: economic inequality. The smaller the gap between rich and poor, the more moderate our politicians; the greater the gap, the greater the disagreement between liberals and conservatives. The greater the disagreement between liberals and conservatives, the less Congress is able to get done,; the less Congress gets done, the greater the gap between rich and poor. That’s not bad math. That’s what happens when the kitchen’s on fire and all you’ve got is matches.
The kitchen is on fire, but Congress is only partly to blame as we see it. Money debasement comes with all sorts of nasty unintended consequences, not the least of which is social disorder. History provides plenty of examples where currency debasement unraveled the social fabric of society: the collapse of the Roman Empire or the fall of the French Republic, and of course, Weimar Germany. Coming back to Keynes, and his now well-known comments on the resulting “continuing process of inflation” – artificially created money redistributes wealth towards those closest to it, to the detriment of those furthest away.
It is no coincidence that median household incomes have remained stagnant for the better part of two decades while inequality has surged; that a record number of Americans are on food stamps, while the top earners take home a larger piece of the pie than anytime since the 1920s credit inflation. Dylan Grice has summed this up quite well in the past. ”The 99% blame the 1%, the 1% blame the 47%, the private sector blames the public sector, the public sector returns the sentiment … the young blame the old, everyone blame the rich … yet few question the ideas behind government or central banks …”
Starting tomorrow, we’ll spend more time considering how to generate returns in this environment and less time pointing fingers. Enjoy the rest of your Sunday and what’s left of this year’s monster rally. We don’t think it will be repeated when the calendar turns.
Posted in Policy.
– December 1, 2013
Catching up on some reading over the long holiday weekend, which provides an excellent opportunity to sit back with some left over turkey and reflect. I thought the piece below was particularly fitting against the current economic backdrop:
We are suffering just now from a bad attack of economic pessimism. It is common to hear people say that the epoch of enormous economic progress which characterised the nineteenth century is over; that the rapid improvement in the standard of life is now going to slow down . . . that a decline in prosperity is more likely than an improvement in the decade which lies ahead of us.
I believe that this is a wildly mistaken interpretation of what is happening to us. We are suffering, not from the rheumatics of old age, but from the growing-pains of over-rapid changes, from the painfulness of readjustment between one economic period and another. The increase of technical efficiency has been taking place faster than we can deal with the problem of labour absorption; the improvement in the standard of life has been a little too quick; the banking and monetary system of the world has been preventing the rate of interest from falling as fast as equilibrium requires.
For the moment the very rapidity of these changes is hurting us and bringing difficult problems to solve. Those countries are suffering relatively which are not in the vanguard of progress. We are being afflicted with a new disease of which some readers may not yet have heard the name, but of which they will hear a great deal in the years to come–namely, technological unemployment. This means unemployment due to our discovery of means of economising the use of labour outrunning the pace at which we can find new uses for labour. But this is only a temporary phase of maladjustment. All this means in the long run that mankind is solving its economic problem.
Unfortunately, most of us are too concerned about today, tomorrow and next week to focus on the long run, but we still have plenty to be thankful for. We have certainly had our share of struggles in the years leading up to and following the global financial crisis, but we submit that the US remains the cleanest dirty shirt in the laundry. I’ll elaborate on this statement between now and year end, but for the time being, interested readers can review Advantage America, written by Gary Shilling, one of the most insightful (and bearish) economists on the street. For what it’s worth, I agree with most of the points here, but the bull story is largely priced for perfection at all-time highs in US equity markets. And in many ways, we still haven’t learned a thing. Back to our holiday reading:
To those who sweat for their daily bread leisure is a longed–for sweet – until they get it. Yet there is no country and no people, I think, who can look forward to the age of leisure and of abundance without a dread. For we have been trained too long to strive and not to enjoy. To judge from the behaviour and the achievements of the wealthy classes today in any quarter of the world, the outlook is very depressing!
The love of money as a possession – as distinguished from the love of money as a means to the enjoyments and realities of life – will be recognised for what it is, a somewhat disgusting morbidity, one of those semicriminal, semi-pathological propensities which one hands over with a shudder to the specialists in mental disease. All kinds of social customs and economic practices, affecting the distribution of wealth and of economic rewards and penalties, which we now maintain at all costs, however distasteful and unjust they may be in themselves, because they are tremendously useful in promoting the accumulation of capital, we shall then be free, at last, to discard.
