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

August 2014 Investment Commentary: Indexation Creates Opportunity

Of late, the financial press has been filled with headlines about the rise (and commensurate fall) of passive (active) investing. This is one of those topics on which everyone has an opinion, and of course, we are no different, though our opinion takes a variant angle than the conventional conversation.  First we will refer you back to our piece from October of last year on “Our ‘Actively Passive’ Investment Strategy”.[1]  The fact of the matter is, the true “debate” on active verse passive obfuscates many important points and in the spirit of conventional discourse, requires people actually subscribe to one camp or the other.  As is typical with our starting point in such debates, reality is far more nuanced than the conversion.

Conventionally, passive means indexing, while active means any strategy that seeks to outperform the indices. Many practitioners define these terms differently depending on the context, though this definition offers a good starting point.  A corollary of this argument has been the assertion that “if one cannot beat the index, then one should not invest actively and instead should simply invest in an index.”  This assertion has helped fuel the massive rise of passive assets under management:

 Passive

In defining our own strategy as “Actively Passive” we mainly riffed on the key problems with active management as it is practiced today.  We summed up the essence of these problems as “active” coming to be defined by actually being active in the form of forever increasing turnover (transactions) and being more about finding arbitrage opportunities, less about actual investment based on business fundamentals.  To that end, a hallmark of our strategy is its aim to turnover no more than one third of the portfolio each year while the average portfolio today (inclusive of passive funds) turns over its portfolio more than 2.5 times each year.  We do this because there is a very real opportunity to make good money in the financial markets by taking a longer-term timeframe and focusing intently on the fundamentals of the businesses in which we invest.

The discussion of “Actively Passive” was built on the notion that stocks are an asset class, in which investors essentially earn the yield on the equity (cash flow divided by market cap) plus or minus growth. With bonds, we understand simply how yield translates into return. Pay $100 par for a bond with a 5% yield and assuming default is not on the table, you know with certainty exactly what your return will be.  Stocks, on the other hand, are similar and different.  You do earn the yield of the equity, and for the sake of simplicity we will call this the free cash flow yield (cash flow from operations minus maintenance capital expenditures divided by market capitalization).  But stocks introduce a lot more uncertainty than bonds and this is where the volatility in market prices comes from. Your bond-like yield will include a growth (or contraction portion) and a change in multiple over time (i.e. how much yield an equity owner is willing to capture from a given stock).

Since most active strategies today have such high turnover, the entire notion of equities as an asset class and capturing the yield they offer becomes an after-thought in the construction of a portfolio. Herein lies one of the reasons people like Jack Bogle have pushed most investors to simply index.  By and large, the principles behind why passive management works can be deployed in active management, and that is part of what we do.

Let’s for a second take a step back and do a little mental exercise. Were everyone in the world simply invested in indices and nothing else, what would happen?  One obvious consequence would be how no one would be invested in companies that were not members of an index.  Somewhere between such a world and where we are today is the creation of opportunity through the rise of what Murray Stahl calls “indexation.”[2] As Howard Marks has taught us, the path to value and turning good investments into great ones is through identifying a mistake in the market’s price of a given asset.[3] The more widely watched a given individual security the more efficient that security’s price. Were everyone to focus on indices and no one focus on individual securities, it’s easy to see how the efficiency of individual securities would go down in the process.

We think there are three important ways that indexation creates opportunity in and of itself, and one important way that those who do not play the indexation game can further set themselves apart.

Three Sources of Opportunity:

1) Inclusion (exclusion) criterion. Certain companies get left out of indices altogether and thus become less followed, while others are included in indices though to a lesser extent because of concentrated ownership structures. This is directly related to our point above that were everyone to invest in indices only, then no one would invest in other companies.  Since the dot.com bust and the Great Financial Crisis, there has been a whittling down of research desks on Wall Street.  Increasingly research and investors alike focus exclusively on the same set of companies, all of which tend to be in one index or another. But there exist an abundance of companies who are in no index at all, with considerable investment merit in their own right. We spend considerable effort familiarizing ourselves with these companies, for even if we do not invest in one such company immediately, building our knowledge-base of off-the-radar companies provides us the necessary information to act if and when an opportunity does present itself.

2) The baby out with bathwater phenomenon. Indices create buying and selling pressure in its constituent securities that is independent of what these particular company’s fundamentals dictate. When there are macro problems, people trim their exposure to indices.  They do not ask themselves “does company X out of 500 deserve to be sold.”  Rather, they sell the index and in doing so, there is selling pressure that flows through to individual securities.  In each and every transaction there is a buyer and a seller.  One of the arguments against active investing is “how do you know that the person selling you his shares does not know more about this company than you?”  When the selling pressure is the result of index-based declines, then the answer is easy: the person not only does not know, he or she does not care.  Such situations are not necessarily available at all times, but when they do exist, those with deep fundamental insight can use it to their advantage.  It’s important to point out that the corollary is true as well; when the indices are simply rising, forced buying can come into stocks that do not deserve upside.  This is a good time to be a strategic seller.

3) Mislabeled sector-level identification.  Alongside the rise in indexation has come the proliferation of the “sector-based ETF.”  This has enabled passive investors to make investments in only those sectors they like and is a means to work around the indexation problem whereby in broadly diversifying, an investor inherently buys “good” areas to invest along with the “bad.”  As evidenced by biological taxonomy, us humans like things to fit neatly into hierarchies and labels. Reality is not so simple. For example, small cap growth companies are often thought of as young, new companies, but you can also have really old companies that were once large market cap behemoths, whose earnings and then stock price cratered, leaving a small cap company. If this company then finds growth once again, it becomes a “small cap growth” stock by definition despite being inappropriately lumped in with “young” companies. Should a company whose revenues are earned via selling newspapers, but whose value is in its real estate holdings be thought of as a newspaper or real estate company?  Well, the way sectors work, this company would most definitely be lumped in with other newspaper companies. Further, does a company who uses the Internet be in a sector called “Internet” when their primary revenues are earned through advertising, or selling household products, or providing software as a service while that same sector excludes an old retailer who makes more money online than in its actual stores?  These questions have real investment consequences that open up considerable opportunity, yet no clear answer in practice.

What non-Indexers can do differently:

In an index, an investor is beholden to the direction of the economy. To an extent, all investor are always exposed to this effect; however, it manifests itself differently for the long-term fundamental investor than it does for the indexer.  An indexer by definition purchases his or her stake in an index and lets it sit idly by.  This is so whether the index is cheap or really expensive, and herein lies the problem: Indexers by definition do not worry about valuation. They operate under the premise that “if you hold long enough you will simply earn the cost of capital.” Yet it has been proven in countless different ways that the starting valuation at your point of investment considerably impacts what your long-term return will look like.

While it is generally true that when indices are expensive, so too are most stocks, but it is not uniformly true. There is a degree of rational flexibility available to the non-indexers not afforded to the purely passive investor.

In the most general sense, contrarianism is the way to make really good money in the stock market but contrarianism in and of itself is no panacea.  One must be both contrarian and right in order to make do well. 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

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.


