May 2015 Investment Commentary: Driving Towards Greater Returns

Two roads diverged in a wood, and I—
I took the one less traveled by,
And that has made all the difference.
–Robert Frost, The Road Not Taken

Map and navigation apps have changed the way we experience driving and managing traffic.  Not long ago everyone stored a map or two in their car glove box.  Thanks to the proliferation of devices with GPS and social map applications (such as Waze and Google Maps), paper maps are a relic of the past.  Historically, we had little way to gauge how long a trip should take with precision. We could examine anticipated mileage and assume some kind of average speed.  Typically, we would say something like “it’s about an hour trip” for anything that took over 45 minutes and under an hour fifteen.  Today we know exactly which trips should take an hour, and we can even choose the best course based on current traffic patterns.  Whether or not maps and direction apps fascinate you (as they do for some of us here), they provide interesting insights into how people operate and serve as a fun metaphor for unrelated but pertinent investment insights.

Let’s say we have a goal of completing a one hour trip in 30 minutes with the secondary goal that we want effectively a 0% chance of finishing the trip in more than one hour.   Assume that we can pick any route in the United States that can be measured by inserting a starting point and ending point into Google Maps where the estimated time with no traffic is exactly one hour.   In effect, we would have to drive twice as fast as the implied trip-speed predicted by Google Maps, while assuming the risks associated with speeding, ranging from getting pulled over by an officer (which costs a lot of time and money) to a car accident (as higher speeds result in an increased risk of accident).  Two separate one hour trips can vary quite significantly by geography, terrain, and road formation.  One option may be an open road highway, with a consistent speed for the entire length, while another might be through a crowded urban artery with lots of merges, turns and varying speeds.  As such, we have considerable flexibility in what kind of one hour trip we would choose. How would we try to accomplish our primary and secondary goals simultaneously?

Montana is a great place for exceptionally fast driving with some of the fairest (Ie. weakest punishment) for speeders.  Montana is known as the Big Sky state because of its huge mountains and expansive horizon.  Driving in this environment often feels as if there is nothing but blue sky ahead.  Even while cruising at 85mph, it feels as if you’re barely moving with a tapestry of mountain peaks fixed to the horizon though slowly growing or shrinking depending on your perspective.  The state is a great place to drive fast and it would be a good candidate to avoid falling short of the one hour estimated time; however, it would be very challenging to find a good location to make a trip in half the estimated time.  This is so because the speed limit in much of the state is sufficiently high enough that only a handful of cars can even reach speeds double that of the speed limit. Even with one of those few special cars that could go fast enough, it would be very challenging.

Montana’s speed limits put the place right at the boundary of what is safely possible to accomplish speed-wise in the typical car today.  To cut a one hour drive in half, we need to find somewhere we are ‘assumed’ to go much slower than we are actually capable of moving through.  Some roads in heavily trafficked, urban areas have slow speed limits that are designed to accommodate the heavy merges and volume of cars that travel those areas, despite the road’s capacity to potentially accommodate much faster speeds.  We know of a few such roads in and around New York City with 25 mile per hour speed limits, where cars theoretically could drive upwards of 70 miles per hour for long stretches.  Yet major slowdowns are all too common on these roads.  Even at off times, you just never know when there will be a traffic jam, a lane closure, or simply too many cars on the road to move fast.

Ideally we would be able to find some relatively straight, open road with at least two lanes headed in our direction and a speed limit between 25 and 30 miles per hour, such that we could travel double the speed limit without testing the safety boundaries of our vehicle.  Two lanes would be essential, for in a one lane road, it would only take one slow car at some point in the trip to make the one hour journey in thirty minutes an impossibility.

Driving double the speed limit in Montana is not too different from investing in some of the growth stocks in today’s market. The fast growers are priced to grow exceptionally fast and as such, there is little opportunity over the long-run to get a return better than that which is implied by the market’s expectations.  These stocks are effectively suggesting there is nothing but blue sky straight ahead — the slightest storm cloud could seriously impair value.

This game we outlined was crafted to be similar to investing.  Think of the expected time as beta, and the quest for exceeding it as alpha. Further, think of the demand that we do not fall short of beta as a form of risk management—an insistence that our vehicles at least give us what is there to be taken. We aim to find these ideal conditions within our investment framework by focusing on value and effectively managing risk. These are principles we discuss in greater depth in our Investment Strategy Overview.[1]  To us, intrinsic value is not defined by a single price, but rather a range of possible outcomes that correspond to a business’ true worth from the owner’s perspective.  To this end, we conduct extensive fundamental analysis in order to fully understand what the market is implying about a company with regard to its cash flow yield, growth, and cost of capital over time and the business’ competitive position in its industry.  After we have gained adequate comfort within our assessment of a given security’s value, we test and retest any assumptions underlying our quantitative and qualitative analysis as time marches on.  This approach enables us to contextualize a business over a long horizon and enables us to operate with a very long-term focus while the market harps on what will happen one or two quarters out in a given stock.  We aim to stay out of the fast-lane in Montana despite how nice the scenery can be – we know better than to push our vehicles beyond the boundaries of their constructs, especially with the knowledge that a quick storm cloud can quickly turn a perfect ride into a disaster.

The heavily trafficked roads in urban areas are not too different from the indexation philosophy taking over the investment world today.  Everybody’s doing it!   When all are doing the same thing, (think of the Cross Bronx Expressway, which is anything but express) it doesn’t take much for an otherwise simple drive to devolve into a traffic mess.   One car jamming the breaks too quickly can ripple into a slowdown for miles, or worse yet, a domino-like multi-car accident.  With so many people piling into index strategies, we worry that if a few big players start to leave the act can ripple into a much larger flight from indexation.

To that end, we think it is best to take road that is “the one less traveled” and focus on areas that the market today is overlooking – the less congested, back-road opportunities.  We can focus on areas we know the market does not favor today, as suggested by our multi-year interest in Europe or our appreciation for stocks that do not fit neatly into the cookie-cutter labels the market assigns.  In our August 2014 investment commentary we discuss indexation in contrast to our ‘actively-passive strategy.’[2] It is worth considering contrarianism (again) in this context:

“A market truism that persists over time is how when everyone does something (aka when something becomes conventional wisdom) it is exactly the time to do the opposite.  The corollary is that when everyone ignores something is the time to be doing that very thing.  The rise of indexing itself is one of the bigger factors creating opportunity in today’s investment landscape.  This does not mean that the non-indexer can beat indices in each and every timeframe, whether large or small, but it does mean that over the long-run non-indexers can put themselves in position to both earn the cost of capital of the asset class (essentially the average long-term return of the indices) and gain exposure to factors which with prudent analysis can lead to increased upside.”

Thank you for your trust and confidence, and for selecting us to be your advisor of choice. Please call us directly to discuss this commentary in more detail – we are always happy to address any specific questions you may have. You can reach Jason or Elliot directly at 516-665-7800. Alternatively, we’ve included our direct dial numbers with our names, below.

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF
Managing Director
O: (516) 665-7800
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-7800
M: (516) 729-5174
elliot@rgaia.com

[1] http://www.rgaia.com/investment_strategy/

[2] http://www.rgaia.com/august-2014-investment-commentary-indexation-creates-opportunity/

April 2015 Investment Commentary: ETF Fund Flows

ETFs have been a tremendously popular tool for investors of all types. For long-term investors, these securities provide a lower-fee alternative to mutual funds, the ability to hone in on a sector, commodity or asset class, combined with intraday liquidity. For traders, they provide similar benefits, though with an emphasis on the intraday liquidity. Both assets and trading volumes have surged across the ETF complex. Many have talked about the role ETFs have played in changing investor allocations and market structure, including us. In our November commentary, we focused on “the oil investors who don’t even know it,” and the role their buying of high yield bond ETFs based on a search for income has played as a source for cheap capital to the energy sector.[1]

We did an analysis of fund flows into (and out of) important and popular ETFs relative to market prices since the March ’09 bottom.  As one would expect, the price of most asset classes and securities have risen in this time period—after all, that was part of the point in selecting the March 09 as the starting point for this analysis. The second reason behind picking the ’09 bottom to start was its status as an inflection point in the most pivotal market dislocation of our time. Such inflection points tend to change the way people think about asset management, and this is something we know did in fact happen.

“More Buyers than Sellers” – or not.

Before getting to the heart of our findings, a slight digression is necessary.  An oft-repeated market cliché to explain why a stock rises is that “there are more buyers than sellers.”  As with many clichés, this is mostly true, but does not tell the full story. In fact, securities can and often do move higher with more sellers than buyers—if by ‘more sellers’ one means the flow of funds out of the security as opposed to transaction volume or the net number of buyers bidding in the market. Securities can also move up with absolutely no transactions at all. A simple illustration can help illicit why: imagine a market where the bidder (Bidder A) is offering $1.00 for a widget, but the seller (Seller A) is asking for $2.00 and the last transaction occurred at $1.50. The spread for this widget is thus $1.00 x $2.00.

A new buyer (Buyer B) comes in and offers $1.25 for the widget, making the new spread $1.25 x $2.00. Upon seeing Buyer B enter the fray, Seller A thinks “maybe $2.00 is too low, I should ask for $2.50.” Meanwhile, seller B, the patient seller has been asking for $2.25 all along. Buyer A really needs this widget and is kicking himself because he could have comfortably owned it already had he just paid what Seller A was asking from the start. Buyer A is intent on not paying up to $2.00, so he places a bid at $1.75, making the new spread $1.75 x $2.25. Given our last quote was $1.50, it’s clear that the market price today has “gapped” above this level and is at lowest $1.75, or more fairly were we to take the midpoint of the spread, it is $2.00. This price increase happened without a single actual buyer transacting and with an equal number of buyers and sellers on each side.

Let’s take this one step further: Seller C, who has been watching from the sidelines, sees there is a buyer for the widget at $1.75 whereas before the buyer was at $1.00. He gets excited and jumps in to sell on the bid, for $1.75. Seller A now has his widget, but in the process we learned that there were really 3 sellers in this market compared to 2 buyers. Yet, the price did ultimately rise.

We can draw out further illustrations on how the bid / ask process works, but now we can jump to the point: George Soros calls this a “price-mediated feedback loop” between market participants and market prices. This is a form of a positive feedback loop (in contrast to the negative feedback loop we covered last month).[2] Movements in bids and asks alone, or movements in price, do in fact change the behavior of market participants and can elicit further changes in price.  It is no coincidence that we keep citing feedback loops in these commentaries, for we feel they are at the very heart of how markets operate. This idea of a price-mediated feedback in one way or another belies all transactions and is a necessary precursor for the explanation of some of our findings in the ETF space.

When we talk about fund flows in ETFs, we are referring to the net addition of new money to an ETF rather than the appreciation (or depreciation) in net value of the ETF itself. In our opinion, this is the cleanest metric for whether there are more buyers or sellers. If funds go out, there are more sellers, if funds go in, there are more buyers. By and large there was nothing remarkable with the relationship between fund flows and price performance. In fact, overall, there has been little correlation between the two in the main ETFs. Price and flow were somewhat correlated in the short-run but random over medium and longer timeframe. The general trend saw more money flow into the core ETFs over time thus putting upward pressure on prices. This is not surprising given it was the case in most markets. However, three ETFs stood out to us as particularly anomalous: QQQ (the Nasdaq-100 proxy index), IBB (the most widely traded biotech ETF) and USO (the oil commodity tracking ETF). What follows are the charts and a brief discussion of what confounds us in each:[3]

The QQQs:

qqq

The blue line is price, while the green is flow. Of the major index ETFs (SPY/S&P 500, IWM/Russell 2000—sorry Dow, you are a mere after-thought to us), the QQQ is the only one to experience net fund outflows.

Here’s the QQQ flows alongside the SPY and IWM:

QQQ PLUS

We have no particularly robust explanation for why the QQQ might be experiencing such significant outflows compared to its brethren, though we do find it noteworthy.  This is especially so at a time when conventional wisdom holds that increasing amounts of money are going into tech stocks. The NASDAQ is known as the tech corner of the market.  Were money flying into tech the primary cause of the advance in stock prices, one would expect to at least see positive flows. Many claim that the market is being driven by momentum-seeking hot money, but if you look at the NASDAQ, that seems to be the converse of reality. The NASDAQ has been a far better performer than the SPY and IWM since the bottom and investors have seemingly been prudent in taking some chips off the table from the hottest of areas. Note that there were negative net fund flows for the first three years of the S&Ps rally off of the March ’09 bottom. The market en masse went up with more sellers than buyers.

The IBB:

IBB

Of the dozen plus ETFs we looked at, this is the only one where price and flow moved upwards in tandem. This is exactly what a price-mediated feedback looks like. The rise in price brings more flow, which drives price higher, thus attracting yet more flow. This is also the explanation for how momentum works and what it looks like in action. While in the past we asserted biotech was not in a bubble based on valuation metrics and the fundamental outlook, this right here is a very concerning development. The longer this persists, the more troubling it will be. While price and flow can keep driving each other higher, when one breaks down, the other too will follow. One of the foremost points we learned from Soros is that when price-mediated feedback loops break, they do not simply find a new equilibrium at the price’s present plateau. Rather, the feedback loop reverses and works in the opposite direction. Note that the move up and down in price and flow are both positive feedback loops—the disequilibrium-seeking forces in markets. As such, these relationships are inherently unstable.

