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/

January 2014 Investment Commentary: Emerging Markets, Discounting the Obvious

“To establish the right price for a stock, the market must have adequate information, but it by no means follows that if the market has this information it will thereupon establish the right price.”

– Benjamin Graham

Heading into January, the biggest story in the financial arena was the accelerating U.S. economy. During the month, most data points confirmed this belief. Yet despite this confirmation, the two big stories coming out of January were the escalating troubles in Emerging Markets and the awful weather experienced throughout much of the United States, ranging from drought to “Polar Vortex” to feet of snow.  In our 2014 Investment Outlook we declared “it is quite possible, almost probable that 2014 will be a better year for the economy than it will be for the stock market.” After one month, this “almost probable” looks increasingly likely.

January 2014 is a tough month to write about for many reasons. Year-end, generally speaking, is an arbitrary metric at which time people make their larger reflections, judgments and projections. In this regard, we are no different than the crowd having recently offered our more in depth expectations for the calendar year ahead. And during January, nothing changed to warrant any deeper consideration of our views. It would be nice to wax eloquently about the Emerging Market troubles while arguing some profound point with conviction; however, there are only two very simple points worth making about “troubled” areas: 1) they are called Emerging Markets because they are prone to troubles; and, 2) there is little risk of contagion from Emerging Markets hurting the actual economy here in the US.  Since we know these to be truths, then why are markets moving so violently based on “Emerging Market” fears? The answer to that is also quite simple: markets had a great 2013 and needed any excuse to cool off for the time being. Secondarily, there are large, multi-national funds that have exposure both to the developed world and Emerging Markets. When these funds realize severe losses in one area, they must trim exposure in the other area in order to protect themselves from further losses.

In our July commentary, we made the following claim with regard to Emerging Markets which we believe rings as true today as it did then[1]:

We can see a path to Emerging Markets regaining favor, though we approach this part of the globe with far more suspicion and uncertainty than we did Europe.

There are several unquantifiable risks, including serious questions about the rule of law in some domains. As such, we pursue exposure to these areas primarily through U.S.-based multinational firms that enjoy earnings leverage to Emerging Markets, without risking permanent impairments to earnings should Emerging Market growth not play out as planned.

While we subsequently did commence one single position that is an “Emerging Market” stock, it has moved minimally amidst this recent fit. We continue to scour those parts of the world for opportunity with ample doses of skepticism.

Beyond this brief conversation about Emerging Markets, there are two further points we want to emphasize coming out of what is amongst the weakest market months in two years: when everyone acknowledges some reality in markets, it’s a near certainty that the point being made does not matter for future stock performance; and, markets and the economy do not necessarily move in tandem. Each point comes with its own corollaries that deserve further explanation.

Mr. Market Discounts the Obvious

When people say that “markets are efficient” they are asserting the fact that markets incorporate all known information into prices. In these commentaries, we have often talked about areas where market efficiency breaks down. This is only natural, for we seek out such situations in order to find attractive investment opportunities and we do think there are ample inefficiencies worthy of our time and attention. That being said, with the big questions facing the economy and to a lesser extent, the questions facing widely followed stocks, the market is incredibly efficient in incorporating widely understood information. Stated another way, it takes an unanticipated surprise (an redundancy of sorts) in order to seriously move the price of a market or stock.

All this serves as a long preface to a rather simple idea: when everyone knows something to be true, so too does the market. Known information gets fully incorporated into market prices, and as such, there is little advantage for an investor to act upon that point of fact.

This was the underlying reasoning behind our assertion that the year would be better for the economy than the stock market. As far as the economy goes, it was so widely asserted in the analyst and financial press communities that the economy would accelerate in 2014 such that there was little, if any value in acting upon this belief. Conventional wisdom is just that, conventional. It takes special insight, analysis or temperament to actually achieve a different outcome.

The Reality/Performance Divergence

Oversimplifying is often helpful, so here goes yet again. There are two basic sources of return in stocks: the yield of the equity and changes in the multiple.

A slight digression is necessary before moving further. When we talk about the yield on the equity, we are referencing something akin to the stock’s earnings per share divided by the price by share. Each year a company makes money. As earnings come in, that value accrues on top of what shareholders already own. Companies can do several things with that money: pay it out to shareholders as a dividend, use it to buyback stock, or invest to grow the business. When we say yield, we mean all of a company’s profit, not just its dividend.

Every year, the yield on the equity accrues to shareholders as a source of return. Let’s say a stock earns $2 per year and is priced at $20. That stock would have a yield of 10%. At the same time, that stock’s multiple would be 10x, meaning the stock trades for ten times its earnings. The yield of the equity and the multiple are related in that they are the inverse of each other.