[3] “It’s All a Big Mistake,” by Howard Marks. http://www.oaktreecapital.com/MemoTree/It’s%20All%20a%20Big%20Mistake_06_20_12.pdf

July 2014 Investment Commentary: Geopolitics

During July some became concerned about rising geopolitical risks.  We caution that such risks tend to be a matter of perception more so than economic risk.  These influences can be drastic in the short-run, but they should not change the posture of true, long-term investors.  It’s a sad but true reality that not even a half-decade has passed in any of our lifetimes without some kind of emergent geopolitical risk-event.  Today Russia has once again become the primary cause for concern, yet stock markets enjoyed some stellar performance during its many decades as our primary global foe despite specific threats against our country.  Here the threat is more abstract, so if anything, it should be less of a concern than that of years past.

The start of the third quarter was much like that of the second quarter in April.  Markets ended the prior quarter poking through to all-time closing highs before weakness took over.  Once again, small-cap stocks were the hardest hit.  However, one big difference did emerge: whereas high yield credit markets remained strong throughout the April selling fit, they weakened and led to the downside this time around.  With continued downward pressure on benchmark interest rates, this brought about a widening in credit spreads for the first time in a while.

Screen Shot 2014-08-14 at 12.17.35 PM

In the grand scheme of things, this is but a hiccup, though it’s slightly larger in magnitude than last summer’s “Taper Tantrum.”  While some have called this a mini Taper Tantrum, the differences between this summer’s sell-off and last summer are more notable than the similarities.  Last summer, the primary action was in benchmark rates, which had their largest surge since the zero interest rate policy came into effect.  Coming into 2014, many expected the rise in benchmark rates to continue, meanwhile throughout the calendar year thus far, rates have declined.  This decline accelerated amidst the recent spike in corporate Treasury spreads.

Many attribute this weakness in high yield credit to the potential for a more decisive retreat from the policies necessitated by the Financial Crisis by the Federal Reserve.  While that may in fact be the case, we want to point out two further caveats, beyond the lack of a rise in benchmark rates.

First and foremost, as we have been saying for some time, the Fed will not take a more hawkish stance unless and until the economy shows signs of tangible and sustainable improvement.  To that end, our theme of the economy outpacing the stock market in 2014 took a turn towards the more correct in the past month.  Reported economic data continued to improve, and the back half of this year is poised for the strongest economy since before the Great Recession.  It is becoming clearer by the day that the first quarter’s decline in GDP was an aberration.  This accelerating strength is something to be celebrated, not feared, for the return of normality bodes increasingly well for the lives of all Americans and financial markets alike.

Second, high yield suffers from its own unique problem in this zero interest rate world.  Rates are so low in this space relative to the long-term risk profile of the sector that value investors will be sidelined until there are substantially better opportunities.  With this the case, when selling flows through this asset class it takes the rebalancing effect in order to bring in a new bids, thus making the process of finding a floor a more uncertain process.

The situation in high yield stocks is similar, but distinctly different from that in equities.  Taken as a whole, July seems like a much-needed cooling off month for equity markets.  Over the past few months, the divergence between small and large cap stocks became pronounced with some increasingly aggressive valuations in subsets of the small cap complex getting smacked back down to reality.  As a result, while the S&P continued its march into uncharted territory, the Russell 2000 has been confined to a rather volatile range.

With the calendar now open to the month of August, it is also time for us to say goodbye to our Summer Analyst, Jonathan Davis.  Jonathan will be starting his junior year at Cornell.  Over the course of the summer, the greatest opportunity set appeared in the retail space and Jonathan was a huge help in advancing our research on this sector.  He contributed tremendously in our effort to distill which companies were merely victims of disruption in sales and distribution from those that truly do something different, better and with considerably more value than the rest.  Jonathan’s contributed to both our qualitative and quantitative analysis, with information that was both actionable today and long-lived whereby its value will continue to accrue to our research efforts over time.  We want to both thank Jonathan for his meaningful contribution to our research this summer and wish him well as he starts the second half of his college life.

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, Esq.
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.

June 2014 Investment Commentary: What You See Is Not Necessarily What You Get

As we hit the halfway mark on the calendar year, it’s worth reflecting on the expectations we outlined in our 2014 preview. If you recall, we emphasized that “it is quite possible, almost probable that 2014 will be a better year for the economy than it will be for the stock market”[1].  Were we wrong? So far this year, reality seems like a mirror reflection of our expectation, for the stock market (as represented by the S&P) is up 6.95%, while the economy (as measured by the Gross Domestic Product (GDP) in the first quarter) appears frighteningly weak[2].  Notice however that we used the phrase “seems like” rather than “is” a mirror reflection of this expectation.  Often times what you see is not necessarily what you get.

It is an exercise in futility trying to estimate stock market performance based on GDP.  More broadly, the first half this year is one of the clearest signals that market participants who spend their time trying to guess which direction the broader economy will go, too often mistake the forest for the trees.  While GDP is obviously a good proxy for the direction of corporate earnings, it is far from perfect.  Moreover, GDP does not tell us anything about how companies are valued, and where those corresponding values will go over time. There are two implicit points here in our knock on GDP as a tool for stock market timing: 1) it is an extremely challenging task to predict what the rate of change in GDP will be one quarter out, let alone one year out; and, 2) even were one to know in advance what GDP would do the next quarter, it does not follow that one would then be able to use that information profitably in the stock market.

This is but one part of why we are strong believers in learning our companies through-and-through, familiarizing ourselves with the sectors within which they do business, and understanding the general context of the economy around them, without shifting our thesis on outstanding businesses based solely on the ebbs and flows of the macroeconomy.

So where does that leave us with regard to our seemingly very wrong assessment of the general landscape for 2014?  Well, given recent stock market performance, we clearly aren’t too disappointed in being wrong.  However, we do think that we are still far more right than it may appear.  While the S&P is off to a great start in 2014, the Russell 2000 is up half as much as the S&P, or 3.26%.  This is evidence that a few large cap multinationals have been pulling up the vast majority of stocks, while the average stock has been, “quite average,” for lack of a better word.

Meanwhile the extremely negative Q1’14 GDP number is far less negative than it appears.  Note that GDP numbers go through many revisions before they are finalized. Importantly, this particular Q1’14 GDP number was drastically impacted by the inclement weather affecting much of the country.  Typically, GDP moves alongside Personal Consumption Expenditures (PCE), which measures the amount of money that households spend, and while GDP was negative, PCE remained positive  All in all, we also still do not know the Q2’14 GDP, and thus cannot speak to the first half in its entirety; however, it’s fairly clear from the context of an amalgamation of leading indicators such as hours worked, durable goods orders, and the Purchasing Manufacturers Index (among other reference points) that the economy has/is accelerating rather than slumping.

Taken as a whole, we think our expectation that 2014 will be a better year for the economy than the stock market remains the correct overall framework when constructing portfolios.  As we discussed over recent quarters, we continue to carry a healthy cash balance, we have little to no exposure to the momentum segments of the market, and we have built a substantial allocation to global equity markets.

With that being said, let’s review our leaders and laggards over this past quarter.

What do we own?