The USO:

USO

The cumulative flow since the ’09 bottom remains below the X axis here—in other words, the flow of funds has been net negative. During much of the period when USO/oil prices trended sideways, investors were pulling money from this key ETF. Once the price of oil started its rapid descent, rather than withdrawing money, traders started piling it in. Clearly traders were eager to buy this dip, with the buying commencing early in the oil decline. This action in USO was not enough to stem the price decline in oil and this makes sense, for in this ETF alone we do not get a clean sense of where the true supply/demand equilibrium shakes out.

To sum this all up, while there is no one overarching point, it merely goes to show that “more buyers than sellers” doesn’t necessarily have any one meaning anywhere. It does however show that certain ETFs can and do have a very real influence on the sectors that belie them (IBB is the extreme example of this), while the flow in others lends skepticism to the prevailing narrative (QQQ and momentum seeking hot money).

Thank you for your trust and confidence, and for selecting us to be your advisor of choice. Please call us directly to discuss this commentary in more detail – we are always happy to address any specific questions you may have. You can reach Jason or Elliot directly at 516-665-7800. Alternatively, we’ve included our direct dial numbers with our names, below.

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF
Managing Director
O: (516) 665-7800
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-7800
M: (516) 729-5174
elliot@rgaia.com

Past performance is not necessarily indicative of future results.  The views expressed above are those of RGA Investment Advisors LLC (RGA).  These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views.  Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice.   The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria.  In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed in item (i) were purchased. (iii) The date or range of dates during which the securities listed in response to item (i) were purchased.

[1] http://www.rgaia.com/the-oil-investors-who-dont-even-know-it/
[2] http://www.rgaia.com/negative-feedback-loops/
[3] All charts use Bloomberg for cumulative fund flows and last price, with data as of March 10, 2015.

March 2015 Investment Commentary: Negative Feedback Loops

 “No matter how cold the winter, there’s a springtime ahead.” – Pearl Jam

With the first quarter now history, the S&P 500 boosted its streak of consecutive quarterly gains to nine—the longest such streak since the 1990s.  In contrast to the 1990s, this quarter’s gains were rather modest, with the S&P advancing 0.88%.  The largest, most interesting and consequential moves were witnessed in currency and international markets. The US Dollar registered just shy of a 9% advance (as measured by the DXY index), its strongest performance since the “Lehman Quarter” in 2008 when a global flight to safety sent our currency soaring.  We also saw legitimate “green shoots” emerge across the European region for the first time since their crisis deepened. Markets in Germany and Italy soared over 20% on the quarter, with the Stoxx Europe 600 adding just shy of 16%. These returns, when translated into US Dollars are less than what European investors experienced, though we believe springtime is unquestionably here for the European continent after a protracted, dark economic period.

We have often written about positive feedback loops—self-perpetuating cycles that accelerate and expand into booms and busts—and less so about negative feedback loops. When markets are trending distinctly in one direction, then positive feedback loops are a more meaningful descriptive force. Further, on the micro level, we are constantly looking for companies with positive feedback loops as tailwinds. Despite this asymmetry in our dialogue, negative feedback loops are an equally (if not more) important force in markets.  A common colloquial synonym for the negative feedback loop is regression to mean or regression to trend. Markets as equilibrium-seeking entities are constantly impacted by negative feedback loops.

A recent example is the oil price collapse: as prices stayed elevated for a long time, producers increased production and new technology increased the available supply, thus pushing prices back towards a more rational equilibrium (see our October 2014 commentary for more detail on how this works).[1] On the micro/firm level, this happens when a cyclical firm earns a high return on capital, signaling to potential competitors that a big profit opportunity exists. When new competitors emerge, they capture for themselves a portion of this excess return, resulting in a lower level of economic profit (earnings in excess of cost of capital) captured by each individual company. Eventually all excess return is competed away, and typically exit barriers in any given industry lead to an oversupply and subsequently negative returns for each individual firm.

While the constructive shift in European policy over the past half-year has helped stimulate the region’s economies, an equally meaningful force has come from the self-calibrating mechanisms (aka the negative feedback loops) inherent to economies.  It is a simple rule of thumb that human instincts and modern-day necessities can only be postponed for so long.  This is what Warren Buffett was hinting at when he said “People may postpone hitching up during uncertain times, but eventually hormones take over” with regard to the inevitably of household formation growth and a recovery in U.S. housing demand.[2] In other words, the recovery of certain core economic goods is a “when, not if” question.  Economic uncertainty is an unfortunate cause for delaying individual life goals, but it cannot be a reason for postponing core desires in perpetuity. At some point people simply say “enough is enough, I am doing this already” (whatever this may be). European economies had stagnated for so long now that certain necessities simply could not be postponed any longer.

We cannot minimize some of the very real hardships felt by far too many people during economic crises. Certain portions of the population simply cannot make ends meet and thus suffer harsher consequences than anyone should in this day and age of global wealth. We are specifically speaking about classes of the economy who have a degree of stability with regard to the basics of life, but cannot fathom making certain key decisions in the face of uncertainty. This pullback in economic activity amidst uncertainty is what Keynes called “the paradox of thrift.”  This paradox is a force that compounds the positive feedback loop in the wrong direction. Liquidationists believe the self-calibrating forces we are speaking about so far in this commentary are enough on their own to restore the economy to growth. While this topics is worthy of a longer conversion, economies are far too complex for one force alone to change the trajectory of a massive body in motion. As we have consistently emphasized, stimulus of the monetary and fiscal variety is necessary to rejuvenate a depressed economy. Without stimulus, the weakest in society would be too vulnerable to increasingly poor outcomes.  Equally important, without these negative feedback loops kicking in, stimulus could never go very far on its own.

The progress in Europe is not just in capital markets; rather, it is observable in actual economic data already. One of the first important data points we track to identify such inflection points turned positive at the end of 2014 and was a notable point in our 2015 Outlook: “We see evidence of upcoming growth with several of the continent’s weakest markets experiencing rising car sales for the first time in over half a decade.”[3]  When cars reach a certain age (typically about 15 years) they are no longer reliable for transportation purposes. As individuals en masse delay auto purchases, a nation’s car stock ages.  When this reaches a certain point, the negative feedback loop kicks in by essentially forcing (rather than merely encouraging) those with too old a car to seek a replacement.  This auto example is illustrative of a demand cycle in one of the more economically sensitive durable goods, with repercussions that ripple through the entire economy. Meanwhile, the same forces are at work in many household, commercial and industrial settings as infrastructure ages and must be retired. Replacements can only be put off for so long.

When you combine these negative feedback loops with a steady dose of monetary stimulus and a declining currency (which stimulates export demand), you have the makings for springtime in Europe and the commencement of a positive feedback loop in the opposite direction.  As Soros’ has taught us, these inflection points tend to be some of the most powerful moves as negative numbers get replaced by positive numbers.  Think of it this way: in moving from 3% growth to 5% growth, 2% is added to the rate; however, in pivoting from 2% contraction to 2% growth, your differential is a whole 6%.  It doesn’t take a whole lot of improvement from a negative environment for the pendulum to swing quite far in the opposite direction.

A Flower Blooms in ING (An early spring tulip, if you will)

We first bought shares in ING Groep in May of 2012. This past month, we doubled down on our holdings. While ING’s price per share is considerably higher now, the risk is materially lower and the reward opportunity remains lush.  This is one of our single favorite ways to capitalize on the recovery in Europe and further exemplifies a situation where both the micro and macro forces compound to create an asymmetric opportunity.

ING today is a completely different company than the one we bought in 2012, and this is by design. When the U.S. housing market collapsed, what had formerly been a global financial powerhouse became just another bailed out institution.  As a condition for ING’s bailout (imposed by the Dutch Government and the ECB), the company had to repay 50 cents for every $1 of capital injected. Moreover, the company had to agree to divest nearly all of its non-European core banking operations. This included ING Direct in the U.S., its Asian Insurance operations, the U.S.-based asset manager (now trading as Voya Financial), the European Insurer (now trading as NN Groep), and more.

These were far more onerous terms than anything witnessed in the U.S. and global investors steered clear of the company’s shares for that reason. Harsh as they may be, the value proposition was too good to pass up. Further, when the asset disposition process started, the path to value realization was highly uncertain. Consequently, the company was trading at a steep discount to its tangible book value. Fast forward from May 2012 to today and many things have changed.  First and foremost, ING realized tremendous value in the disposition of its assets, having sold some of its most valuable pieces at premiums to book value, while spinning off vibrant stand-alone companies and trimming stakes opportunistically as prices appreciated.

Prominent bank analyst Mike Mayo has argued both JP Morgan and Bank of America should break up because the sum of the parts would be worth much more than the whole is today.[4] ING is the most distinct case globally where this has happened and the process has been managed adeptly throughout.  As a result of the successful dispositions, ING was able to repay their bailout to the Dutch government earlier than expected. As a result, what remains today is an over-capitalized bank that earns decent returns on equity (in excess of their cost of capital). ING was once again able to pay a shareholder dividend—this was formalized as of February.[5] Management has signaled a 40% payout ratio, which based on the quarter-closing price of $14.61 amounts to a 3.8% yield on expected 2015 earnings. Plus, with a tier 1 capital ratio of 13.59%, low leverage, and healthy stress test results, there could even be room for a special dividend.

The move to reinstate the dividend is huge on two fronts. The obvious impact is that recommencing the dividend opens the shares up to a broader universe of investors—those who require income/dividends. Considering this will be an ample yield in a world where many countries are at the zero-bound, such a yield on a safe, almost boring bank is nice. The not so obvious part is the role returning capital will have on the bank’s ratios. Too much cash, whether it be on a balance sheet or in a portfolio, can be a drag on performance. Considering one of the biggest critiques of ING today is that they are “too boring” a company without assets in high growth areas anymore, and a pristine balance sheet, the return of capital to shareholders would be a very real boost to returns on capital and thus equity. Banks are valued based on how much they can earn on each dollar they have, so earning the same amount on fewer total dollars should lead to a better multiple.

Interestingly, another condition of the bailout will soon be lifted: as of November 2015, ING once again will be allowed to make acquisitions. is the company is much farther along its recovery and transformation than many European peers.  Banks around Europe remain depressed valuation-wise and cheap, though loaded with uncertainty. Some are only now beginning large-scale dispositions. ING will be in excellent shape to act strategically and grow its core European bank operations. Stated most succinctly, 2015 will be the year this company pivots from a dispositive, de-risking strategy to an income and growth strategy.

What do we own?

The Leaders:[6]

Fiat Chrysler Automobiles (NYSE: FCAU) +40.9%

Fanuc Corp (OTC: FANUY) +32.8%

Howard Hughes Corp (NYSE: HHC) +31.6%

The Laggards:

America Movil (NYSE: AMX) -7.8%

Groupe SEB (OTC: SEBYF) -3.0%

Siemens AG (OTC: SIEGY) -1.0%

Thank you for your trust and confidence, and for selecting us to be your advisor of choice. Please call us directly to discuss this commentary in more detail – we are always happy to address any specific questions you may have. You can reach Jason or Elliot directly at 516-665-7800. Alternatively, we’ve included our direct dial numbers with our names, below.

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF
Managing Director
O: (516) 665-7800
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-7800
M: (516) 729-5174
elliot@rgaia.com

Past performance is not necessarily indicative of future results.  The views expressed above are those of RGA Investment Advisors LLC (RGA).  These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views.  Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice.   The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria.  In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed in item (i) were purchased. (iii) The date or range of dates during which the securities listed in response to item (i) were purchased.

[1] http://www.rgaia.com/october-2014-investment-commentary-flooded-in-oil/

[2] http://fortune.com/2012/02/25/buffett-on-housing-was-dead-wrong-but-still-believes/

[3] http://www.rgaia.com/december-2014-investment-commentary-our-2015-investment-outlook/

[4] http://fortune.com/2015/03/26/bank-of-america-break-up/

[5] http://www.ing.com/Newsroom/All-news/Press-releases/PR/ING-Bank-posts-2014-underlying-net-profit-of-EUR-3424-million-Dividends-reinstated-with-EUR-0.12-per-ordinary-share.htm

[6] All gains (losses) are from date of purchase (sale) within quarter, if applicable. All gains (losses) on international securities are in U.S. dollar terms.

Investment Strategy Overview

Please feel free to download our Investment Strategy Overview here

Investment Overview:

We invest with a 3 to 5 year timeframe, hoping to hold each position as long as possible, though knowing markets often overshoot to the upside as they do the downside. Given this reality, we understand that an infinite holding period is the exception, not the rule. We target the 3 to 5 year timeframe because while the market itself tends to price in a long duration, the average annual turnover of US stocks is over 250% per year, and consequently, the average transaction is premised on the quarterly newsflow of a given company rather than the long-term value proposition. This mismatch between the duration of equities and the holding period of the average investor is a crucial source of inefficiency in market valuations. Moreover, longer holding periods provide a tax advantage and minimize transaction fees.

The essence of our strategy is based in the principles of Graham and Dodd and their progeny who focused on quantifying measures of quality and growth in valuation.

Investment Objective:

The following represent our core investment objectives:

  • Build a semi-concentrated portfolio
  • Target global businesses, with no pre-designated allocation by country, with an
  • emphasis, but not a mandate to invest in companies in developed markets.
  • Invest with a 3-5 year timeframe
  • Target portfolio turnover of 20% with 30% being the high-end, though knowing in times of intense volatility turnover will have to rise to accommodate the rapidity of price action.
  • No position size greater than 10% of the portfolio and no greater than 6% upon the commencement of the position.
  • Invest opportunistically across the capital structure and amongst and between the various asset classes.
  • Target companies with market caps between $500 million and $10 billion, though sometimes we will buy smaller or larger companies when the opportunity meets our risk reward profile.