Of course there will still be many people with intense, unsatisfied purposiveness who will blindly pursue wealth – unless they can find some plausible substitute. But the rest of us will no longer be under any obligation to applaud and encourage them.
But beware! The time for all this is not yet. For at least another hundred years we must pretend to ourselves and to every one that fair is foul and foul is fair; for foul is useful and fair is not. Avarice and usury and precaution must be our gods for a little longer still. For only they can lead us out of the tunnel of economic necessity into daylight.
Some things never change. The global risk that respondents at this year’s World Economic Forum rated most likely to manifest over the next ten years is severe income inequality. Perhaps we’ll have better luck over the next hundred years if we don’t pull ourselves apart at the seams before then.
Meanwhile there will be no harm in making mild preparations for our destiny, in encouraging, and experimenting in, the arts of life as well as the activities of purpose.
The pace at which we can reach our destination of economic bliss will be governed by four things – our power to control population, our determination to avoid wars and civil dissensions, our willingness to entrust to science the direction of those matters which are properly the concern of science, and the rate of accumulation as fixed by the margin between our production and our consumption; of which the last will easily look after itself, given the first three.
But, chiefly, do not let us overestimate the importance of the economic problem, or sacrifice to its supposed necessities other matters of greater and more permanent significance. It should be a matter for specialists-like dentistry.
If economists could manage to get themselves thought of as humble, competent people, on a level with dentists, that would be splendid!
- John Maynard Keynes, Economic Possibilities for our Grandchildren (1930)
Splendid indeed, says my good friend and family dentist, Dr. Graham. Despite my personal ongoing bad attack of Keyne’s economic pessimism, my no-cavity streak remains intact. See you in six months!
Posted in Policy.
– November 30, 2013
It’s been a while since we checked in on our friends at Lumber Liquidators (LL) and a lot has transpired since we first published our short thesis on the stock in December 2010. After a brief rally in Q1-11, shares were effectively cut in half over the next couple quarters, before bottoming at $13.43 and rallying to a high of $120 earlier this year!! While we haven’t had a position in the stock since 2011, and don’t plan on initiating new shorts anytime soon, Whitney Tilson’s recent presentation at the Robin Hood Investors Conference provides a good overview of the bear case for Lumber Liquidators, which has only gotten stronger since we last looked.
In the meantime, we feel cash is a more effective hedge against potential market dislocations given today’s liquidity-driven environment. Simply stated, with central banks pushing asset prices higher regardless of fundamentals, shit floats to the top. And with that said, we’ve embedded the slide deck below.
Posted in Security Analysis.
– November 25, 2013
Global equities have re-rated sharply higher over the past two years as the correlation between stocks and macro data has broken down. Developed markets have been the largest beneficiary of central bank policy during this period, evidenced by the current nosebleed valuations now seen in the US. The Shiller PE on the S&P 500 is approaching 25 – a starting level that has historically produced negative real returns for investors over the next ten years. If growth returns to trend and rates remain near zero, then perhaps investors will continue to reward stocks with historically rich multiples. I suppose anything can happen, but we typically shy away from betting big on a long shot unless we are getting very good odds – 25x normalized earnings is a bit of a stretch. Recent remarks from Gerard Minack put conventional wisdom into perspective: “Markets appear to expect that global growth will accelerate next year. The economic consensus has expected acceleration towards trend growth ‘next year’ every year for the past three.”
Posted in Portfolio Strategy.
– November 20, 2013
Yesterday, I had the pleasure of speaking with the Bowden Group at ASU and meeting with this year’s CFA Research Challenge Team. It’s still early, and we have a lot of work (and glazed doughnuts) ahead of us, but I’d say our chances of a three-peat are strong . . . to quite strong.
My presentation to the team is embedded below and covers 1) the current macroeconomic landscape, 2) the importance of finding your investment niche, 3) our own rather boring niche, 4) knowing where to fish, 5) speed kills and cheap thrills, and 5) the results of a value-oriented, high-quality investment approach.
At last year’s visit to ASU, we pitched our investment thesis in Oaktree Capital Group (OAK) to the Bowden Group. This year, we explored our investment in Cedar Fair (FUN) which was first published in last month’s issue of Value Investor Insight.