The Leaders:

Platform Specialty Products (NYSE: PAH) +47.14

This is Platform’s second consecutive appearance on the leaderboard.  When we covered Platform last quarter, we spent most of our dialogue discussing its CEO, Martin Franklin’s history and background as well as explaining the company’s emphasis on “asset-light, high-touch niche products.” This alone made the investment worthwhile from our perspective. Now we think it’s worth explaining why this investment remains one to hold, rather than sell after such stellar performance. We have often spoken about feedback loops, and the role positive feedback loops in particular play in economies and markets (we spent extra time on this in our March Commentary).[3]

In essence, the Platform business is an effort to create just such a positive feedback loop. As a roll-up, Platform’s strategy involves purchasing high quality businesses for fair-to-cheap prices.  Initially, Platform was financed with capital from its founders and early investors to make these purchases.  As time progresses, these purchases will be financed with a combination of the cash flows from companies it owns, and either debt or equity, whichever is cheaper. As the stock moves higher, equity itself becomes cheaper.  Moreover, as the stock moves higher, there is a larger equity capitalization to work with, and use as currency for future acquisitions.

The positive feedback loop works as follows: Platform makes an acquisition that makes its stock more attractive. Its stock then moves up in price reflecting the added value of this acquisition. The higher stock provides more currency with which Platform can make another acquisition. Platform makes another acquisition with its now higher stock, which the market then greets favorably, thus leading to further price increases. Rinse, wash, repeat. Now obviously this type of feedback loop cannot work in perpetuity; however, in certain industries (here we’re talking about specialty chemicals), and starting from a small market cap, there is a long runway within which to operate in such a way.  Mr. Franklin’s track-record suggests he is quite good at this, and we are more than happy to ride his coattails as the stock marches on.

Banco Santander Brasil (NYSE: BSBR) +24.24

We spent some time earlier this year parsing through opportunities in emerging markets.  We were particularly attracted to Banco Santander Brasil for its incredibly high quality balance sheet, strong track-record and sharp management team.  We also felt Brazil had particularly favorable valuations relative to its peers, and for the most part, its rule of law was less risky than some other emerging markets, like Russia or China.  Lastly, we liked that Banco Santander Brasil was a largely owned subsidiary (formerly wholly owned subsidiary) of Santander (NYSE: SAN), a generally well-run Spanish bank.

While we are pleased with Banco Santader Brasil’s performance in our first quarter of ownership, we will chalk up the emergence of a recent catalyst to luck. Santander, the Spanish bank offered to buy out all other shareholders in the Brazilian subsidiary for a greater than 30% premium in the form of a stock for stock deal.  While the premium sounds quite nice, we think this price is at a substantial discount to where the Brazilian bank could have traded two or three years down the line given a normalization in the business cycle in Brazil, a reorganization of the company’s balance sheet to streamline its capital ratios, and the private sector taking an increasingly large slice of the lending market in Brazil as the government pulls back some.

We remain undecided on whether we will own Santander, the parent company in perpetuity; however, we do expect to hold our shares until this position can move to long-term capital gain status. We will do so because a) we are quite comfortable with Santander itself for now; and b) we think the European environment right now is particularly favorable for its banks.  Were these two conditions not present, we would simply sell Banco Santander Brasil and move on; however, we would like to protect as much of our gain as possible from short-term tax consequences while maintaining some potentially nice upside.

Devon Energy (NYSE: DVN) 18.63%

We have owned Devon for some time now and it has made more than one appearance in the laggards section.  Consequently, we are quite pleased to see Devon in the leaderboard and comfortably above our purchase price.  Devon is an extremely well-run oil and gas exploration company, which has been in the midst of an overhaul whereby the company has been selling off outside of U.S. assets and using the proceeds to purchase higher quality domestic energy sources.

Devon remains well-exposed to natural gas, and has an increasing amount of shale oil exposure. The pricing environment in its core operations continues to improve; all the while management continues to take smart steps in order to mitigate the tax consequences of its transformation and maximizing the realizable value on the disposition side.

Devon was cheap because of its ongoing transformation, but also because of the distressed environment that emerged in natural gas intensive companies following the collapse in prices of natural gas.  Companies were pumping out supply and selling at prices below break-even, acting in uneconomic, irrational ways. We liked Devon’s capacity to both weather the storm and emerge as an opportunistic purchaser of higher quality assets. So far the company has been delivering on our expectations, though up until this quarter the market had been treating the company as guilty until proven innocent.

The Laggards:

Fiat SpA (BIT: F) -15.25%

Fiat, a frequent leader in our previous commentaries is a laggard for the first time, thus hammering home the lesson that nothing goes up in a straight line.  There is little to add to Fiat above and beyond what we have previously discussed; however, it’s worth noting that Fiat, this quarter, delivered a quite ambitious 5 year plan.  The market has treated the company’s ambition as risk, as has been the case from the beginning with its approach towards Sergio Marchionne, though we think this is misguided. Ambition and risk are not even two sides of the same coin. As outlined, Fiat will be investing considerably in expanding some of its premium brands, and in doing so, will require some kind of fundraising and/or increasing leverage. In this global environment where capital investment has been frustratingly anemic, those companies who do just that can build a sustainable leg up for themselves against competitors into the future with smart investment (key word here being “smart”). Fiat’s leadership has proven adept through a variety of challenges, and we think the quality of management will once again shine through as opportunity is pursued.

While the market disagrees at the moment, investment is not on its face a bad thing so long as certain objectives are continuing apace, and sure enough, during this past quarter we got continued evidence that the pivot to luxury brand growth is accelerating. For three quarters running, Jeep has posted its best ever monthly car sales numbers, going back well before the financial crisis, while Maserati this May sold five times as many cars as it did in May of the prior year.[4][5] Admittedly, Maserati is growing from a small base, however its margins are better than those of higher volume Fiat brands and its runway for growth is quite large.

The New York Times Company (NYSE: NYT) -11.16%

Here’s another leader turned laggard.  We think this move is largely just a little reflex as to how large the gains have been over the past year.  Nothing fundamentally drove this move lower, though recently NYT has been caught in the upward drift of momentum and thus was punished when momentum unwound. As with Fiat, there is little new left to be said about The New York Times.  The company’s transition to a more digitally domiciled revenue strategy continues apace, and there are signs that the decline in ad rates will reverse.

During the quarter, the company fired its Editor in Chief, Jill Abramson, and replaced her with Dean Baquet.  While there had been rumors of Abramson’s potential departure for some time, the market viewed this as an opportune to sell off and consider the consequences.  Separately, though potentially relatedly, an incredibly smart and thorough document covering the company’s perspective on innovation in content creation, distribution and consumption was leaked.  For anyone with even a passing interest in media, we recommend giving the piece a look for it includes a well-rounded summary of both the history and the landscape today within which the company is operating. [6]

UCP Inc (NYSE: UCP) -9.23%

We commenced our position in UCP at the tail end of last quarter.  UCP is a spin-off from a diversified holding company/insurer, PICO Holdings (NASDAQ: PICO). During the crisis, PICO/UCP bought up lands in California, around but not in the San Francisco area, and in Washington State, around but not in Seattle.  Homebuilders struggled in the first half of this year as winter generally speaking is not the real estate “selling season,” the particularly cold winter negatively impacted clarity on forward expectations of sales, and the spike in interest rates that started last summer and lasted into the early New Year left many questioning whether it would hurt sales moving forward.  That being said, we think an improving employment situation, lower expectation for the trajectory of interest rates, softening of underwriting standards (from extremely cautious to cautious, so not concerning ease), and an expected uptick in household formation all bode well.