Markets as Complex Adaptive Systems:

Philosophically we are not subscribers to the efficient market hypothesis (EMH). While the EMH takes physics and applies its principles to financial markets, we believe that financial markets exist in the domain of biology and can best be described within the Complex Adaptive Systems (CAS) framework. Markets are complex, meaning they are “complicated” and have “interrelated parts.” Markets are adaptive, such that they adjust to circumstances “by modification.” Markets are systems, which consist of “regularly interacting …group(s)” joining together to form a “unified whole.” This is very much our prevailing philosophy towards financial markets, and the reason behind our interest in the Santa Fe Institute. Such systems are found in many places, including nuclear physics, biology, anthropology, social structures, genomics, chemistry and drug discovery.

Two important market forces are reversion to mean (or trend) and the persistence of trends. Mean reversion is one of the better understood concepts in financial markets, and underlies the physics-based understanding of economics. Alternatively, the persistence of trends (also known as momentum) is one of the documented inefficiencies within the EMH paradigm, though notably, this area is little understood. CAS provides a robust framework for understanding when, where and why these two powerful forces appear. In both mean reversion and trend persistence, feedback loops (both positive and negative) appear. In markets, negative feedback loops are the primary force behind mean reversion, while positive feedback loops are the drivers behind trend persistence.  George Soros’ “Theory of Reflexivity” was an important contribution for market participants to understand the role of feedback loops on asset prices. Reflexivity explains how assets enter into a price-mediated feedback between fundamentals and market price. As Soros explains:

“a positive feedback process is self-reinforcing. It cannot go on forever because eventually the participants’ views would become so far removed from objective reality that the participants would have to recognize them as unrealistic. Nor can the iterative process occur without any change in the actual state of affairs, because it is in the nature of positive feedback that it reinforces whatever tendency prevails in the real world. Instead of equilibrium, we are faced with a dynamic disequilibrium or what may be described as far-from-equilibrium conditions. Usually in far-from-equilibrium situations the divergence between perceptions and reality leads to a climax which sets in motion a positive feedback process in the opposite direction.  Such initially self-reinforcing but eventually self-defeating boom-bust processes or bubbles are characteristic of financial markets, but they can also be found in other spheres.”

The lessons from behavioral economics are particularly important in the CAS structure. Within this paradigm, we believe the combination of a robust process with sound temperament to be extremely important. Temperament is far too often taken for granted, and it is our belief that the EMH mistakes volatility for risk, when reality demonstrates time and again that risk is borne from the human response to volatility and not volatility itself.

Investment as an Actively Passive Endeavor:

What is Active Management?

The most basic problem with the above question is how “Active Management” is simply painted with one brush. Active management has come to mean something very different over time. John Bogle, considered by many to be the “Father of Indexing” recently published a book about (and aptly titled) “The Clash of Cultures.” Bogle borrowed Keynes’ distinction of investing as “forecasting the prospective yield of the asset over its whole life” and speculation as “forecasting the psychology of the markets.” What most people think of as active management today is actually more akin to speculation and momentum trading than true investing.

In practice, active management has become what we popularly call “trading” and this is evidenced by the explosion in portfolio turnover at the average investment fund. Bogle laments how “in 1950, the average holding [period] for a stock in a mutual fund portfolio was 5.9 years; in 2011, it was barely one year.” As of 2011, annual turnover of U.S. stocks was over 250% per year!

Consequences of High Turnover:

This explosion in portfolio turnover has profound consequences for investors. Most frighteningly, it has created a system in which the vast majority of stock market participants are no longer real stakeholders in the success (or lack thereof) of our country’s publicly traded businesses. Is it any surprise that a 2004 working paper from the NBER found “55% of [corporate] managers would avoid initiating a very positive NPV project if it meant falling short of the current quarter’s consensus earnings?” This clearly indicates that management, in aggregate, specifically passes over projects that will increase a firm’s actual value (NPV=net present value) in order to smooth the trajectory of earnings. When the entire purpose of management is to maximize firm NPV and managers admittedly are not doing this because of their guess at how markets will behave, we know there is a problem.

This should be shocking, though in practice, it is easy to rationalize. Corporate management is simply responding to the fact that the vast majority of investors are participating in the “Keynesian Beauty Contest” of predicting shifts in psychological sentiment rather than buying fractional ownership in real businesses. The existential purpose of a stock market is “to provide companies a means through which to raise capital in order to invest in their businesses, and [for] investors to allocate capital in order to generate a return.” These turnover numbers tell us that markets have moved very far from their essence. Today’s markets more closely resemble an arena in which strategists compete for increasingly low- margin arbitrage opportunities. And sadly, corporate managers have become willing participants in this game.

Randomness vs. Investing:

In explaining the parable of Mr. Market we often reference Benjamin Graham’s observation that “in the short run the market is a voting machine, but in the long run it is a weighing machine.” This game of arbitrage is reflective of an important market reality: the short-term is the arena of randomness, while the long-run is the home of the investor. When people colloquially speak of “active management” today, they are implicitly speaking of this short- term arena because that is where so many of today’s market participants operate. As the domain of randomness, it comes as no surprise there is little persistence in returns from active investors other than amongst the bad ones.

Bogle emphasizes that “beyond the crazy world of short-term speculation, there remain commonsense ways to invest for the long term and capture your fair share of the returns that are earned by our public corporations,” with the most important being a focus on the long-term, with an emphasis on the fundamental value of businesses. While Bogle’s name is inevitably tied to indexing, his point is far broader and applies to how active managers should operate as well.

Michael Mauboussin of Credit Suisse, one of our favorite strategists on Wall Street, did a study to find what the best performing fund managers from 1996-2006 had in common. Sure enough, there were four tell-tale traits shared by these top funds that run completely contrary to what has become of active management today. These are the traits:

  1. “Portfolio turnover. As a whole, this group of investors had about 35 percent turnover in 2006, which stands in stark contrast to turnover for all equity funds of 89 percent. The S&P 500 index fund turnover was 7 percent. Stated differently, the successful group had an average holding period of approximately three years, versus roughly one year for the average fund.”
  2. “Portfolio concentration. The long-term outperformers tend to have higher portfolio concentration than the index. For example, these portfolios have, on average 35 percent of assets in their top ten holdings, versus 20 percent for the S&P 500.”
  3. “Investment style. The vast majority of the above-market performers espouse an intrinsic-value investment approach; they seek stocks with prices that are less than their value. In his famous ‘Superinvestors of Graham-and-DoddsviIle’ speech, Warren Buffett argued that this investment approach is common to many successful investors.”
  4. “Geographic location. Only a small fraction of high-performing investors hail from the East Coast financial centers, New York or Boston. These alpha generators are based in cities like Chicago, Memphis, Omaha, and Baltimore.”

From the beginning, RGA Investment Advisors, mission has been to adhere to these first three traits, and while we cannot claim adherence to the forth, we do strive to operate with an “Off Wall Street” mentality. The combination of a low turnover strategy, with a focus on fundamental valuation is consistent with Bogle’s studies and the points that make “passive” an effective strategy when compared to “active.” In that vein, we think of our strategy as “actively passive” for how it combines the benefits of passive strategies, with its own active twist to enhance returns and better manage risk.

Idea Generation:

We break down our idea generation into the abstract and tangible endeavors. The abstract provides a framework, context for our subsequent research, and sometimes specific investment ideas worthy of an in-depth analysis. Our abstract idea generation starts with a healthy regimen of reading. This reading is multi-disciplinary in nature, which in addition to the well-known financial publications, includes topical readings on the social sciences like history, sociology, global politics and trade journals in the hard sciences like physics, biology and chemistry. While we are by no means experts in any given specialty, we think it is important to take a generalists perspective, and to understand and use what Charlie Munger calls “the truly big ideas in each discipline.”

In the tangible arena, we deploy several screens focused on quality, value, the intersection of quality and value, and ownership structure. We scrutinize these various screen outputs using our knowledge and framework acquired in our abstract idea generation process. This helps us focus on ideas we think most worthy of our attention and to filter out ideas that do not reconcile with our broader understanding of the world today.

Valuation analysis:

We don’t think of intrinsic value as any one price; rather, we view it as a range of possible outcomes. Our first priority in any valuation analysis is to work backwards and ascertain what the market is implying about a company with regards to its cash flow yield, growth and cost of capital over time.

We don’t think any particular valuation technique is the one and only appropriate technique. It is our belief that prudent valuation analysis is a three-step process: first, one must solve for the embedded assumptions in a stock’s price relative to its value; second, one must ascertain which valuation technique is most sensible in a given situation; and third, the appropriate technique must be applied. In some situations, more than one technique may be appropriate. This first step of inversion is an important starting point in all of our analyses for it provides the benchmark to which we can compare the numbers we calculate and the qualitative elements we consider.

We rely on several valuation techniques, including: earnings power value, discounted cash flow analysis, comparables analysis, internal rate of return analysis, implied multiple calculations, and franchise value analysis. In our understanding, all valuation relies on asset value, cash flow, and the relationship between the two with regard to the stock’s price. To that end, we focus extensively on business metrics pertaining to asset value, cash, cash flow, and the returns a business can generate on both its existing asset base and on continued deployment of new capital.

Our Checklist:

To paraphrase the Innovator’s Dilemma: financial analysts have intuition for valuing resources, investors need intuition for valuing both resources and processes. It is in the processes that a company earns their franchise value. Our checklist is designed to decompose the important elements of both the resource value and the franchise value. In our checklist, we look at valuing the company’s income stream, the quality and value of its balance sheet, management’s business strategy and track-record on capital allocation, the industry’s competitive dynamics, the growth trajectory of the company, the ownership structure of the business, a look at any imminent catalysts, risk factors impacting the business, technicals of the stock price and behavioral questions.

Some factors we are attracted to include, but are not limited to the following:

  • A conservative balance sheet
  • Management that promotes from within, and has an incentive structure aligned with shareholders
  • Strong history of prudent capital allocation
  • Management that targets long-term corporate objectives over quarterly earnings
  • Intrinsic value increasing at a rate faster than that of the stock’s price
  • A business that has high switching costs and/or intense brand loyalty
  • A brand that increases the price consumers are willing to pay for the product
  • A bias towards capital-lean business models
  • Strong relationship with leverage over key suppliers

Our bias is towards companies that demonstrate growth at a reasonable price (GARP), and we think the traditional industry divide between growth and value wrongly implies that the two are mutually exclusive. Growth is a factor which provides an important margin of safety for long-term investments. In our ideal scenario, we can buy a company whose valuation is reflective only of its existing earnings power, with growth providing a call option of sorts to skew our returns asymmetrically in the positive direction.

Portfolio Construction:

We operate what we would call a moderately concentrated portfolio. We target 25 total positions, with a standard deviation of 5. Our top 10 positions will consistently account for around half of our portfolio. We sometimes build individual positions with more than one security (for example, we might own a stock itself and call options on the stock), though we view this as one position, not two for the purposes of our 25 position target. When we develop a broader thesis worthy of conviction, we will target a portion of our portfolio towards that thesis, but divide the allocation amongst several separate and distinct securities.

The typical approach to diversification is unidimensional, with little concern for the correlations or interrelations amongst those diverse elements. Further, much diversification willfully overlooks the fact that an overly broad allocation will inherently include investments unworthy of consideration. Our portfolio construction uses what we would call stratification instead. We want to stratify variables like sector, geography, duration of a given investment, valuation approach, yield and even our theses. We make sure that at all times, our portfolio has some kind of exposure to each unique given area. With regard to our theses, we think it’s important to diversify both the risk factors of all our investments and the upside factors that can drive performance. We constantly and dynamically test the dispersion of the factors that drive risk and reward in each and every position. Along these lines, we place a priority on diversifying the magnitude of risk across our positions.

Each position is analyzed in terms of the relationship between the probability of being right and the odds received in the tradeoff between risk and reward. In essence, we are applying the Kelly Criterion, a formula developed alongside Information Theory, designed for the maximum compounding of capital for a portfolio when the probability and odds can be quantified. The following visual provides some perspective on how the Kelly Criterion would size an individual position:

Risk Taking

The problem with using the Kelly Criterion alone in position sizing is that it leads to far too much volatility. As such, we use Kelly Criterion more to provide a binary yes/no indicator of whether the balance between risk and reward is worthwhile given our subjective understanding of the probability of a positive outcome. If we get a positive answer from our analysis, then we will make the investment.

We use three standard position sizes in our portfolio. Note that these position sizes are guidelines, not strict rules, and we allow for sliding scales in between each level. Also note that the actual factoring of the odds and probabilities is far more nuanced, for most investments are not binary in nature and there are degrees/magnitudes to which we can be right or wrong. Our aim is that in each situation, our reward is asymmetric to our risk. The following breaks down the standard characteristics of each investment, which falls within each bucket:

  • 5% positions are reserved only for our highest conviction ideas, with the greatest probabilities of a positive outcome.
  • 3% is our core position size reserved for investments where the balance between risk and reward is worthwhile. Typically we define such positions as situations where we can quantify our reward being $3 per unit of risk, with a probability of a positive outcome being in excess of 50% given our subjective understanding of the investment.
  • 1% is the default size we use when we encounter what we would call an extremely asymmetric opportunity, where the risk is absolutely (a position could end up being worthless), but the payout is above $5 per unit of risk and the probability is around 50%. We will never dedicate more than 5% of the portfolio to such positions.