The original article is available here with permission of Value Investor Media, Inc. Investment thrill-seekers, can also click here for our full report on FUN – a high-quality, spine-tingling business that benefits from high barriers to entry and durable pricing power.
– November 19, 2013
I had the pleasure of hearing Paul Volcker at lunch yesterday, who spoke for nearly two hours on a variety of subjects ranging from central bank policy, government inefficiencies, international monetary affairs and market confidence. The Former Chairman of the Federal Reserve still has one great advantage over all of his successors – a simple trait that is apparently lost in route to today’s PhD standard – common sense. The comment below perhaps illustrates this perspective best.
“My confidence in economists, in general, is not high. What surprised me about Greenspan is the enormous faith he placed in mathematical models. We have 250 PHD’s on the Federal Reserve Board. We’d probably get along fine with 50. If we had another 50, perhaps we’d find the right model. Greenspan thought he knew the world much better reading from a text book.”
These models create an expectation that the Fed can achieve more than it is capable of achieving. The question is, what can the Fed actually do. Chairman Volcker rightfully insists that the basic responsibility of all central banks is price stability, which is the foundation for other desirable goals. But a dual mandate may prevent the Fed from restraining the economy as much as it should in the face of increasing inflation and high unemployment. The political process makes this even more challenging. Bottom Line: When you keep interest rates very low for very long, you are going to feed the danger of creating bubbles.
Well said Chairman. Perhaps today’s central banksters should take their heads out of the text books and take some advice from the man who steered the US economy out of high inflation and slow economic growth. Sure, political pressure may make it more challenging to “take our medicine” this time, but some would say that Volcker experienced more political attacks and public protests than any other Fed Chairman during his tenure. High interest rates almost killed the construction and agricultural industries at the time. Farmers blockaded the main office of the Board of Governors with tractors. Contractors and carpenters, who complained their wood was not needed since no one was buying houses, actually mailed 2×4′s to Volcker’s office!
Times have changed. The current “pedal to the metal” Fed party – the driver of this subpar economic recovery and relentless rise in risk assets – is certain to come with a nasty hangover. Where is this leadership today?
Posted in Policy.
– October 30, 2013
“If you are in a surfing competition, the key thing is to take the right wave and ride it safely, which means don’t bump into people riding the same wave. It also means you have to kick out before the wave hurts you, and then go back and ride another wave. There are two types of errors you can make. The first error is never taking a wave because it is not perfect, which is the equivalent of staying in cash. Staying in cash, with a negative real rate, eats away at your principal. The other mistake is to take a wave that is too crowded and you are not able to get off it safely. For the past few years, we all have been riding the central-bank liquidity wave, and as investors we need to figure out how to safely continue to do that, because it is a very crowded wave. So if there are any signs of weakening, there will be a lot of people rushing to the door, as we saw last May and June.
“We are trying to focus on those parts of the liquidity wave that are more robustly anchored. So I spoke about shorter-dated debt in certain sectors. Second, there are sectors that are not being embraced because of liquidity issues. So I mentioned certain municipals and certain emerging-market bonds, especially in local currency. We are also focusing on companies that have very solid balance sheets and are generating a ton of cash, because they are giving that back to the equity investors. So, dividend-paying companies likely to increase their share buybacks are attractive.”
Friends may wonder if the above quote came from a certain colleague who recently traded the luxury of Zegna in NY for the warmth and flexibility of QuickSilver in LA. While we are sure this particular CIO, has plenty of advice on riding the big swells on the horizon (click graphic below for official soundtrack), the words of wisdom above came from PIMCO’s Mohamed El-Erian in a recent interview with Barron’s.
For our part, we are inclined to agree with Mr. El-Erian on most counts. Waves are getting very crowded these days, but we still see pockets of value in short-duration, off-the-run credit and in municipals. The risk of spiraling currency crises keeps us on the defensive with regard to emerging markets, but we main comfortable with our exposure to the emerging market consumer, predominantly through investments in the developed world’s Global Gorillas. We would highlight one additional factor working in favor of many of those high-quality, dividend-paying companies – increased activism.