Specific to UCP, we think their ownership of valuable lots at low cost bases bodes well moving forward.  One of the biggest problems for homebuilders has been a lack of good, developable lots as evidenced by an NAHB survey of homebuilders:

Given UCP owns an abundance of lots in prime areas, they have a leg up on competition and they also could have strategic value to some larger homebuilders.  One factor we particularly like with UCP is that PICO, who it was spun off from, is an owner-operator with a value-driven investment philosophy.  Their goal is to create value via their near 58% equity ownership, and in that sense, the incentive structure of minority shareholders is properly aligned with management. To that end, several noted value shops have also taken substantial stakes in UCP, and we think this creates a stable, long-term investor base.

UCP NAHB survey

(Source: Bloomberg)

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, Esq.
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/december-2013-investment-commentary-our-2014-outlook/

[3] http://www.rgaia.com/flushing-out-momentum/

[4]http://media.chrysler.com/newsrelease.do;jsessionid=DB87995E6A47326A95FE16036AE81A36?&id=15685&mid=1

[6] http://www.scribd.com/doc/224332847/NYT-Innovation-Report-2014

May 2014 Investment Commentary: Framing Broadly and Thinking Globally

What’s a valuation conscious investor to do in the face of markets hitting all-time highs on an absolute basis, and expensive valuations on a relative basis? This is a fair question to ask, though we think it also falls victim to the framing effect. There are several implicit points embedded in this statement, one of which has serious consequences for the ultimate answer—you see, not all markets are hitting all-time highs, nor are all markets expensive. This statement implicitly assumes that the investment pool is restricted to the United States and the United States alone. While many institutions are restricted via mandates to put their investment dollars to work in the United States, and/or U.S. markets, not everyone suffers these restrictions. Yet, many subconsciously end up the victims of what the investment community calls the “home country bias.”

European markets in particular remain some of the cheapest in the world today. We all know that the Eurozone went through an existential crisis of sorts, and some might argue that this particular crisis is far from over. Further, some might argue that European demographics are a concerning headwind to long-term growth (and thus equity returns) amongst other problems. While these are valid concerns, there remains a safety valve investors can use to their advantage in making a foray into Europe more palatable. We have discussed Europe several times in this forum, starting with our July 2012 commentary, continuing with our Preview for 2013, and most recently with our August 2013 note.[1] [2] [3] One of the most important points remains how global European businesses actually are. The companies that populate both our portfolio investments and European watch list make plenty of money outside of the Eurozone to the point where it mitigates the risk of Eurozone disintegration, and makes the demographics fears largely irrelevant.

Why do we think it necessary to make this point yet again? While the Eurozone’s problems remain a concern, we think right now is a crucial inflection point where policy imperatives shift from preservation of the “Euro project” to fostering a recovery environment. Since our first investments in Europe, the focus of the policy community on both the monetary and fiscal side has been taking steps that build confidence amongst Union members with competing interests, and building the institutional structure necessary to take the Euro from a largely fragmented collection of nation-states, to a true Union of integrated economies.

Hints of stronger action had been growing throughout the early part of this year, as inflation was decelerating and Mario Draghi was looking for more creative policy measures to boost Eurozone economies.[4] The firmest sign that monetary stimulus was imminent came when the Bundesbank, Germany’s own central bank that exercises considerable control over the ECB, shifted its stance from resistance to acceptance.[5] Although during the month of May, the precise actions to be taken remained unclear, everyone in the investment communities marked June 5th on their calendar as the date when it all would take place.

Two key objectives are improving the corporate lending market and weakening the Euro, both of which would be extremely positive for European multinationals.

To that end, we commenced a position in a company we had followed since we first started looking at Europe: Groupe SEB. We think Groupe SEB in particular has a confluence of favorable traits that standout amongst European companies. These are worth highlighting, below:

  • The company is owned and operated by its founding family, collectively owning over 40% of the stock. This has fostered an environment of long-term, strategic thinking, with the owners acting like and protecting the interests of shareholders.
  • Groupe SEB is number one, two or three globally in most of its key product segments from pots and pans, to bread makers, to coffee machines and waffle makers. Their products include a broad array of householder essentials, everyday appliances, and premium accessories.
  • The company owns some of the most recognizable household brands in the world, like All-Clad, Krups, Tefal and Moulinex.
  • With its leading brands, and global positioning the company is able to grow consistently without spending a lot of money on capital expenditures. CAPEX amounts to a mere 3.2% of revenues annually, on average.
  • 36% of their sales are in the Eurozone, with the remainder around the world including large presences in Asia, North America and Latin/South America.
  • Going back to 2007, the year before the Great Recession began, revenue growth has averaged over 7.5% annualized, EBITDA growth over 10% annualized, and book value has compounded at over 10%.
  • Today the company is trading at around 8.0x EV/EBITDA and 9.8x EV/EBIT. Similar companies in the U.S., like Williams-Sonoma, Jarden, Newell Rubermaid all trade at double-digit multiples EBITDA multiples and over 10x operating income.
  • This growth was consistent and persistent through the Great Recession and beyond, as have returns on equity and returns on invested capital. ROEs have consistently been in the low teens and higher, while ROIC has consistently been in the double digits, and above the company’s cost of capital
  • Groupe SEB’s balance sheet is as de-levered as its been, with the company considering possible buybacks, while also leaving ample room for accretive acquisitions—the kind of which Groupe SEB has an excellent track record of pursuing.
  • Many operating expenses are fixed in Euros, and the rising price of the Euro combined with the global sales base suppressed growth and made the company’s actual performance look less impressive than it truly was. While actual revenue grew 2.5% annualized, organic revenue grew at 5.4%. With the ECB taking aim at weakening the Euro, the benefits here will all flow through to operating profit. This has been a headwind to profitability for two years now.
  • This is a heads we win, tails we don’t lose situation, for should the Euro rise, our position denominated in dollars would increase in value, while the company’s performance would continue apace. Meanwhile, were the Euro to fall in value, our dollar-based position would decline, but the operating leverage to the Euro would greatly accelerate growth in profitability translating to a higher price in Europe and a higher multiple.

It’s very hard to find companies in the U.S. today with products that are not subject to the disruptive impact of the app economy, that are sold globally, capable of generating persistent and high margins for their owners, who also have really cheap prices. In targeting a holding period of three to five years (or longer) in the companies we buy, cheap valuation is an important criteria in achieving our return objectives. We have often emphasized the two key sources of returns in our timeframe as being the cash flow yield of the equity and the change in multiple over our holding period. When you can buy cash flow yields well into the double digits, you simply do not need multiple expansion to achieve good returns. However, if multiple expansion does work out in your favor, than “very nice” returns can become exceptional.

In our work on the company-level, we aim to identify situations where our confidence in the cash flow yield is high. What we cannot do is define an exit multiple. Mr. Market is far too temperamental in this respect. We can, however, identify situations where: a) a given multiple is simply too low today; and b) where the market should assign a higher multiple in the future were it to treat the equity more rationally.