At all times, cash is amongst the largest positions in our portfolio. We do this for the natural balancing effect it has in the cyclical, sine wave path of markets. When markets rise quickly, our cash balance as a percent of the portfolio naturally declines, encouraging us to think about selling a position in order to return cash to target levels. In declines, the cash balance as a percent of the portfolio increases as the portfolio drops. This encourages us to put more cash to work. This process is based off of Claude Shannon’s (the father of Information Theory) investment strategy built largely upon the rebalancing effect.

While we do not believe volatility itself is risk, we recognize the behavioral limitations of us humans to make prudent decisions in the face of volatility. To that end, we target a portfolio Beta of no more than 1 (inclusive of our cash position).

Risk Management:

Consistent with our emphasis on the Kelly Criterion we operate under the belief that risk = Hazard x Exposure, where hazard is our potential for being wrong and exposure is how much we stand to lose should an investment experience a loss. We do this analysis on both an individual security level and a portfolio basis, while our portfolio composition is designed to mitigate all of these risks as much as possible.

Each and every individual investment is analyzed intently to determine its potential risk on a fundamental basis. This risk is reassessed dynamically as time and events evolve. The portfolio is constructed in such a way as to limit the correlation of risks between investments. Our goal is to maximize the total number of risk factors our portfolio is exposed to, such that no one factor can inflict too much damage, and in doing so, we aim to help minimize the correlation amongst the performance in our positions over time.

We view risk management as a dynamic endeavor, which involves constantly testing and retesting any assumptions underlying our quantitative and qualitative analysis. We also view it as a systemic endeavor, whereby consistent and prudent processes in and of itself serve to mitigate overall risk.

Always move forward:

While these are our strategies and beliefs, we are constantly striving to improve ourselves and our processes. We believe wholeheartedly in Charlie Munger’s notion of “worldly wisdom” and the pursuit thereof, which calls for “building a latticework of models” to deploy in various situations. Our strategy overview starts with a description of markets as Complex Adaptive Systems because to us, it is essential to recognize how dynamic and subjective the process of valuation analysis and investment can be. Without recognizing this reality it becomes too easy to fall victim to the behavioral forces that operate on market participants every day.

Stated simply, we operate a GARP strategy; however, we believe our diverse set of models and diverse worldview make for a unique and robust approach that does not fit neatly into one label. Further, we believe our fully integrated approach of starting with a theory for how markets operate, executing a flexible but disciplined valuation strategy, and deploying holistic portfolio construction combine to create a positive feedback loop for compounding capital into the future.

Disclosures:

RGA Investment Advisors LLC (“RGA”) has provided these materials (together with any accompanying oral presentation and supplementary documents provided therewith, the “materials”) for information purposes only. The materials are not intended to be, and must not be, taken as the basis for an investment decision. The materials are necessarily based upon economic, financial, market and other conditions, and information available or provided to RGA, in each case, existing as of the date of this report (unless otherwise specified) and, accordingly, should be regarded as indicative, preliminary and for illustrative purposes only. In its preparation of the materials, RGA has assumed and relied upon, without assuming responsibility for independent verification of, the accuracy and completeness of all such information. RGA does not assume any responsibility for independent verification of such information and makes no representation or warranty, express or implied, as to the accuracy or completeness of such information. Although subsequent events may affect the accuracy and completeness of the materials, RGA assumes no responsibility for updating or otherwise revising the materials, and the delivery of the materials will under no circumstances create any implication that the information contained herein has been updated or corrected. The materials should not be construed as investment, legal, tax or other advice, and you should consult your own advisers as to legal, business, tax and other related matters concerning an investment decision. Past performance is not indicative of future results. The materials do not constitute an offer to sell or a solicitation of an offer to buy any security and may not be relied upon in connection with any purchase or sale of securities. Forward-looking information contained in the materials, including all statements of opinion and/or belief, are based on a variety of estimates and assumptions by RGA, including, among others, market analysis, estimates, projections and similar information available or provided to RGA. These estimates and assumptions are inherently uncertain and are subject to numerous business, industry, market, regulatory, competitive and financial risks that are outside of RGA’s control. There can be no assurance that the assumptions made will prove ac- curate. Neither RGA nor any of its affiliates or representatives has made or makes any representation to any person regarding any of the potential transactions described herein, including that any of such transactions can or will be completed or, if completed, that they will be completed on the terms described herein. The materials contain confidential, proprietary, trade secret and other commercially sensitive information, and shall be kept strictly confidential and not disclosed or disseminated to any other person or entity or used. The returns contained herein with respect to unrealized investments are being provided for informational purposes only and are not intended to be indicative of any future performance of such investments. IRR represents, on a net of fee basis, the aggregate compound annualized return rate (implied discount rate) attributable to the portfolio being referenced, which has been calculated using all cash inflows and cash outflows affecting the referenced portfolio.

 

February 2015 Investment Commentary: Long Term Investing

During the month of February we were lucky enough to get our hands on an investment book called 100 to 1 In the Stock Market: A Distinguished Security Analyst Tells How to Make more of Your Investment Opportunities.[1] Since the book had been out of print since the early 1970s and a well-capitalized, smart cadre of investment professionals took a cult liking to it, prices on secondary markets soared. As little as three months ago, copies were exchanging hands at over $600 on Amazon. This January, the publisher authorized a limited release of new copies for $40 each. We quickly pounced on the opportunity and could not be happier that we did.

A slight digression: The process through which we ended up buying this book is not too dissimilar from how we invest in stocks. We do not simply research cheap companies which satisfy our criterion. Rather, we research many companies, with an emphasis on those that have quantitatively clear business quality; a sustainable competitive advantage if you will. Many quality businesses trade at prices and valuations that we would never pay. Yet in performing our extensive research, we build the knowledgebase necessary to pounce on an opportunity if and when it may present itself. We believe it is far better to be prepared and ready for a situation than to simply react to it. With a double-dose of patience and discipline, opportunities inevitably present themselves.

100 to 1 was written by Thomas William Phelps, a man whose career in investments started on the eve of the Great Depression. Phelps wisdom accrued through years of writing and editing for the Wall Street Journal and Barron’s, working in the finance departments of du Pont and Socony Mobil Oil, and at several investment firms through the years.

One of the foremost lessons to take out of this book is the need for patience and discipline in the stock market. This is a point we will continue to emphasize. Markets gyrate. Nothing aside for fraud travels in a straight line. Growth, in particular, is lumpy over time. Howard Marks has offered this quote from Rudiger Dornbusch which carries much wisdom: “In economics things take longer to happen than you think they will, and then they happen faster than you thought they could.”[2]

However, in finding 100 to 1 stocks, there is no avoidance of the elements of time and patience. It takes 35 years compounding at 14% annually, 30 years at 16.6%, 25 years at 20%, 20 years at 26% and 15 years at 36%. To earn these returns requires extremely persistent increases in the intrinsic value a company. More realistically, as Phelps outlines, it requires a combination of persistent increases in intrinsic value alongside the market’s rerating of the company’s prospects. By this, we mean the multiple the market is willing to pay for the company’s earnings must increase alongside its intrinsic value. This is something we have talked of frequently—the two sources of return in a stock.[3],[4] On the one hand you have the company’s cash flow yield and on the other you have the multiple the market is willing to pay. Both sides are dynamic: the cash flow yield and the multiple both can rise and fall. However, those companies that make it to 100 to 1 will by nature have to increase both consistently.

A second lesson is how often history repeats itself. There are certain constituencies with loud voices in the financial community whose volume simply does not fade across the decades. These groups, in no particular order are: the dollar doomers, the peak-Americanists, the valuation alarmists, the inflationistas, the Gold bugs, etc. There are however two steady constants: if your timeframe is long enough, equity markets in aggregate will go up; and, across all timeframes there are outstanding companies who prosper in markets good and bad. In perusing the Amazon reviews of 100 to 1, there are a few negative reviews that bemoan the lack of a clear-cut recipe to finding such stocks. Such reviews are amusing and reminiscent of the proverb: “Give a man a fish and you feed him for a day; teach a man to fish and you feed him for a lifetime.” The key takeaway from the book is the proper mindset that should be adopted in thinking about the stock market. It is no wonder that many of the most powerful concepts from Warren Buffett and Charlie Munger seem to have their origin in this book. Some of these concepts range from the idea of buying only stocks that you would be content to own were the market closed for 10 years, to Munger’s “tell me where I’m going to die, so I won’t go there.” It is also no wonder that many Berkshire observers note and study how “in the early 1970s, Berkshire slowly but very significantly changed its business strategy.”[5]

The optimism inherent to Buffett’s investment philosophy and the very idea of “Buy American” have their distinct origins in this book. We would urge everyone we know, whether client or fellow investor to read this book and grasp some of the profound lessons on the long-term power of compound interest and patience. These past few years in the markets have seen a rapid rise in asset prices. It is simply impossible for this rate of ascent to continue in perpetuity, but it is equally important to remember that as they say, “no one rings a bell at the top.” No top is “the” top. Great companies do great things regardless of market highs and lows, because they are incented and driven to do so. To that end, we are constantly aware of the bigger risks facing the economy and the stock market, but focus the vast majority of our research on understanding the actual drivers of the businesses in which we invest.

Thank you for your trust and confidence, and for selecting us to be your advisor of choice. Please call us directly to discuss this commentary in more detail – we are always happy to address any specific questions you may have. You can reach Jason or Elliot directly at 516-665-7800. Alternatively, we’ve included our direct dial numbers with our names, below.

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF
Managing Director
O: (516) 665-7800
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-7800
M: (516) 729-5174
elliot@rgaia.com

Past performance is not necessarily indicative of future results.  The views expressed above are those of RGA Investment Advisors LLC (RGA).  These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views.  Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice.   The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria.  In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed in item (i) were purchased. (iii) The date or range of dates during which the securities listed in response to item (i) were purchased.

[1] At the time of this writing, 100 to 1 (paperback) is listed as ‘In Stock’ at the following web link

[2] http://www.oaktreecapital.com/memo.aspx

[3] The prelude to our 2013 Outlook contains an explanation on the role of a change in the market’s multiple on long-term return: http://www.rgaia.com/wp-content/uploads/2013/08/December-2012-Investment-Commentary.pdf

[4] Our description of “actively passive” investing highlights some of the principles of long-term investing that attract us to the 100 to 1 philosophy http://www.rgaia.com/october-2013-investment-commentary-our-actively-passive-investment-strategy/

[5] http://fortune.com/2015/02/28/berkshire-after-50-years/

January 2015 Investment Commentary: Pursuing the Energy Sector for Value Opportunities

The month of January saw a continuation of 2014 year-end market trends. Crude oil continued its decline, shedding another 12.5%. Energy-induced volatility helped drag down the equity indices, with the S&P dropping 3.0% and the Russell 2000 losing 3.3%. The 10-Year Treasury started the month yielding 2.17% and ended at 1.68%. Between the fall in the 10-Year Treasury yield and the fall in the S&P 500, last month marked a notable stock market occurrence. January 2015 will go down in the history books as just the fourth time since 1960 that the yield on the S&P 500 exceeded that of the 10 year Treasury.[1]

This is unquestionably a notable moment for the market. Context is particularly important. To that end, let’s examine the historical ratio of the 10-Year Treasury yield to the S&P 500’s dividend yield:

Screen Shot 2015-02-06 at 3.09.06 PM

                     (Source: Bloomberg)

Note that for most of the period between 1980 and 2007 the 10 year Treasury yield was between 2.0 times and 2.9 times that of the S&P 500. Many view this as a perversion, or distortion imposed on markets by the Federal Reserve Bank’s low interest rate policy. That may be a worthwhile debate for policy analysts to have (we think concerns about low rates are misguided, but that has been a longer conversation that we will leave out of this particular commentary), but as asset managers we must deal with the world in front of us irrespective of whether we think it is justified or not. Lower interest rates have a huge effect on companies. Too many express their disdain for lower rates alongside the boost they give to valuations without considering the micro consequences.

It is thus worth examining stock market performance after past incidence of this same yield crossover, as Bespoke Investment Group recently did:

Screen Shot 2015-02-06 at 3.09.19 PM

                   [2]

Note that each time the yield of the S&P 500 exceeded that of the 10-Year Treasury, the S&P has rallied strongly over most timeframes. A sample size of three is certainly not a robust data set; however, it is worthwhile to think about why this situation has been good for stocks in the past. A huge pool of global assets is managed with a pre-defined split between stocks and bonds that is rebalanced when allocations veer too far in either direction. As Treasury yields make a big move lower, the principal value rises. When this happens alongside a sideways or down stock market, there is a powerful bid in stocks from the reallocation. Further, consider the decision certain allocators who may not have pre-defined stock/bond splits but do have annual income targets face (an endowment fund might be an example of this). When the yield on the S&P is greater than that of longer-dated Treasuries, one can make more progress on your income goals, while adding potential capital appreciation to the portfolio in the stock market. As shown above, this opportunity does not present itself very often. The risk side of the coin is that such a fund may have more volatility in its value; however, a long timeframe mitigates that problem to an extent. None of these situations are clear-cut. Certainly many active allocators faced with such a dilemma make differing choices based on their own institutional constraints, but this effect is unquestionably a stimulus to stocks.