Poor performance at some of America’s largest corporations has driven a number of restless shareholders to rock the boat. Whatever the reason, it appears that institutional investors are supporting activists more and that boards are more open to “conversations” about enhancing shareholder value. Bottom Line: We have detected the emergence of an underlying theme threaded across a number of positions in our equity portfolios - Quality With A Catalyst. We believe investors will be well served over the years by identifying these high quality franchises which stand to benefit from the tailwind of active shareholders who serve as a catalyst for value-realization.
Value investors are always on the look out for catalysts. While buying assets at a discount from underlying value is the defining characteristic of value investing, the partial or total realization of underlying value through a catalyst is an important means of generating profits. Furthermore, the presence of a catalyst serves to reduce risk. If the gap between price and underlying value is likely to be closed quickly, the probability of losing money due to market fluctuations or adverse business developments is reduced. In the absence of a catalyst, however, underlying value could erode; conversely, the gap between price and value could widen with the vagaries of the market. Owning securities with catalysts for value realization is therefore an important way for investors to reduce the risk within their portfolios, augmenting the margin of safety achieved by investing at a discount from underlying value.
Catalysts that bring about total value realization are, of course, optimal. Nevertheless, catalysts for partial value realization serve two important purposes. First, they do help to realize underlying value, sometimes by placing it directly into the hands of shareholders such as through a recapitalization or spin-off and other times by reducing the discount between price and underlying value, such as through a share buyback. Second, a company that takes action resulting in the partial realization of underlying value for shareholders serves notice that management is shareholder oriented and may pursue additional value-realization strategies in the future.
- Margin of Safety by Seth Klarman
– October 22, 2013
“An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative.”
“There is intelligent speculation as there is intelligent investing. But there are many ways in which speculation may be unintelligent. Of these the foremost are: (1) speculating when you think you are investing; (2) speculating seriously instead of as a pastime, when you lack proper knowledge and skill for it; and (3) risking more money in speculation than you can afford to lose.”
- Security Analysis, Benjamin Graham and David Dodd
In a recent post, we submitted that while one could certainly make the case for a year-end rally once Washington comes to its senses, it’s important to recognize the difference between speculation and investment. With markets surging to new highs on the heels of yet another poached punt by politicians, we submit that the majority of today’s market participants may be guilty of Graham’s “unintelligent speculation” – speculating when you think you are investing.
Asset bubbles are like mopeds. They are a lot of fun to ride, but nobody wants to be seen on one. Or perhaps more accurately, nobody wants to be seen picking themselves off the pavement after they crash.
So while there is a speculative case to be made for riding this rally into year-end, “intelligent speculators” should recognize that mopeds grow increasingly unstable at high speeds. Here’s John Hussman on the case for a year-end speculative rally:
Based on numerous past speculative episodes in the financial markets, we know that financial bubbles have often proceeded in an oscillating pattern featuring increasingly frequent cycles of advance, punctuated by gradually shallower declines reflecting an accelerating eagerness to buy dips. This can produce what Didier Sornette has called “log-periodic” oscillations. Given the negative return/risk estimates we observed in April and early-May, I believed that this series of oscillations was ending several months ago. In order to preserve a log-periodic pattern, further oscillations needed to exhibit an even faster alternation between steeply-sloped advances and shallow declines. Yet despite the strongly negative return/risk estimates we already had in April and May, this is unfortunately what has unfolded. With the Fed’s decision last week, we can’t rule out one particularly extreme version of a log-periodic bubble that is consistent with price fluctuations to date. That version is pictured below, and would comprise an advance above 1800 in the S&P 500 over a period of about 6 weeks. Again, this is emphatically not a forecast, but the conditions for a final wave of speculation may have been created by the Fed’s decision last week, and it leaves us unable to rule out this admittedly hypothetical possibility – particularly in the context of what has been a classic Sornette-type bubble to-date.
If interest rates remain under control, if the Fed is able and willing to continue its ongoing and increasing purchases of government debt, if speculators continue to afford the market a higher and higher multiple on lower and lower earnings estimates, than one could make the argument that the stock market’s upward momentum, driven by an increasingly desperate search for return in the absence of alternatives, could propel prices even higher. But history warns that the further markets move from fair value, the more forceful the reversion will be in the future. In other words, today’s gains come at the expense of tomorrow’s returns. It’s like déjà vu all over again. In our next post, we’ll take a closer look at the investment case for stocks at current levels.
Posted in Portfolio Strategy.
– October 18, 2013