Consider: if you buy a stock with a 15% cash flow yield for half of its fair value multiple, then in five years, were the multiple to stay exactly the same, you would expect a 15% annualized return. Were you to get a fairer exit multiple, your annualized return would be 32% over your holding period. To get this 32% we assume one buys $1, that compounds in value at 15% annualized, which can then be sold dollar-for-dollar at the end of $5 years. There is an embedded assumption here: that the company can continue to invest the proceeds of the 15% annualized cash flow return to generate those very same returns moving forward as it has done in the past. This is where our qualitative analysis becomes extremely important and is one of the focal points of our analysis. Taken altogether, this illustration shows how over five years, an investor can take a position that should reasonably earn 15% annualized, or double over five years, into one that quadruples. This by no means serves to suggest that we expect to earn these kinds of returns in this position, or any position for that matter; but we do spend considerable effort trying to find situations where if things go wrong, we fare well as investors, but if things go right we can earn outsized returns.

Multiple expansion is a true performance enhancer (though its opposite, multiple contraction is a huge detractor). Multiple contraction is exactly what people are referring to when they say that any one market is overvalued, and thus forward returns will be suppressed. –The assertion of overvaluation is merely the argument that the multiple coefficient of returns will be a drag over your desired holding period. Though this may be a problem in the U.S., first, it does not necessitate negative returns; second, it does not mean that each and every security will suffer from the drag; last, and most important in our eyes, it does not suggest that one must invest only in the U.S.

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, Esq.
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/july-2012-commentary-bulls-and-bears/

[2] http://www.rgaia.com/december-12-year-end-investment-commentary-looking-forward-to-2013/

[3] http://www.rgaia.com/july-2012-investment-commentary-europe-one-year-later-our-conviction-remains/

[4] http://www.bloomberg.com/news/2014-04-30/euro-area-april-inflation-quickens-less-than-estimated.html

[5] http://www.reuters.com/article/2014/03/25/us-ecb-weidmann-idUSBREA2O1K320140325

April 2014 Investment Commentary

“In order to form an immaculate member of a flock of sheep one must, above all, be a sheep.”

– Albert Einstein

Were one to look at the S&P 500 or Dow Jones in April, the month looked fairly tame with the indices tacking on 0.70% and 0.75% gains respectively.  However, April was by no means a calm month, as the Russell 2000 experienced significant pain, shedding 3.75%. There were many stocks around the market down over 10% in the month alone.  All this was masked in the major indices by outperformance in defensive sectors like Utilities, which added 5.36% on the month. We had been calling for a “momentum flush out” for several months running, and the spread in performance between the Russell and the more senior indices is the clearest sign that this flush out is underway.

It is unlikely for the major market indices to stay completely free of the pain while momentum gets punished; however, longer-term we view this action as extremely healthy. Had these egregiously valued technology stocks continued their march higher, it would have created an increasingly unstable market environment. What these flush outs do is remind overconfident traders that gains in markets should not be easy, and pain is natural every now and then. As such, this should help reign in risk management and make market participants once again more sensitive to valuation.

Markets work whereby such events are disorderly and emotional. This is an important fact, for we all must be aware that things can and often do get messy. The broader economy has little exposure to the noise brought about by these problems and given this, we would label this more of a “valuation correction” than a repricing of risk in the economy. Although our portfolios are more conservatively postured than the market, we will not be able to avoid the impact of rising volatility. Though fear not, as such volatility is the catalyst out of which opportunity is born. Indiscriminate and emotional selling is exactly what creates value-driven investments.

We think it is important to note that we entered this period with a detailed watch list of potential investments, with target price alerts set and our research largely finished. Some other managers start their research as opportunity arises, but we start our action. Our research has been done in anticipation of just such an event, and we will patiently await the right kinds of situations to step into, in the right kinds of companies.

Although US markets have been a bit shaky to start 2014 (as evidenced by the Russell 2000), we continue to find value in Europe. Many European markets remain at depressed valuations. Further, Europe has a large population of extremely high quality global companies owned and operated by their founding families. These families have a long-term focus, and operate their business from the perspective of how best to increase the value of the equity and keep their businesses immune from the principle-agent problem we see so often in US-based companies.

Most important, since we are first and foremast sensitive to valuation, these companies trade at valuations half those of their US peers.  While US markets have largely recovered from the Financial Crisis, and European economies continue to improve from their own woes, values remain far more favorable across the pond than they do here. When we make investments, often our aim is to make money both on the high free cash flow yield these companies offer and on multiple expansion (see our January and February commentaries for a deeper conversation on market multiples as this is an important recurring theme).[1][2]

We are hopeful that given this spate of volatility, some extremely attractive long-term investments will hit our target prices.  While we think some of these companies are already at points where long-term investors can generate positive expected returns, we do not think the tradeoff between risk and reward is favorable enough.  Should the balance shift further in our favor, we will be ready to act accordingly. Most of the time in markets the key to making money is to do nothing, and considering some of the portfolio balancing we did earlier this year, we by and large think this is the case right now.

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, Esq.
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/emerging-markets/

[2] http://www.rgaia.com/pockets-of-momentum/

March 2014 Investment Commentary: Flushing out Momentum

Two themes are quickly emerging this year and both have been covered in these commentaries: 1) the economy needs to catch up to the stock market; and, 2) pockets of momentum have become quite irrational. There is an underlying thread that unites these two themes and that is the positive feedback loop. The simplest possible explanation of a positive feedback loop is a definition we will borrow from Wikipedia: “A produces more of B which in turn produces more of A.”

Substitute “a rising stock market” for “A” and “a strengthening economy” for “B” and we have a good shorthand explanation for the relationship between the stock market and the economy. 2013 was the year of a strong stock market and a relatively tepid economy. Thus far in 2014, we have seen a strengthening economy, helped by the wealth effect and optimism derived from growing stock market valuations. Meanwhile, the stock market has largely stagnated as evidenced by the S&Ps 1.70% first quarter return. In order for markets to return to “A” (a rising state), we need the economy to do its share and strengthen, providing the impetus for continued increases in stock values.

We will revisit this relationship and the role that stock market multiples play in this bigger game, but for now we would like to focus our attention once again on these pockets of irrational momentum by way of anecdote. Craps is one of the most popular games in a casino. If you hear a raucous, joyous sound in a casino, odds are the craps table is its source. While the casino does offer nearly true odds for a bet behind the pass line, the true appeal of the game is how every participant joins forces to root in tandem for their united cause of collectively winning money. For the most part, when one person wins money at the craps table, so too does everyone else, yet not everyone wins the same amount of money in the same way.

The process of betting on craps can easily become its own feedback loop. This is something beginners are most vulnerable to, but experts are not immune from themselves. When a hot roller gets into a groove, craps players have money coming into their racks on nearly every throw of the dice. Each time more money comes in, new wagers are placed on the table or existing wagers are pressed. This effect increases the scale of winnings so long as the roller’s momentum is maintained. The process of momentum is a positive feedback loop, whereby winnings lead to increased wagers, which lead to increased winnings, and on, in a virtuous cycle.

It is when that momentum is not maintained that the craps player runs into trouble. Momentum does not merely wane; rather, it halts suddenly when the dice land on seven, the dealer shouts “seven out” and all bets remaining on the table are cleared. This is when the craps player learns how much he truly won on the hot roller, for far too many people end up with a growing arsenal of wagers on the table that get cleared off on the reset only to realize their stash barely grew, if it all, during the course of the hot streak.