In a blog post last year written by Elliot Turner and David Doran, they explain this effect:

One must be a realist and look at the actual, factual influence that interest rates play in the cost of capital for a company. Low interest rates, as is evidenced in various arena, allow borrowers to tap into capital at a lower cost. Rates at some point will eventually rise and raise the cost of capital. However, given the length of time of low interest companies had ample time to finance themselves cheaply and lock in rates for the long-term. The early years in a rising rate regime will be somewhat mitigated by companies already having secured low rate financing….

Complain all you would like about interest rates being “artificially” low, but the reality of the situations is clear. So long as companies can and do tap into lower cost sources of capital, then the returns available to those companies will rise accordingly. We will let academics handle the debate about how and why interest rates are so low and instead we will focus on business analysis and looking at the ways in which low interest rates tangibly alter the math in valuing companies.[3]

What’s New?

In our 2015 Investment Outlook, we explained that we will no longer write out our leaders and laggards on a quarterly basis.[4] We asked for suggestions of better ways to incorporate an overview of the companies in our portfolio and particularly liked one suggestion we received from a client to briefly review new positions as we initiate them in portfolios.

Howard Hughes Corp (NYSE: HHC)

In perusing the energy sector for value opportunities, we asked ourselves “what are some companies or sectors that have been unjustifiably punished alongside the carnage in oil?” The answer had us exploring several alternative energy companies, a few banks, and one real estate company that looked particularly attractive: Howard Hughes Corp (NYSE: HHC).

Howard Hughes came into being as a carve out from General Growth Properties’ bankruptcy reorganization. The founder and Chairman is Bill Ackman, one of the best hedge fund managers today. Ackman and insiders own about 13% of the company, with Horizon Kinetics owning 13% awe well. In other words, there is a stable, long-term oriented investor base.

HHC owns several unique properties that are undergoing transformations right now, making it very challenging to model exactly what their future income stream will look like. Regardless of the exact path, we do know there is immense value. Overall, the risk long-term is fairly low, though when and how the upside materializes is challenging to say with precision., This is a company that cuts at the distinction between risk and uncertainty, where risk is defined as situations in which we know what the distribution of potential losses looks like, while uncertainty is when we do not know what the distributions look like. We like low risk, high uncertainty situations where it’s clear there will be value, but unclear exactly how much.

The properties, in order of their potential value that attract us to this situation are: the South Street Seaport in Manhattan, the Woodlands in Houston Texas and the Ward Center in Hawaii (which the company describes as their “crown jewel.” In addition, HHC owns a slew of other properties, including a valuable Master Planned Community in Howard County, Maryland and major tourist attractions like the Riverwalk in New Orleans. The South Street Seaport is undergoing extensive renovations and will be re-leased to premium shops starting in late 2016, early 2017. It is conceivable that five years down the line, the Seaport alone, with its potential 600 square feet of leasable space ends up worth more than the entire market cap of the company today.

The Woodlands in Houston is one of the finest Master Planned Communities in the country, yet, this property is specifically why the stock has been so hard hit of late. The company’s own build-up of net asset value and analyst estimates put a value on The Woodlands at near one-fourth of HHC’s total asset value. Houston is associated with the energy boom and people fear there will be further pain for energy companies. Mr. Market has essentially written off the value of the Woodlands. While we do think energy companies are in for a tough go, it is important to think about who HHC’s tenants will be. Exxon’s new 10,000 acre campus is starting to open and will be fully operational next year. They are pre-committed to a lease that will generate $15m in annual net operating income for HHC. Exxon’s credit, despite the energy woes, is as good as they come. Some neighboring residential properties may be at risk of lower realizable values, but the market has simply moved too aggressively in discounting HHC’s “energy exposure.” All in all, we think the energy-related risk is largely overstated, and the elite properties the company owns in Houston will yield considerable growth down the line.

The Ward Center in Hawaii already generates over $25m in annual net operating income. More interestingly HHC is building residential developments that have pre-commitments of purchase for 75% of the units. Deposits already in (which are counted as liabilities today, but will shift over to revenue once done) are over $100 million, with purchase commitments of over $700 million. There will also be additional commercial space available for lease.

As of today, HHC is not organized as a REIT. This is so because the company is using its income in order to invest in these transformational properties. This is a shrewd move, as it affords maximum flexibility to take advantage of the over $300m in net operating losses received in the carve-out from GGP. Once the transformations are done and the NOLs are used, the company then can convert into a REIT, which will greatly lower their cost of capital and turn HHC into an excellent yield vehicle to own. As we have done with several investments, we like to look at the out-year earnings and yield potential and see a huge opportunity for time arbitrage.

Thank you for your trust and confidence, and for selecting us to be your advisor of choice. Please call us directly to discuss this commentary in more detail – we are always happy to address any specific questions you may have. You can reach Jason or Elliot directly at 516-665-7800. Alternatively, we’ve included our direct dial numbers with our names, below.

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF
Managing Director
O: (516) 665-7800
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-7800
M: (516) 729-5174
elliot@rgaia.com

Past performance is not necessarily indicative of future results.  The views expressed above are those of RGA Investment Advisors LLC (RGA).  These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views.  Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice.   The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria.  In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed in item (i) were purchased. (iii) The date or range of dates during which the securities listed in response to item (i) were purchased.

[1] http://www.marketwatch.com/story/stock-dividend-yields-are-above-treasury-yields—-and-thats-bullish-2015-01-20

[2] http://www.raymondjames.com/images/inv_strat/150120_5lg.gif

[3] http://compoundingmyinterests.com/compounding-the-blog/2014/2/27/the-markets-betting-line-a-look-at-implied-growth-1.html

[4] http://www.rgaia.com/december-2014-investment-commentary-our-2015-investment-outlook/

December 2014 Investment Commentary: Our 2015 Investment Outlook

The big events of 2014

In 2014, the S&P 500 returned 11.4% in what appears like a steady continuation of the bull market that began in March of 2009. This is somewhat misleading. Some of the broader and global indices are more representative of what the year was like in equity markets: the Russell 2000 returned 3.5% during the same time-period, while the MSCI World Index eeked out a 2.9% gain. The year started with Emerging Markets showing signs of trouble, dragging down the S&P alongside.[1] Momentum stocks rallied aggressively early on, before a blow-off top in late February.[2][3] Momentum issues then experienced a rapid unwinding to much lower levels. The recovery in these stocks has been disparate and for the most part, tame, with biotech the notably strong exception. Commodities collapsed throughout the year with iron ore looking particularly bad throughout.  Meanwhile, crude oil’s late year slide stands as one of the most notable market moves which will surely have consequences for years to come.[4] The U.S. dollar rallied mightily to multi-year highs in the second half despite prognosticators perennially declaring its death.  Absolutely no one predicted interest rates would fall in 2014, but fall they did.

2014 was a year in which the unpredictable happened frequently, with almost an air of predictability. It was a year filled with proverbial minefields where most investors were forced to “dodge bullets” more so than generate significant returns. Our 2014 outlook proclaimed, “it is quite possible, almost probable that 2014 will be a better year for the economy than it will be for the stock market.” Despite the S&P’s double-digit return, we think the story played out largely along these lines. Our 2014 outlook further explained that, “While we did not see the economy’s traditional metrics of success reach ‘normalized’ levels in 2013, it has been clearly positioned for the long awaited, but elusive escape-speed breakout from the Great Recession.” Weather threw a wrench in the economy’s trajectory early in the year, but once that headwind lifted, a crescendo of accelerating growth commenced.

For the most part, 2014 concluded with the U.S. economy on as solid a foundation as it has been in years, though we continue to expect markets to be weak and volatile compared to the economy. It is important to remember the economy and the stock market do not necessarily move in tandem. In our notes below we will both cover what has happened in the recent past and what we are prepared for moving forward.  Take any remark about the future with a grain of salt, for we perceive these expectations as a series of hypothesis from which we structure our portfolios, but never lever them to. We think it is extremely important to remain flexible enough to revise any thesis; as John Maynard Keynes once said, “when the facts change, I change my mind. What do you do sir?” Our investment decisions are always based on the bottoms-up fundamental analysis we do on individual companies; however, these macro questions provide an analytical framework through which we can hone in on areas with promise and avoid undue risk.

A visual overview of stocks and the economy:

Earnings (not the economy) drive the stock market:

Many complain about the market’s strong performance relative to the economy since the March ‘09 bottom.  We think this perspective is flawed due to incompleteness and ideology.  A common gripe maintains the market’s performance is merely the outcome of aggressive monetary policy.  Cause and effect in markets is never simple and always dynamic. Such a simplistic argument ignores the most significant long run driver of stock markets: earnings. Since the March bottom, the S&P has closely tracked the trajectory of its earnings per share, with earnings actually leading the way most of the time.

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Importantly, this is the most significant driver of stable stock returns over the long run. Take a look at the S&P verse earnings since 1960. The index has deviated over time, most notably in the dot.com bubble era; however, each deviation has been met with the market reverting back towards a steady trajectory relative to earnings. Recently the market has moved slightly ahead of earnings, yet once the fourth quarter of 2014 is reported this will look more benign. Further, this discrepancy will be relatively small such that it can be worked off with the kind of volatile sideways action we expect.

2

Industrial production is surging which supports the rise in EPS. Notice that the chart below looks a little like the S&P (though with a more persistently positive slope). Also notice how severe the impact of the Great Recession was on production. It’s worth repeating yet again that this was no run-of-the-mill recession. This one chart is great proof that this recovery is real and the claim that this is merely a result confined to asset prices is wrong.

3

(Source: https://research.stlouisfed.org/fred2/graph/?graph_id=74717&category_id=)

The Strong Dollar Yellen Fed (take THAT conventional wisdom):

In the same vein that people complain about the market’s performance verse their perception of the economy; they similarly bemoan the impact monetary policy is expected to have on the value of the dollar. To that end, people have been calling for the demise of the dollar, dollar doom, and the end of the dollar as a reserve currency. Remember when it was conventional wisdom that the U.S. dollar had only one way to go and that was down?  In 2014 the dollar reached its highest levels on a trade-weighted basis since before the Financial Crisis (below).

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This all happened despite the growth in money supply and is contrary to what textbook economics says will happen in a vacuum. People point to a plethora of reasons behind this move ranging from a flight to safety out of struggling global economies, technical trading action, a strengthening U.S. economy, and a divergence in monetary policy between the US and the rest of the world. As is often the case, no one reason is the answer—a little bit of each of these factors adds up to a strong move.

Will 2015 hammer the final nail in the “secular stagnation” meme?

One thing economists look at to measure the depths of the Great Recession is called the GDP output gap. In the chart below, the spread between the two lines represents the degree to which the economy is underperforming its potential. Notice how closely the blue and red lines tracked each other until the Great Recession. This was distinctly not a run-of-the-mill recession.  When people speak of “secular stagnation” they mean the blue line will permanently stay below the red line. Further, they mean the red line should be redrawn to reflect a new permanence to the lower growth trajectory (as it has in below). Though the blue and red have yet to converge, 2014 went a long way towards easing concerns that they never will. The efforts taken by policymakers to counteract the Great Recession have the economy legitimately on track to recoup all of the lost ground. We believe that in the coming years convergence will in fact occur and only then will we need to worry about when, where and how the next recession happens. Importantly, we think the next recession will come from an economy that accelerates too much and must be slowed down via a tightening of monetary policy, rather than one where a credit contraction puts us on the precipice of deflation. In other words, the next recession will be of the run-of-the-mill variety, which are never fun, but are far less troubling than once-in-a-lifetime financial crises.

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(Source: http://research.stlouisfed.org/fred2/graph/?g=VWx)

A clean balance sheet with a solid foundation for growth:

One of the most constructive factors in our outlook several years running has been the status of debt service payments as a percent of disposable income. Previously, we explained how two important catalysts fueled the decline in debt service: first, the impact of deleveraging; second, the impact of falling interest rates. While many remain unsatisfied because gross debt levels have not contracted significantly, this need not happen when the service of debt becomes consequentially cheaper.  Debt burdens remain at generationally low levels and increasing confidence on the household level can go a long way towards maintaining the momentum of the economy.

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(Source: http://research.stlouisfed.org/fred2/graph/?g=VWn)

Further, sectoral leverage in each component of the private sector continues to improve. 2014 saw notable continuity in the financial sector and household sector components’ leverage, while the corporate sector’s debt levels increased slightly. Importantly, it is the corporate sector that has the greatest capacity for increased leverage. This is but one of the forces underlying the rise in activist investing this past year and the consistently large share repurchases from companies the past few years. Note that these numbers are as a percent of GDP, so while gross leverage did increase in all areas, it was grew at a slower rate than GDP. This highlights the importance of speaking about debt in the context of GDP and the significant role that nominal GDP growth in particular can play in mitigating the damage inflicted by the kinds of excessively large debt burdens present prior to the financial crisis.

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(Source: http://research.stlouisfed.org/fred2/graph/?g=VWA)

Job security is high and Millennials are finally finding their way out of the basement:

The unemployment rate started 2014 at 6.6% and as of the end of November was at 5.8% (as of the time of this writing we do not know the December number). While many focus on the unemployment rate exclusively, we find more value in looking at the four-week average in continuing claims. This is a higher frequency number, but also has fewer moving parts. Continuing claims are hovering at incredibly low levels indicating those who are employed are maintaining employment and the supply of potential new hires is becoming increasingly scarce:

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(Source: http://research.stlouisfed.org/fred2/graph/?g=VWt)

One of the groups hardest hit by the Great Recession were the young adults of the Millennial Generation. 2014 will mark the year that the Millennial employment situation finally took a turn for the better. This bodes well for the economy. Demographically, this age group will have to foot an increasing burden of consumption and investment in order to maintain the long-term growth orientation of our economy. The lack of household formation has been a big force holding back the economy. Household formation results in increased demand for dwellings, an area that generates considerable investment and a high multiplier of follow-on spending. In order for household formation to recover, we need the youngest generation of workers to find lucrative, productive and enduring jobs.

Further, household formation is a necessary precursor to an improvement in the birth rate. Birth rates took a severe hit during the Great Recession and as of 2013 had not bottomed yet. While data on a national level is slowly aggregated and we will not know the final birth rate for 2014 until one year from now, we strongly believe this was the year that the birth rate did in fact bottom. Nothing gets Americans spending like buying a new house and making babies. It is no coincidence that economic booms have come alongside demographic booms (and vice versa).

9

(Source: http://research.stlouisfed.org/fred2/graph/?g=VWu)

Some deeper thoughts on monetary policy:

We have long maintained the end of the aggressive monetary policy deployed to stave off a deeper crisis would not be a cause, but rather would be an effect. The distinction is important. While conventional wisdom holds that the Fed normalizing policy could lead to volatility in financial markets, we think this misses the point. There will always be volatility around inflection points. More importantly, the Fed normalizing policy will be an acknowledgment that the economy has legitimately accelerated and the financial crisis was comfortably left in its wake. As the Fed has maintained all along, normalization will come with “escape velocity” from the crisis period.

In other words: normalization of Fed policy will be a reflection of a “normal” economy; not an imposition of risk moving forward. To that end, while we think some volatility would be normal; volatility in and of itself is not risk (contrary to the efficient market hypothesis).

It is never comforting to say something that can be perceived as “mission accomplished” in financial markets in particular; however, we think it’s safe to say that right now the Fed has successfully staved off the risk of deflation in the U.S. economy. That does not mean there is no risk from monetary policy moving forward. It does mean that longer-term, the biggest risk for the economy is inevitably heating up to an uncomfortably, unsustainable pace with inflation the unfortunate byproduct. This cannot and will not happen until the output gap discussed above is closed. Or alternatively, it could mean that the Fed tightens a little too early thus staving off a fuller recover before it can materialize. We welcome the Fed’s insistence that further action will be “data dependent” for it is important to remain flexible in the face of a dynamic situation.[5]

The death of commodities as an investable asset class:

This is one of the most consequential happenings of 2014. While many are looking for some kind of normalization and a return to a higher price range on key commodities like oil, we take a different perspective. In our estimation, this past year is a “regime change” (we are using this phrase with the economic, not geopolitical meaning) of the variety that happens only once a decade or so. Commodities experienced a decade where demand grew quicker than supply. Demand came from a combination of surging infrastructure investment in the developing world and increasing financialization in the developed world. This put upward pressure on commodity prices during the entire period and climaxed in a wave of neo-Malthusians calling for “Peak Oil” and a permanence to the high prices of commodities.

The problems with Malthusianism are many, with the biggest misses obvious in hindsight. High prices were premised on demand growth consistently outpacing supply.  While demand continues to grow, the rate of growth has slowed down.  More importantly, high prices led to investment in increased supplies and technologically based alternatives (with fracking being an intriguing combination of both supply-driven investment and technological innovation).

The concept of regime change is not receiving the due respect it deserves; though, this is typical. When something lasts for a decade—as the surge in commodity prices has—it is far easier to extend a trend in perpetuity than to position for a reversion to a longer cycle (think 100 years) mean. The status quo of a decade long trend is mentally challenging to part with. Yet, in reality, a “permanently high plateau” in prices (sorry for the misappropriation of the infamous quote Irving Fisher quote, but it perfectly applies here) as had been called for in commodities is the exception, not the norm.[6]

Consumers will feel the savings from cheaper commodities in many different ways. While some worry about the lack of CAPEX spending that results both directly and indirectly from investment in commodity supplies, the benefits in nearly all respects outweigh any reason for concern. This is most evident in the price of gasoline at the pump:

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(Source: http://research.stlouisfed.org/fred2/graph/?g=VWk)

In the coming year, global citizens will spend far less on fueling their cars, heating their homes and powering their electronics. This money will be split between increased spending in other areas and increased savings. The benefits of cheaper oil will be most pronounced for households with the highest marginal propensity to consume. Such spending has a high multiplier for the economy and down the line will provide a strong buoy for growth.

What now serves as an unexpected consumer surplus ready for spending or investment formerly was profit margin for energy producers.  With much of the world’s oil supply dominated by state-funded enterprises, these funds were not spent or saved in a way that was beneficial to the U.S. economy. In many respects, the producer surplus these sovereigns enjoyed were wasted as reserves hoarded to accomplish monetary, fiscal and ideological policy goals. Hoarded reserves act as a suppression of demand. With oil producers now forced to dip into their stashed savings there will be a new round of dollar-based savings unleashed as demand. Latent, in other words, will turn patent.

2015: The year Europe finally embraces policies for growth?

For a long time the powers that be in Europe wanted a cheaper euro. Today we have that cheaper euro, yet its actuality is stoking fears amongst investors and pundits alike. The surest sign to us that these fears are unwarranted comes from the convergence in sovereign interest rates across countries (excluding Greece)

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This purple line on this chart is the important one for it represents Germany’s 10-year bond yield. The white line is Spain, the yellow is Portugal and the green is Italy. During the depths of the crisis, there was huge space between Germany and the other three countries. This divergence in yields represented the risk premium the market was assigning to Spain, Portugal and Italy relative to the safest European country—Germany . While only Spain is now an equal of Germany as far as 10- year yields are concerned, Italy and Portugal have moved a long way towards convergence.

This is a fundamental change for policy endeavors moving forward, and private sector credit access and stability. The fears today are primarily about growth, whereas the fears yesterday were about viability. In the peak of the European crisis, policy efforts focused on taking the euro from the brink of demise to some kind of stability. Today’s efforts can be aimed towards growth without the overhang of collapse. Clearly at some point a lack of growth can become a problem that imperils viability; however, that is a two-step process whereas before the Eurozone was literally staring at the abyss.

While 2015 begins with many fearful of another acute phase of crisis for the content, we are much more sanguine. Notice however that we left our preface to this section an open question rather than a statement. We are quite confident that Mario Draghi will do what is necessary at the ECB; however, in a high stakes situation with national pride on the line, one can never speak with absolute certainty. The fact is, despite Europe’s lackluster economic environment today, the earnings outlook for European companies is improving significantly on the backs of a weakening currency (this is a huge boon to exporters) and some catch-up demand on durables. Per Barron’s, the range of the earnings growth outlook in Europe runs from six to thirteen percent.[7]  Notably, the low-end growth would high enough as to warrant material multiple expansion in European markets. We see evidence of upcoming growth with several of the continent’s weakest markets experiencing rising car sales for the first time in over half a decade.[8]  We will continue to maintain our overweight posture to Europe with a focus on high quality, global companies.

Yield trade is reaching its limits:

In this low rate world, people have searched for yield wherever they can. Vehicles like MLPs and REITs, and safe areas like utilities and consumer staples have become incredibly popular for their stable, growing yields. Needless to say, these yields are as compressed relative to their historical ranges as can be. To simplify this point, there is literally no upside left from further yield improvement. All upside must come from growth here on out. Meanwhile, growth is threatened in many ways for the two most popular yield trades. Energy infrastructure benefited from a massive build out that was reaching its limits even before oil collapsed. With growth CAPEX set for a severe cut from the energy industry, there is little reason to expect upside from the extremely popular retail trade long the energy-MLPs. This is an area in which we foresee much pain.

In utilities, the business model is under its biggest threat in years—this threat is two-pronged. Energy consumption has been on the decline for the first time in ages as investment in technological efficiency come to fruition. Further, new sources of energy like solar change the nature of the game. Utilities must pay to maintain the grid for energy distribution, yet do not get the revenues commensurate with that portion of energy consumption. While solar is still in its early stages of adoption in the US, it is accelerating tremendously and its potential disruption is growing nearer. The valuations in utilities are downright frightening heading into 2015.

What do we own?

While the New Year period is an arbitrary time to review the past and look towards the future, we welcome any good opportunity for reflection. At the end of Q1 2013 we introduced this section featuring our three best and three worst performers. As time marches on, due to our limited turnover and the presence of a few volatile securities within our portfolio of 25-30 holdings, this section has functioned differently than our intent.  Specifically, the same few securities have ping-ponged back and forth between the leaders and laggards, leaving us covering the same companies over and again.  Moving forward, we will simply list our three best and worst performers each quarter, while focusing the written portion of this section on our one or two favorite ideas that we subjectively determine are worthy of elaboration. A great subjective determination would come from a client request to cover a given security, so we welcome any and all feedback on a) how you would get the most value out of this section; and, b) what specific stocks you would like to learn more about.  Please do reach out to us with any thoughts or suggestions.

The Leaders:[9]

Platform Specialty Products (NYSE: PAH) +64.0%

Teva Pharmaceuticals (NASDAQ: TEVA) +48.7%

Walgreens Boots Alliance (NASDAQ: WBA) +33.9%

The Laggards:

UCP Inc. (NYSE: UCP) -26.8%

Siemens AG (OTC: SIEGY) -16.7%

The New York Times Co (NYSE: NYT) -15.7%

Thank you for your trust and confidence, and for selecting us to be your advisor of choice. Please call us directly to discuss this commentary in more detail – we are always happy to address any specific questions you may have. You can reach Jason or Elliot directly at 516-665-7800. Alternatively, we’ve included our direct dial numbers with our names, below.

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF
Managing Director
O: (516) 665-7800
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-7800
M: (516) 729-5174
elliot@rgaia.com

Past performance is not necessarily indicative of future results.  The views expressed above are those of RGA Investment Advisors LLC (RGA).  These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views.  Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice.   The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria.  In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed in item (i) were purchased. (iii) The date or range of dates during which the securities listed in response to item (i) were purchased.

[1] RGAIA January 2014 Commentary: Emerging Markets, Discounting the Obvious http://www.rgaia.com/emerging-markets/
[2] RGAIA February 2014 Commentary: Rational Expectations Through Pockets of Momentum http://www.rgaia.com/pockets-of-momentum/
[3] RGAIA March 2014 Commentary: Flushing Out Momentum http://www.rgaia.com/flushing-out-momentum/
[4] RGAIA October 2014 Commentary: Flooded in Oil http://www.rgaia.com/october-2014-investment-commentary-flooded-in-oil/
[5] http://www.businessinsider.com/janet-yellen-press-conference-sept-17-2014-9

[6] https://www.youtube.com/watch?v=y4oMStJevCw

[7]http://online.barrons.com/articles/european-stocks-could-rise-10-1419655992?mod=BOL_hp_we_columns
[8]http://www.inautonews.com/europe-car-sales-up-in-december-in-spain-and-italy#.VKrhPmTF8lQ
[9] Please note: these are not the 2014 returns for each security. Returns are reflected from our point of purchase or sale and only cover our holding period.

November 2014 Investment Commentary: The oil investors who don’t even know it

Last month we commented on the swift decline in oil prices and its consequences on the economy and your portfolios. This was by far our most read commentary to date, so we thank all of you who shared our note with your friends. We have yet to speak of the same topic two months in a row, though given the broad level of interest and immense market impact, we feel this topic is worthy of continuation. Our last commentary left off with the notion that this “new lower [price] level [of oil] is just beginning” and sure enough, the oil crash of November made October look tame. When all is said and done, this will stand out as one of the most consequential market moves of 2014. The primary US benchmark for crude oil dropped 17.7% in the month of November alone. In order to fully explain the implications of oil’s move on markets and the economy, we would like to debunk one of the primary myths related to oil’s present drop and further explain what will likely be the biggest second-order risk out of the energy route.

We are going to discuss second-order consequences/risks in the narrative below, but what exactly are we referring to? People (and investors) focus on the immediate result of an action (for example, “My business is running a loss so I decide to cut expenses in order to increase profitability”). Actions, however, often have unintended second-level consequences beyond the primary scope and intent of the actors (often separated by a duration of time). Consider our first example above about cutting expenses to boost profitability (First order consequence) — “Due to staff reductions, my business was unable to adequately serve its clients – we lost 30% of our customers in the 12 months to follow” [Second order consequence]. While our example reflects a favorable intended consequence, it results in an unfavorable second-order consequence.

This example decision maker failed to consider alternative results from his original decision. Many decision makers in his position fail to consider the gravity of second-order consequences on their decision-making in a competitive market. Often (and certainly in the investment realm), successful businesses recognize potential second and third order consequences early and mold their decision-making around such information. This is part of what we mean when we speak of the investment world as a “complex adaptive system,” whereby relationships between agents and actions are dynamic and impactful upon each other. This also evokes key elements of game theory, where decision-makers must consider the rationality of their adversaries and the scope of the potential outcomes. The situation in oil markets right now is your classic prisoner’s dilemma and deriving the intent of various actors is important in thinking about future consequences.

The Myth of the Saudi Squeeze:

Things were already looking bleak in oil markets when a Thanksgiving Day OPEC decision to maintain production levels sent prices spiraling downward.[1] Since then, conventional wisdom has developed a narrative around how Saudi Arabia is purposely pushing the price of oil lower in an effort to drive US oil producers out of business.[2] This narrative is complete bunk on many levels.   Understanding why is important for thinking about the second-order consequences in this context.