The sectors prone to momentum in the stock market function very similarly to the craps table. These stocks are the domain of speculators (in contrast to those focused on fundamentals) in that people are essentially wagering that the direction of the trend will persist. As these stocks rise, traders implicitly have more money riding on each position. As traders make more money, they become less risk averse and spread their bets to other momentum situations. Soon wagers of a much larger scale are on the proverbial table. While there is no direct equivalent to “seven out” in the stock market, momentum is equally fleeting as it is in craps. There is no waning period, but rather a sharp, decisive reversal at which point these stocks collapse in spectacular fashion. Only after the wind is taken out of momentum’s sails does a momentum trader know how much money was made during the full cycle.

This story is by no means a suggestion that everyone who flirts with momentum loses money. There are some spectacular traders in this arena of the market, who consistently grow their betting stash; however, it is impossible to know who really did make money until the table craps out.  AQR Capital does outstanding research on market conditions and historical performance of strategies. They interestingly observed how momentum strategies tend to work; however, the average investor does not do well with momentum because they buy into these strategies far too late.[1] This is similar to how things work in craps. When a roller first picks up the dice, it is impossible to know whether they are hot or not. As they get rolling and start winning, only then can one say a roller is “hot,” at which point the bettor presses his bets.

We tell this story because right now momentum is getting clipped in the stock market. It is happening swiftly and violently and it is by design that our allocation to these areas remains almost nil, for these pockets of momentum are the gambler’s corner of the stock market. People do not own these companies for solid fundamental reasons, but rather for the prospect of “fast money”. Further, we operate on a totally different wavelength than these types of speculators. When markets rise, rather than increase our wagers, we take chips off the table and stash them as cash. This provides us the ammo necessarily to increase our wagers when the market goes down.

This conversation we have been carrying of late about momentum begs another question: is this a repeat of 1999 all over again? We are extremely confident in our answer that it is not. We have consistently labeled this problem as “pockets of momentum[2]” and pockets is a very fair way to put it. As we went over with implied growth of the S&P, expectations on average are not low, but neither are they high. One mistake punditry often makes in discussing market valuations is that by nature of the game, one must have a position. By that, we mean that when someone appears on TV or in the press talking about the stock market, that person by nature gets backed into a corner whereby they must label the market “cheap” or “overvalued.” In fact, it is those who most vocally argue one side or the other that get called upon to speak their opinions. It is very unsexy to think of the market as place with a range of possible outcomes and no one binary answer to the “cheap vs expensive” question.

If you were to ask us today where the market stands, we would tell you it is well within average ranges of valuation. In fact, the market could go higher or lower without changing our answer. Were you to ask us what we expect the market to do this year, our answer would be it “it will go up, it will go down, and ultimately it will not repeat last year.” While these appear as non-answers, they are important answers nonetheless. Markets spend most of the time walking within a few steps of fair value. It is the exception to find a situation en masse where prices are extreme in either the cheap or expensive direction.

Flushing out these pockets of momentum will inject some volatility into markets, but it will not jeopardize the trajectory of outstanding businesses at cheap to fair prices, of which we think we own many. We think the key in this environment remains focusing intently on the quality of the companies we own, the risk/reward proposition of ownership, and the management teams at the helm who should be working as stewards of our capital, building long-term value all the while.

To that end, let us turn our attention to this quarter’s leaders and laggards.

What do we own?

The Leaders:

Fiat SpA (BIT: F) +40.6%

Fiat rang in the new year with some exciting news: the company agreed to pay VEBA $3.65 billion in total consideration for the ~41.5% of Chrysler it did not already own.[3] Not only was this an extremely attractive price for Chrysler, a key source of value in our Fiat thesis, but it was also paid for primarily with cash on Chrysler’s balance sheet. This afforded Fiat considerable flexibility with regard to both the quantity and timing of fundraising necessary to execute its integration plan forging the new Fiat-Chrysler Automobiles. With the agreement complete, the new combined company can accelerate its focus on strategically using excess capacity in Europe to ramp its higher margin brands like Maserati and Jeep. This particular transaction affords us the opportunity to introduce an important market concept that we actively seek out: the Post Earnings Announcement Drift (PEAD).[4]

In this particular situation, the Post Earnings Announcement Drift is a misnomer, but do not be confused as it is directly related to what has happened with Fiat. On the day of the announcement, Fiat’s stock rose 15.06%, a spectacular one-day return. Notice however that 15% is not even half of the total move the stock experienced during the quarter. PEAD is one of the market inefficiencies (also called anomalies) documented and agreed upon by proponents and opponents of the Efficient Market Theory alike. Efficient markets are supposed to instantly and properly incorporate new information into a stock’s price; however, the PEAD suggests that the market is very slow to adjust to events that are of the extremely good (or bad) variety. To that end, when a particularly good surprise occurs, a stock’s price experiences a powerful move in the direction of the event; however, the ensuing period following the event sees price continue to drift in the direction of said event.

While Fiat’s positive event was not “earnings” in the literal sense, it was an extremely positive event which we felt the market clearly undervalued on the first day following the news. To that end, we used the catalyst as a reason to increase our existing position in the stock. Further, we would call the agreement with VEBA an important “de-risking event.” When we look at any potential company to own, we think about the risk relative to the reward. In a de-risking event, the reward side of the equation does not change, but the risk side decreases. Think about it mathematically. Let’s say you look for investments with three units of reward per unit of risk. Then, let’s say the risk in the situation is cut in half due to some catalytic event. When that happens, what formerly was 3:1 reward: risk now becomes 6:1.

All this is a roundabout way of saying our investment in Fiat remains one of our most attractive opportunities in today’s market despite the already solid unrealized capital gains we have earned.

Platform Specialty Products (NYSE: PAH) +34.74%

Platform Specialty is a unique situation. The company came public on the New York Stock Exchange through a “reverse merger.” Reverse mergers are typically looked at with scorn in the investment community and most of the time that is the correct way to think about such situations; however, not all of the time. This particular reverse merger was sponsored and largely owned by some parties who have exceptional records of value creation and outperformance. First and foremost, Platform Specialty is an initiative undertaken by Martin Franklin, formerly an activist investor who took over, renamed and completely revamped what is now known as Jarden Corp. We are sure you all have encountered Jarden products in your day-to-day lives. Jarden products range from mason jars, to K2 skis, to Coleman outdoor gear, Mr. Coffee makers and beyond.

Since Mr. Franklin joined Jarden in 2001, their stock has appreciated by 2,898.5% compared to 53.42% for the S&P. These are spectacular numbers and are reflective of Mr. Franklin’s strategy which calls for acquiring high margin, market-leading niche products with minimal capital needs. Jarden focused primarily on household and consumer products, but Mr. Franklin today claims that a very similar set of conditions exists in the specialty chemicals sector for the deployment of such an acquisition strategy. Based on what we have learned about the sector, we completely agree, though we would be willing to settle for a return less than that of Jarden’s (which is another way to say that while we like the potential here, it would be unreasonable to expect a return as spectacular as that of Jarden’s). Importantly, we did not buy Platform as a shell, for Platform’s initial offering on the NYSE came alongside the completion of its acquisition of MacDermid, a specialty chemicals company with a great track-record of its own and a management team that explicitly subscribes to Warren Buffett’s philosophy of ownership and operation. To that end, the MacDermid management team took a decent-sized stake of its own in Platform in the acquisition.