Many OPEC members face considerable risk amidst lower prices. Last month we did the back of the envelope explanation for why Russia (a non-member, but large producer) could not cut its own oil output. This story about budgetary problems is no different for the likes of Venezuela, Iran, Iraq and the United Arab Emirates, all actual members. Two of these parties—Iran and Iraq—are in the process of ramping production as they are presently under-producing their quotas. Given this reality, where is there room for production cuts? All cuts would thus fall on Saudi Arabia. In effect, when people speak of OPEC production cuts, they are implying only Saudi Arabian production cuts.

Put yourself in the shoes of Saudi Arabia for a moment. If every other nation-state producer will not just maintain, but rather ramp production, why would you be the one and only state to cut production? Take this thinking one step further: when one of your sworn enemies with whom you are fighting what some consider a proxy war with (Iran) is in position to ramp production, why would you yourself cut back in order to give your enemy a better price and thus more money? It stands as no surprise that as the decline in oil prices accelerated, Saudi Arabia intimated they too would be willing to cut production if and only if others would follow suit.[3] Needless to say, this clearly is not happening.

This myth is important to debunk because, were it true that Saudi Arabia is merely trying to push out fringe energy producers (particularly in the U.S.), the price decline could be deemed merely temporary. If, on the other hand, production cuts are not happening because no one producer can cut production, our world is truly awash with supply. A world awash in supply is one with sustainably lower prices. When we wrote our commentary last month, many investors were still operating under the belief that oil prices were temporarily low and would soon rebound. Today oil prices are roughly 17% beneath last month’s prices and only now are people revising expectations to project October as ‘normal’. In our perusal of opportunity in the energy space, we have yet to encounter investors and analysts pricing in the potential for today’s actual prices to be anything other than temporary. Until that happens, there remains considerable room for further pain in portfolios overexposed to energy.

The oil investors who don’t even know it:

Speaking of overexposed—what if investors had significantly more energy exposure than they realized? In August we spoke about the rise of indexation and the opportunities it creates for active investors.[4] Passive investment has become increasingly popular in recent times with the aim being to capture the risk premium of various asset classes. The problem is that index inclusion criteria and the direction it takes are not necessarily consistent with the idea of maximum diversification and limited risk.

In October, we attributed some of the market’s selling to carnage in the energy space, with the quote worth repeating here:

… many portfolios globally were very long oil on the heels of its success over the prior decade. Alongside this current, many oil companies levered their capital structure premised on the expectation of consistent, if not higher oil prices. With oil prices now souring, many assumptions have to be revisited, leading to a de-risking, and forced selling in the space. [5]

This quote alludes both to the presence of a lot of debt in the typical energy company capital structure and to the passive investing phenomenon of correlated exposures across sectors. It takes some chaos for such stories to reach the surface, but it turns out that over the past decade, energy’s share of high yield (aka junk debt) issuance has surged from 4% of debt outstanding to 16%.[6] High yield in aggregate is a $1.3 trillion market, so this is no small allocation!

An increasing amount of investor money is coming into high yield from passive sources. The rise of ETFs has been one such facilitator.

Screen Shot 2014-12-09 at 10.57.19 AM

(Source: Bloomberg)

This chart shows the rise in allocations to the two main high yield bond ETFs—HYG and JNK. This is not the performance of the respective securities. The value of each share of HYG (the mustard colored line in the chart above) is down 13% over this time (this is not to be confused with total returns, but is representative of the principal value under discussion). We therefore know the increase in assets at these securities is not due to performance, but rather something else–allocation. The premise behind these allocations is that they are a low cost, highly diversified way to capture the yield from junk bonds. Diversification, in theory, is supposed to mitigate some of the risk.

In aggregate, over $23.4 billion has been allocated to these two securities which did not exist a decade ago. This money then went into its target markets. Here is a recent sector-level breakdown to paint a picture for how it flowed through the high yield complex:[7]

Screen Shot 2014-12-09 at 10.57.32 AM

The Consumer Services sector makes sense as the largest allocation here. In 2013, services accounted for 44.7% of U.S. GDP, just shy of half our total economic output.[8] Nothing stipulates that a diverse portfolio’s allocations should perfectly mirror economic output, nor does the “Consumer Services” label fully capture “services” as represented in GDP; however, energy by lower estimates accounts for 2.5% of GDP and higher estimates up to 7.7% of GDP.[9] In other words, no matter which way you measure it, energy, as a percent of high yield debt is substantially overrepresented compared to its share of economic output.

Meanwhile the S&P 500 has the following sector weights:[10]

Bloomberg

This seems more in line with energy’s share of GDP and what a balanced, diversified economic weighting would offer.

The concentration of junk debt in energy is concerning and something that can only happen in a world dominated by passive allocation with little regard for where the dollars end up, and a sector coming off of a great run where mean-reversion is inescapable. Consequently, companies in the energy space received funding through high yield debt far more liberally than discriminant investors should have allowed. Instead of mean reversion in allocations to energy, we have had a positive feedback loop of increasing prices leading to increasing allocations and on. When these types of positive feedback loops break (and we have just such a catalyst for that to happen in oil today) then a positive feedback loop is likely to begin moving rapidly in the opposite direction (an unwind in this excess exposure to energy).

This is one of the most concerning market dynamics today. As we mentioned above, few analysts and investors have opened up to the possibility that oil prices are to remain low for a long period of time. Meanwhile, some who have explored various low oil price scenarios come to the following conclusion: “Should oil prices fall below $65 per barrel and stay there for the next three years, Tarek Hamid, a high-yield energy analyst at J.P. Morgan Chase & Co., estimates that up to 40% of all energy junk bonds could default over the next several years.” [11]

While 40% default rates may sound extreme, this assumes oil stays where it is as of this writing and better-capitalized companies do not start acquiring their distressed peers thereby assuming some of this debt. $65 per barrel of oil is certainly within the range of possible outcomes, and we can envision worse scenarios. Alternatively, scenarios where oil is worth upwards of $90, the level upon which much of this debt was funded, look increasingly unlikely. Oil will not stay exactly where it is today, as these commodity markets do move fast. Consolidation will certainly come to the sector as distress increases. 40% default rates therefore are not our expectation, but they do provide a numerical context for the degree of risk present in energy-related debt securities.

In January of 2013 we talked about increasing levels of risk-taking in high yield debt and the role passive allocations shifting from equities to debt had in this phenomenon.[12] We left our thinking uncertain as to how exactly pain would flow through high yield debt markets, but we are starting to think that an unwind in energy markets could be exactly such a catalyst. While lower energy prices are unequivocally a great thing for the U.S. economy (do not for one second listen to those folks who argue this would negatively impact our economy), we now have concerns about how these market events could play out. The most likely outcome is that we should expect an increase in volatility near-term as big pools of money adjust to the market’s price signals. While we are contrarian by nature, we think the contrarian position remains to be underexposed to energy and instead exposed to those areas where consumers stand to spend some of their savings from the pump.

Thank you for your trust and confidence, and for selecting us to be your advisor of choice. Please call us directly to discuss this commentary in more detail – we are always happy to address any specific questions you may have. You can reach Jason or Elliot directly at 516-665-7800. Alternatively, we’ve included our direct dial numbers with our names, below.

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF
Managing Director
O: (516) 665-7800
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-7800
M: (516) 729-5174
elliot@rgaia.com

Past performance is not necessarily indicative of future results.  The views expressed above are those of RGA Investment Advisors LLC (RGA).  These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views.  Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice.   The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria.  In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed in item (i) were purchased. (iii) The date or range of dates during which the securities listed in response to item (i) were purchased.

[1] http://www.reuters.com/article/2014/11/27/us-opec-meeting-idUSKCN0JA0O320141127

[2] http://money.cnn.com/2014/11/28/investing/opec-oil-price-us-shale/

[3] http://www.telegraph.co.uk/finance/newsbysector/energy/oilandgas/11268611/OPEC-Saudi-Prince-says-Riyadh-wont-cut-oil-unless-others-follow.html

[4] http://www.rgaia.com/august-2014-investment-commentary-indexation-creates-opportunity/

[5] http://www.rgaia.com/october-2014-investment-commentary-flooded-in-oil/

[6] http://www.ft.com/intl/cms/s/0/1ef90bb4-7590-11e4-b082-00144feabdc0.html?siteedition=intl#axzz3KbuS9fKk

[7] http://www.ishares.com/us/products/239565/ishares-iboxx-high-yield-corporate-bond-etf

[8] http://useconomy.about.com/od/grossdomesticproduct/f/GDP_Components.htm

[9] http://www.washingtonpost.com/blogs/wonkblog/wp/2013/04/23/the-oil-and-gas-boom-has-had-a-surprisingly-small-impact-on-the-u-s-economy/ and http://energyanswered.org/questions/how%20much%20does%20the%20oil%20and%20natural%20gas%20industry%20contribute%20to%20our%20gross%20domestic%20product

[10] http://us.spindices.com/indices/equity/sp-500

[11] http://blogs.wsj.com/moneybeat/2014/12/01/falling-oil-prices-could-lead-to-massive-junk-bond-defaults/

[12] http://www.rgaia.com/january-2013-investment-commentary-high-yield-corporate-debt-markets/

October 2014 Investment Commentary: Flooded in Oil

October was an eventful month in global markets.  At the midpoint of the month, the S&P hit a low 7.7% below that of the month’s start and just shy of 10% from 52-week highs.  This October was well on its way to competing with other miserable Octobers of lore before markets magically rebounded to close at new all-time highs; with the S&P 2.4% above where it began the month.  Some attributed the selloff to Ebola fears, passing around a chart that highlighted the correlation of Ebola mentions in the press with fear in the stock market.

In our estimation, the most consequential move this month was in the commodity complex, specifically crude oil.  Oil has been a hot button topic of socioeconomic and political relevance for longer than any of us can remember.  Not long ago, the conversation centered around “Peak Oil” before pivoting to the massive surge in domestic U.S. shale production.  Today we think a new narrative begins honing in on a global supply glut and irrational state actors.  In our March commentary, we spoke about feedback loops and the impact they can have on market prices[1]. Over the past decade, oil benefited from a tremendous feedback loop of soaring emerging market demand, tightening supply in older production fields and from geopolitical tensions, and the creation of vehicles whereby oil became an investable asset class. This last point is critical, for through ETFs the average American could own oil in their retirement account instead of simply treating it as a consumable commodity.  Moreover, funds could bet on oil in increasingly exotic ways. The positive feedback loop here is important, as George Soros explains:

… positive feedback process is self-reinforcing. It cannot go on forever because eventually the participants’ views would become so far removed from objective reality that the participants would have to recognize them as unrealistic. Nor can the iterative process occur without any change in the actual state of affairs, because it is in the nature of positive feedback that it reinforces whatever tendency prevails in the real world. Instead of equilibrium, we are faced with a dynamic disequilibrium or what may be described as far-from-equilibrium conditions. Usually in far-from-equilibrium situations the divergence between perceptions and reality leads to a climax which sets in motion a positive feedback process in the opposite direction. [2]

When prices of a commodity good rise, consumers and suppliers each adapt to the new price. Consumers pull back consumption, while suppliers increase production.

Consumers did this by buying more efficient cars:[3]

efficient cars

And driving fewer miles:[4]

fewer miles

Meanwhile suppliers, most notably in the U.S., ramped up production:[5]

US ramp production

And this is where the supply story really gets interesting. The oil market is not your typical commodity market.  In theory there is an oligopolistic price setter in the form of OPEC, and every other producer is a price-taker. This has given immense geopolitical power to the OPEC group, yet with non-OPEC production surging, their market power has come under threat.  In microeconomic theory, suppliers of commodities are motivated by profit.  Yet, with many of the largest suppliers actually state actors, what may be rational to protect the oligopoly economically speaking might be very irrational politically.

Take the example of Russia. Since 1998, Russia has been careful not to run budget deficits.  Oil’s rise this past decade has been a fortuitous source of funding for the state, as revenues from the country’s production cover about half of their annual budget.[6]  This year, Russia’s budget called for a small deficit premised on $100 oil and pre-Ukraine-related sanctions. With oil prices collapsing, and sanctions limiting access to global capital markets, how will Russia finance its government?  Bullish oil analysts have suggested huge producers like Russia and Saudi Arabia would merely cut production in order to protect price.  If Russia were to cut its production by 10% at $85 per barrel, it would chop off 1.6% of its GDP in the middle of a recession no less.  Economically, cutting production might be rational, but politically, increasing production might be a necessity.

A quote from Iran’s oil minister is quite telling on the impact of political over economic objectives: “Under any circumstances we will reach 4 million bpd even if the price falls to $20 a barrel.”[7]

This leaves us in a world awash in supply, while consumers are cutting back on demand and the reality is that the boom itself has led to what now looks like the early stages of a bust. Why is all this relevant now? For one, many portfolios globally were very long oil on the heels of its success over the prior decade. Alongside this current, many oil companies levered their capital structure premised on the expectation of consistent, if not higher oil prices.  With oil prices now souring, many assumptions have to be revisited, leading to a de-risking, and forced selling in the space.

While after-the-fact rationalizations are dangerous and vulnerable to considerable biases, we think this is one of the most sensible explanations for what went wrong in markets in the first half of October, while also offering a built-in segue for what went right in the second half of the month. We are a consumer-driven economy and consumers have been constrained by a lack of wage growth and soaring commodity costs for the past decade. With oil reversing, consumers will benefit from one of the more stimulatory market-driven events we have seen in recent times. It’s very challenging to quantify the exact effects on consumer wallets, but “Economists at J.P. Morgan Chase estimate that a 10% decline in oil prices will, over time, add roughly 0.25 percentage points to U.S. GDP”[8].  At the end of October, oil was 21.8% off its high for the year, and down about 11.8% year-to-date.  If this new lower level is only just beginning, and we believe that it is, then look for an increasingly favorable consumer environment into next year which will surely impact our portfolios going forward.

Thank you for your trust and confidence, and for selecting us to be your advisor of choice.  Please call us directly to discuss this commentary in more detail – we are always happy to address any specific questions you may have.  You can reach Jason or Elliot directly at 516-665-1945.  Alternatively, we’ve included our direct dial numbers with our names, below.

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF
Managing Director
O: (516) 665-7800
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-7800
M: (516) 729-5174
elliot@rgaia.com

Past performance is not necessarily indicative of future results.  The views expressed above are those of RGA Investment Advisors LLC (RGA).  These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views.  Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice.   The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria.  In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed in item (i) were purchased. (iii) The date or range of dates during which the securities listed in response to item (i) were purchased.

[1] http://www.rgaia.com/flushing-out-momentum/
[2] http://www.ft.com/intl/cms/s/2/0ca06172-bfe9-11de-aed2-00144feab49a.html#axzz2kMJs54ti
[3] http://www.washingtonpost.com/blogs/wonkblog/wp/2013/12/13/cars-in-the-u-s-are-more-fuel-efficient-than-ever-heres-how-it-happened/
[4] http://research.stlouisfed.org/fred2/graph/fredgraph.png?g=P1H
[5] http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=MCRFPUS2&f=A
[6] http://online.wsj.com/articles/russia-may-need-to-cut-budget-spending-finance-minister-says-1414158145
[7] http://www.reuters.com/article/2013/12/04/opec-agreement-idUSL5N0JJ2QF20131204
[8] http://online.wsj.com/articles/americas-uneven-boost-from-cheaper-oil-heard-on-the-street-1415125113

September 2014 Investment Commentary: The Great Divide

Last quarter was not your typical quarter in financial markets. While the S&P registered a flattish +0.62% on the quarter, suggestive of complacency, there was in fact considerable action beneath the hood.  There were two large moves we want to highlight in particular, before doing our quarterly “What do we own?” segment.

The Euro: Down, but Not Out

One of the most notable was the Euro’s 7.9% fall relative to the dollar.

Great Divide 1

This is one of the sharpest selloffs in the euro, though this is different than prior similarly extreme contractions in price. Whereas previous selling in the euro was due to concerns about the currency’s viability, this particular selloff is the result of explicit actions taken by policymakers to effect such a move. Notice the contrast: prior selloffs were borne in fear; this selloff is borne in intent. While the outcomes appear similar, the consequences are vastly different.  This will actually help ease some of the problems which led the euro to the brink of collapse in the first place, by creating a natural calibrating mechanism for the particularly troubled economies to improve their export competitiveness and thus their economies.

Though we have accumulated European positions without accompanying currency hedges, we built our positions specifically in companies who do considerable business outside of Europe. Our reasoning on this was fairly simple: these companies’ costs are fixed in euros, while their revenues are denominated in foreign units. This leaves their operating expenses fixed, while their revenues are variable. Thus, when the euro decreases in price, their expenses stay exactly the same, while they make more euros per sale. This is defined as operating leverage to a currency. Consequently, as time marches on, and the euro settles upon a new, lower exchange level, these companies will have considerably better profit margins and greater earnings.  This should also help promote growth in companies who compete with international competitors. While the currency move translates negatively in the short-run, we believe this greatly improves the long-run outlook, and long-run return potential for our positions.

Russell 2000: The Great Divide

We noted above how the S&P 500 finished the quarter slightly positive. For those who follow the broader, small cap oriented Russell 2000, this would come as a complete surprise. On the quarter, the Russell shed 7.65%, and underperformed the S&P by 8.36%.

Great Divide 2

In the chart above we can see in visual form when past large divergences have occurred (follow the dark blue line). In the past 30 years, there have only been three quarters where the Russell had worse underperformance:

  • September 1990 happened on the heels of Iraq’s invasion of Kuwait. The S&P dropped 14.5%, while the Russell tanked 25.1%. The next quarter, the S&P rallied 7.9%, while the Russell tacked on 4.3%.
  • September 1998 was in the thick of the Long Term Capital Management crisis. The S&P was down 10.3%, while the Russell shed 20.5%. The next quarter the S&P soared 20.9%, while the Russell surged 16.1%.
  • March of 1999 was when fears of Y2K became most pronounced. The S&P was up 4.6%, though the Russell lost 5.8%. The next quarter the S&P went up 6.7% and the Russell gained 15%.

Note how each of the major divergences in the past 30 years could be explained by some kind of major market moving event; meanwhile today, if anything, people concur that there is a void of really large worries. In the past, each quarter following the occurrence of such a divergence saw markets rally substantially. What does this mean right now? We have no clue, and today’s environment is considerably different than that of 1990 or 1998/99. Some might suggest that between Russia’s invasion of Ukraine, the growing threat of ISIS and Ebola there are legitimately concerning geopolitical events, though we would caution holding these up to the historical significance and situational context of 1990s markets.

If we have no clue what this means today, then why mention it? We believe this is something rare enough, and large enough to warrant attention. The average spread between the S&P and the Russell over this timeframe was 0.096%, while the standard deviation of the spread is 4.86%.  Further, we believe many of today’s narrative-driven observations about today’s markets (like excessive complacency, over-optimism, etc.) fail to hold muster in the face of this reality.

By its nature, the Russell is more volatile than the S&P given it is representative of small cap companies; however, its larger quantity of constituent holdings provides great insight into what most stocks are doing. Though it may not appear to be so from the S&P, markets have been fairly weak of late. Towards the end of the quarter, Bloomberg noted that 47% of the NASDAQ index constituents were in “Bear Market” territory (ie down more than 20% from 52-week highs)[1]. This perhaps highlights the most important takeaway in this section: there is by no means runaway euphoria in today’s markets and that is a good (and healthy) thing!

What do we own?

The Leaders:

America Movil (NYSE: AMX) +22.5%

America Movil has made its way to the laggards section in two of the past three quarters, and fortunately, this quarter’s boost more than makes up for any of its past woes. Given its frequent appearances in this section, we have commented on this stock as much as any in our core portfolio. As such, there is little new to add to the thesis. We think this quarter’s strength is merely a reflection of how heavily the market discounted its expectations of pressure on America Movil’s bottom line as a result of regulatory woes. These woes were eased somewhat by initial signs of interest in a large international telecom purchasing some of the company’s Mexican assets. It is suggested that AT&T is one such company preparing a bid, which we find this interesting given that at the close of the second quarter, Carlos Slim himself purchased AT&T’s formerly large stake in AMX.[2] We will certainly be following these events closely, and expect that a formal conclusion to the mandated changes will refocus investor attention on the many positives present at AMX. Further, once this takes place, investors will realize that all the “cannibalization of shares” (aka buybacks) during the trough period will result in considerably more shareholder value than before.

Bed Bath and Beyond (NASDAQ: BBBY) +7.9%

We commenced this position during the quarter and the performance reflects not BBBY’s, but rather our return during the quarter on this holding. Just above we mentioned “cannibalization of shares” and this concept is core to our thesis in BBBY. Over the past year, BBBY has shrunk their share count by 10.7%. Since five years ago, the company has repurchased a whopping 25.9% of outstanding shares. Over this time, revenues have grown at 9.8% annualized, while earnings on a normalized basis have grown by 14.0% (this is understating 5 year growth since we will overstate 2009 earnings during the financial crisis). One might ask, with these great numbers, then why is the stock down? The biggest problem at BBBY has been the contraction of their industry leading gross margins to 39.3% (TTM) from upwards of 41%. But these are still industry-leading margins mind you! Meanwhile, the perception on Wall Street holds that the company is increasingly vulnerable to the price transparency (and product mix) online competitors offer. Given the company’s history of providing minimal information to Wall Street (for example, not holding a Q&A session after prepared remarks in quarterly conference calls), analysts would rather shoot first, think second about the value proposition in these shares. We think there is the potential for BBBY to turn into a great long-term holding.

Fanuc Corp (OTC: FANUY) +4.92%

Fanuc is a world class robotics and automation company based in Japan. As is typical of a Japanese company, they are overcapitalized.  We have now held this position for over a year and it has quietly delivered. We started scouring Japan for interesting investment opportunities when the implementation of Abenomics became imminent. Rather than focusing on net/nets or dirt cheap, our interest was confined to quality at a fair price. The company has consistently earned double-digit returns on invested capital, while generating operating margins in excess of 30%. The business is somewhat cyclical in that it relies on investment in manufacturing capacity (or repurposing manufacturing) though it also has a secular component from the “new” replacing the “old.” With many of Fanuc’s products, there is a hardware and software component. The hardware makes great margins at sale, while the software comes with outstanding recurring margins over the life of the hardware. The business model, the returns and the balance sheet all are attractive here.

The Laggards

The New York Times Co (NYSE: NYT) -26.00%

This is another frequent resident in our “What do we own” section. This was a laggard last quarter, though was one of our best performers in calendar 2013. While we are still up considerably on this position since commencement, we are back to prices where the net cash + the building – pension debts is worth more than the current market cap of the equity. Though there is no clear path to the company liquidating its stake in the building, we do think once the option period ends, and NYT resumes complete control of the building, there will be more flexibility for constructive action. We are willing to wait for this day to occur. In the meantime, markets are concerned about slowing growth in online subscriptions, and the continued erosion of ad sales in print. This has been the source of pressure on the stock. We find it ironic how people are willing to pay massive dollars/eyeball on “new” online companies, while they essentially ascribe negative value to an old company’s online endeavors, despite the old company being equally competent at garnering the attention of web traffickers (and more competent at generating revenues). Think of this as an investment in New York City real estate at a discount, with a $0 basis call option on an extremely popular website while also getting the runoff cash flows from what is a shrinking, albeit still profitable print newspaper.

Walgreen Company (NYSE: WAG) -19.6%

Walgreen has been one of our best performers since 2012 yet failed to once finish amongst our top three performers in a given quarter. Three separate times it was our fourth best position. The stock has been so consistently good for us that we thought about giving it a shout-out in our 2013 year-in-review. Sure enough, its first appearance in the “What do we own” section comes as a laggard. The fall this quarter was in part fundamental (lowering of 2016 estimates), and mostly due to the reversal of speculative interests in the company. When we purchased WAG, the company had been in a dispute with Express Scripts and was just purchasing a stake and an option to buy the remainder of Alliance-Boots. Many in markets perceived Boots as a negative. We did not. We were intrigued by Stefano Pessina and what he could do for the company moving forward as both an executive and its single largest shareholder (back then it was 8% now it’s about 16%).  Owner-operators are appealing to us for many reasons, and Pessina’s long track record of value creation in pharma struck us as an obvious plus. Fast forward to today, and speculators began betting that WAG might use its ownership of Boots in order to do an “inversion” and switch its tax base to a lower-tax European domicile from the US. Regardless of the merits of an inversion, this would have hurt us as shareholders: we have a low cost basis and such an inversion would have triggered immediate capital gains. WAG is built for steady compounding of value over the long-run and we expect continued initiatives to improve distribution efficiency and margins on the pharmacy side, alongside expanded offerings of proprietary products like Boots No 7 on the front-end. This is a bump on the road in what we think will be a true long-term buy and hold.

Devon Energy (NYSE: DVN) -13.8%

Here is yet one more frequent constituent of this section.  Devon is in the middle of transforming itself from a natural gas company with assets both inside and outside the US, to a domestic oil and natural gas company. All the while, the company has maintained a pristine balance sheet and has taken steps to maximize tax efficiencies in its disposal of assets. Management without a doubt has been prudent operators here. While Devon had an outstanding second quarter, the third quarter was disappointing. There is a simple fundamental fact behind why Devon fell so hard this quarter: the price of oil dropped 11.5%. We worry that oil markets have not properly accounted for a dearth of supply coming from the US and abroad, though have no true way to predict how this will impact the price of oil down the line. While we like the company and we like the management, we do not have nearly enough certainty about the future path of oil prices and are increasingly concerned that this risk may be under-appreciated by markets. This is something we could write paragraphs about, so if it is a topic you are interested in, please feel free to ask us for more context.

Thank you for your trust and confidence, and for selecting us to be your advisor of choice.  Please call us directly to discuss this commentary in more detail – we are always happy to address any specific questions you may have.  You can reach Jason or Elliot directly at 516-665-1945.  Alternatively, we’ve included our direct dial numbers with our names, below.

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF
Managing Director
O: (516) 665-7800
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-7800
M: (516) 729-5174
elliot@rgaia.com

Past performance is not necessarily indicative of future results.  The views expressed above are those of RGA Investment Advisors LLC (RGA).  These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views.  Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice.   The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria.  In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed in item (i) were purchased. (iii) The date or range of dates during which the securities listed in response to item (i) were purchased.

[1] http://www.bloomberg.com/news/2014-09-14/record-s-p-500-masks-47-of-nasdaq-mired-in-bear-market.html
[2] http://www.bloomberg.com/news/2014-09-15/america-movil-said-to-seek-at-t-bid-for-17-5-billion-of-assets.html