One of the facts we like most about Platform’s early rise is how it provides Mr. Franklin and his team an increasing amount of currency with which to undertake their stated acquisition strategy. While the stock is not cheap per se, one of the great ways for a fairly valued stock to become cheap is via the acquisition of companies and pieces that are in fact cheap. Between the ample cash flow that MacDermid throws off, the recently obtained warrant proceeds, and a rising stock, Platform has plenty of dry powder for acquisitions. In today’s environment, specialty chemical companies around the world are spinning off “non-core” businesses, many of which fit Platform’s criteria of high margin, high-touch niche products. The combination of ample ammunition and plentiful targets play right into Mr. Franklin’s hands and we are excited to watch this strategy play out over time.

Teva Pharmaceutical Industries Ltd (NASDAQ: TEVA) +32.83%

Teva was the second worst performer in our portfolio last year, and appeared in the laggards section of our quarterly commentary twice. While the stock did enjoy a positive return on an absolute basis in 2013, its return relative to the S&P was quite poor. All that changed in a flash when the calendar turned to 2014. We have spoken at length about Teva in the past, though find it worth emphasizing a key point: Teva is a textbook example of a situation where all the negatives are known, obvious and heavily discounted in the stock’s price, but where the market refuses to look past them. Headlines end up on top of a story for a reason—they are designed to draw attention. Few people could look beyond the headlines at Teva for they attracted all the wrong kinds of interest.

Someone who followed the newsflow in Teva last year sees a company whose lead product (Copaxone) is losing patent protection and a management team in disarray. Those who dug deeper would see that Teva had an opportunity to protect some of its potential revenue hit from Copaxone and that even if they were not able to do so, the price of the stock reflected its entire loss anyway. Here is where the relationship between price and value is so important. Bad news is inherently implied in the price of a cheap stock. Digging even deeper, one could then realize how significant a company like Teva is in today’s pharmaceutical landscape. Generics are becoming increasingly important globally and are one of the key sources of price pressure amidst rapidly escalating health care costs.

Further, as the largest generic drug company in the world, Teva not only is perfectly positioned to help drive down costs in the health care system, but they also have the capacity to sell at scale in a time when distribution and retail are consolidating in a push for more scale.  Witness the Walgreen’s/Alliance-Boots deal with AmerisourceBergen and the McKesson merger with Celesio. While these mergers put downward pressure on pricing at generic companies in the short-run, they create a profit opportunity for those who can trade some margin for a lot of scale on a global level. Therein lies a longer-term opportunity for Teva to continue its dominance in generic prescriptions worldwide.

The Laggards:

America Movil SAB de CV (NYSE: AMX) -14.93%

This is America Movil’s second consecutive appearance in the laggards, though the stock remains largely range-bound. In the past, we have emphasized our belief that the company has been under pressure generally speaking from weakness in emerging markets, and specifically from a regulatory overhaul in Mexico’s telecom sector. We maintain that these problems are fully priced in, and at today’s value, America Movil is a great stock to own. Carlos Slim is a proven operator who is backing his beliefs with money from two angles: Slim continues to buy more shares in his personal capacity, and the company continues to “cannibalize” its own shares with large repurchases.

Given many of these points are redundant, we want to highlight an investment concept that attracts us to America Movil. Think of the stock market has having two kinds of waves: long waves and short waves. Long waves are the trends that take place over years to decades, while short waves are the trends that take weeks or months to play out. Towards the end of a long-wave in the upward direction, a stock becomes pretty expensive as investors assume the past trend will continue in perpetuity (which never happens in reality). When the trend inevitably breaks, the stock gets re-priced downward and then proceeds sideways for a long time. For us to be interested in the stock, one of the most important factors is that during the sideways action, the intrinsic value of the company continues to increase while the stock stagnates. This in turn leads to valuation compression.

Valuation compression is that situation where simply by moving sideways, the stock becomes “cheaper” from an owner’s perspective. Stated another way, you can buy considerably more with the same amount of money. America Movil’s long-wave came to a conclusion in early 2008. From then on, the company’s intrinsic value has continued to increase, though the stock largely has moved sideways. Today’s ~$20 America Movil earns over double the revenues and over 50% more in operating income than 2007’s $20 America Movil. Clearly profit margins have not been as robust as in the past, but the fact remains that America Movil is a considerably more attractive bargain today than it was seven years ago at the same price. Back then the stock was priced for growth, while today it is priced for contraction. In reality, the company throughout this time period has delivered modest, but steady growth and we expect that to continue into the future; though we believe we are in position for a favorable investment outcome even if growth comes to an end.

Cree Inc. (NASDAQ: CREE) -9.53%

Cree is another repeat offender on the laggards list, though it also finished our 2013 Leaderboard in second place. The biggest problem facing the stock is that early last year’s price appreciation went much farther than its fundamentals. Now the fundamentals need to spend some time catching back up with the stock price. In essence, Cree is like America Movil circa 2008, though with a much quicker cycle that should not see valuation compression last nearly as long. As we have pointed out in the past, we already realized considerable gains on Cree, though we have maintained an average allocation to the stock with the residual of our sales. We do this for several reasons: 1) being as large a gain as Cree has, our unrealized gains are effectively a deferred tax loan that leverages the upside of our holding; and, 2) we continue to believe that the long-term outlook holds the potential for even better performance.

In our 2013 review we said that Cree has a “modestly expensive valuation” and this fact remains true today, though to a slightly lesser extent. We continue to like the outlook for 2014 and beyond now that the incandescent bulb ban is fully in effect. Importantly, Cree’s light bulbs have established themselves as the cleanest and purest “new” form of light. Light bulbs are often discussed as a textbook example of an innovative product turned into a commodity good, and certainly down the line LEDs will follow that same route. However, in the near-term, we think there is considerable opportunity to benefit from ramped utilization, which will more than offset price declines; and, longer-term we see upside from the company’s leading presence in LED fixtures, and a pipeline of opportunities to use lighting in new ways.

Johnson Outdoors (NASDAQ: JOUT) -7.10%

We bought Johnson Outdoors and almost instantly the price dropped sharply. The catalyst was the company’s fourth quarter earnings, though we would be hard pressed to say these earnings fell short of expectations. For one, the fourth quarter is always a slow one for Johnson considering the company specializes in warm weather outdoor goods, and second, few analysts follow the stock, rendering expectations largely a moot point. Despite the decline, we are excited to have found this stock and think the timing is largely right.

Johnson is an owner-operator, of the same family that is behind SC Johnson & Co. Johnson has several lines of business: Marine Electronics, Outdoor Equipment, Watercraft and Diving. In recent years, the vast majority of income has been earned in the Marine Electronics segment, which makes the Hummingbird line of fish/depth-finders. Over time, diving has been profitable, though it has struggled lately since much of its business has been earned from tourists in and from the most troubled European economies. The watercraft business is Johnson’s oldest and most troubled. As of today, there is talk of possibly selling that business to a purchaser and reallocating that capital. The Outdoor Equipment line is one area where the company recently made a strategic acquisition with vast potential: Jetboil. Jetboil makes a new line of camping stoves that is simpler to use than any predecessor and already is a top seller at many outdoor outlets.

Taken together, Johnson is an interesting collection of niche products, with the company’s lines either the number one or two best sellers, where brand recognition is important and long-term profit margins are attractive.  Johnson is reliant on leisure spending and during the crisis households cut back significantly on these purchases. On the plus side, Johnson’s core earnings were largely unscathed (they did take significant goodwill write-downs, but these were non-cash expenses). On the minus side, the company experienced a liquidity crunch during the crisis, and as a result, has maintained excess capitalization ever since. That minus has since turned into an opportunity for the company, as now that economic normalization is further along, there is considerable room for balance sheet optimization to drive better returns on equity. The company’s reinstatement of a dividend towards the end of 2013 was a key step in this direction.

The outlook for leisure spending looks increasingly good as the unemployment situation nationally continues to improve. With Johnson now trading at some of the lowest multiple valuations we see in the small cap space, this is a very attractive investment opportunity.

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, Esq.
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://compoundingmyinterests.com/compounding-the-blog/2013/10/16/learning-risk-and-the-limits-to-forecasting-and-prediction-w.html

[2] http://www.rgaia.com/pockets-of-momentum/

[3] http://www.fiatspa.com/en-US/media_center/FiatDocuments/2014/Gennaio/Fiat_to_acquire_remaining_equity_interests_in_Chrysler_Group_LLC_from_VEBA_Trust.pdf

[4] http://en.wikipedia.org/wiki/Post-earnings-announcement_drift

February 2014 Investment Commentary: Rational Expectations through Pockets of Momentum

In February, markets (as represented by the S&P 500) recouped all of their January losses and closed the month essentially flat for the year.  In our 2014 Outlook we emphasized the fact that strong market years like 2013 tend to pull forward future returns.  As such, the start to 2014 is very consistent with our belief that it is “quite possible, almost probably that 2014 will be a better year for the economy than it will be for the stock market.”  Fear not, for this is very constructive.

There are two ways for markets to digest gains: either they can decline in price or consolidate sideways over time.  Often times digestion comes with a little bit of both, and depending on your timeframe, one can see we have in fact experienced a little of each.  January brought about a market decline while, after two months of 2014 markets sit exactly where they started the year. Considering the magnitude of the rally in 2013, we think this period of digestion and consolidation can and should continue.

Embedded Expectations:

In last month’s commentary, we discussed the role of a stock’s multiple in driving returns[1].   The multiple is the best proxy for expectations in the stock market: a high multiple is a sign of confidence, while a low multiple signals a lack thereof.  We also emphasized that not all multiples are created equal.  While a multiple is inherently subjective, and noisy over time, there are some tools (aka formulas) we can use to approximate what a fair multiple would look like.  One nice feature of these formulas is that when we know the multiple at a given point in time, we can work backwards to solve for the embedded implications.

While most of the conventional discussion on multiples focuses on the P/E ratio, the P/B ratio is a close cousin that offers equally important insight. P/B is the price-to-book ratio, a measure of the market’s price in relation to the value of the assets minus liabilities at a company (or in an index).

The formula for P/B is as follows:

Justified P/B = (ROE-g) / (r-g)

We know all of these variables except for “g”—the expected growth of earnings over time.  Importantly it is expectations of “g” which influence multiples, so in solving for this variable we can learn exactly what the embedded expectations of “the market” actually are.  This implied growth would tell us what level of future growth the market would need in order for an investor today to earn his expected return. Expected return here is a loaded term, and we solved for it in two separate ways, though to simplify it is a return that essentially equally the long-run annualized return (over 100 years) that has been experienced by US investors.

We worked with a friend in the investment industry to solve for the market’s growth expectations over time in hopes of gaining some insight.  Sure enough, the chart was rather enlightening:

Implied Growth w 2 WACCs

The chart provides a roadmap of sorts, showing where the market has been over the past decade and offering us the threshold for growth that earnings must meet in order to earn an average return in the market over the next ten years. For an investor today to earn 7.91% annualized (this is total return, inclusive of inflation), then the earnings of the S&P 500 would need to grow at 4.31% annually.  This contrasts to the 5.3% average growth in earnings realized since 1950.

There are some further important takeaways worth emphasizing.  Many have talked about the market having more lofty valuations today.  While that is true relative to where we have been in the recent past, expectations remain fairly modest.  The flip side of the coin is that from here on out, companies will in fact have to deliver future growth in order to rise in healthy fashion.  Otherwise, expectations can quickly become detached from reality, as they did in the bubble of the early 2000s when markets were pricing in unprecedented and unjustifiable levels of growth.

Since the initial bounce-back from the Financial Crisis, implied growth has peaked near the 5% level.  In other words: markets have been digesting (selling off or moving sideways) each time implied growth has reached the 5% level.  This is consistent with the mainstream theme that we are in a “low growth environment.” While some believe we have reached “escape speed” in the economy, meaning we will return to a pre-crisis trajectory in growth, it’s clear that the markets are simply not there yet, though they are close. For much of 2011 and 2012, the market was pricing in no growth, so a substantial portion of normalization is expected on the earnings front.

If you find this topic of implied growth interesting, check out Elliot’s blog for a more detailed analysis of the market’s expectations[2].

Momentum Returns:

One corollary of higher growth expectations is the return of momentum. Much of the day-to-day action in markets has shifted from buying pressure from disciplined investors to speculative buying driven by momentum riders.  Pockets of momentum have been visible even during the depths of the Financial Crisis, yet today that pocket has been increasingly broadened. In our August commentary we highlighted some of the embedded assumptions in Tesla’s valuation[3]. This is not dissimilar from how we looked at the broader market above. Needless to say, Tesla has risen considerably since we took this first look, while the trajectory of Tesla’s growth has merely continued apace. Tesla’s price has gone up, while the value proposition has stayed exactly the same.

Tesla is not alone.  We ran a screen for stocks with in the Russell 3000 with market caps greater than $5 billion and a price-to-sales in excess of 10x.  Only four quarters in the past twenty years had a greater quantity of stocks meeting this criterion. Those four quarters are quarters one through four of the year 2000.  Moreover, regardless of how broad this list is, were one to invest in such stocks as a strategy, the likelihood of poor returns is exceptionally high, with a substantial likelihood of realizing negative returns.  These losses are not necessarily imminent, for the last time a similar population of richly valued companies appeared, the situation persisted for a full year.  Meanwhile right now it’s merely been present for part of one quarter.

Facebook is one such company.  Its stock is pricing in rich expectations, and Facebook’s acquisition of WhatsApp has striking similarities to behavior in the Dot.com bubble.  In fact, people who are justifying the WhatsApp acquisition are using the same arguments that failed way back when, asserting “users” as value with the expectation that revenues and profitability will follow.  While its certainly possible for the acquisition to work down the line, the higher the expectations the more likely it is that something can go wrong. In markets we want to pay as much as we can for what’s tangible, in situations where expectations enhance, not justify our return.  Clearly some have not learned the appropriate lessons of the past decade.

While we are concluding this letter on a cautionary note, it’s important to emphasize the overall expectations of the market are quite rational and quite justifiable.  These pockets of momentum will eventually be flushed out, and cause losses to people who are flirting aggressively in risky areas, though this day of reckoning might not happen for a while.  When it does, it could hurt the broader market in the short-run, but will not have too big an impact in the long-run.  All the while, we will remain disciplined and focused on owning only quality at the right price.

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, Esq.
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/emerging-markets/