When you buy a stock, you will earn the yield insofar as the earnings continue to come in, but the multiple is subject to change. At the end of a year, shareholders would “capture” that $2 in earnings, and the stock in theory should be worth $22 at the end of the year, assuming the earnings stream was not growing. Were the company to pay out 100% of its earnings as profits, then a shareholder would still own a $20 stock, but have the $2 in his/her pocket, thus also effectively “owning” $22 in value. However, at the end of the day, there is no guarantee that the multiple will stay at 10x. Perhaps investors believe the company’s future outlook is better than the recent past. In that case, investors would be willing to pay a multiple higher than 10x, and the stock price would rise accordingly without any actual change in the level of earnings. Alternatively, perhaps investors fear a competitor will steal business from the company. Then, investors might only be willing to pay a multiple that is 5x earnings and the stock price would drop accordingly.

Since the multiple is driven by confidence and expectations, it is inherently prone to behavioral biases. Further, the multiple tends to be far more volatile than the actual trajectory of the underlying earnings themselves. Herein lies the reason why reality and performance often do not move in tandem.

Where does this leave us today?

As of the close of January, markets are throwing a hissy-fit and everyone is searching for reasons. We think the most obvious reason is that markets had a great year in 2013 anticipating the improvement in the real economy that is starting to play out in 2014. Considering the economy is improving, and the risks of recession remains fairly low, the stock market should experience a much-needed correction without entering into a more concerning Bear-market.

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/2013/08/

 

December 2013 Investment Commentary: Our 2014 Investment Outlook

“The prevailing wisdom is that markets are always right. I take the opposition position. I assume that markets are always wrong. Even if my assumption is occasionally wrong, I use it as a working hypothesis. It does not follow that one should always go against the prevailing trend. On the contrary, most of the time the trend prevails; only occasionally are the errors corrected. It is only on those occasions that one should go against the trend.” – George Soros 

A Look Backwards:

2013 was a stellar year for the stock market. Every major index sans the NASDAQ closed at record prices, while the NASDAQ ended a spectacular year within striking distance of the dot.com bubble highs.  Meanwhile, bonds and commodities, particularly gold, struggled tremendously.  Arguably we have seen the collapse of the “fear trade” in which financial doomsters were posturing their portfolios for the possibility of a second Great Depression.  In our 2013 outlook, our case for a strong stock market was based in our belief that Europe was improving considerably, households were rapidly repairing their balance sheets, real estate was resurgent, energy was getting more abundant and cheaper, and the technology sector was in position for a rally.[1] In the end, our main failing was not pounding the rhetorical table more emphatically on the setup for an epic, rather than merely strong, stock market rally.

While we did not see the economy’s traditional metrics of success reach “normalized” levels in 2013, it has been clearly positioned for the long awaited, but elusive escape-speed breakout from the Great Recession.  In many respects, the stock market has now surpassed the real economy in its estimation of improvement.  Given that reality, it is quite possible, almost probable that 2014 will be a better year for the economy than it will be for the stock market.

One reality we all must accept is how great years in the stock market tend to borrow from future returns, rather than enhance them.  Heading into 2013, one could have reasonably expected to earn an annualized return of 6.67%  – on par with the market’s average since 1925 – over the course of the next decade.[2]  The S&P 500 started 2013 at 1426.  Factoring in a 6.67% annualized return the index would be at 2720 at the end of ten years.  Assuming that despite last years’ near 30% return, this 2720 ten year S&P index target does not change, the expected return over the next nine years would be 4.39% annually, instead of 6.67%.

In traditional financial parlance, Total Return for an investor = Alpha + Beta.  Beta is the return given by the market, while Alpha is the excess return provided by active management (see our October Commentary on “Our ‘Actively Passive’ Investment Strategy)[3].  When we suggest that the market’s expected annualized return over the next ten years should drop, we are alluding to a weaker tailwind from the stock market itself—Beta— as a source of returns over the next nine years.  We by no means view 2720 as a firm target for the market down the line, and we would not be surprised to see the market outperform or underperform the 6.67% long-term average.  Reversion to mean (or reversion to trend) is an important force in financial markets, though it is by no means the only force; nor is it the most powerful.  When we suggest that your investments might not benefit from the same tailwind that has helped this past year, there are two key takeaways: 1) great years are the exception, not the norm; and 2) markets are equally as likely to have a great year as they are a bad one.

We led this commentary with a quote from George Soros that lends itself nicely to where we think the markets are at this point in time. Prior to 2013, both the economy and stock market had been inconsistent, with “sputtering” serving as the most descriptive path. While last year was a great time to be looking for an inflection point and an escape from the sputters, we think 2014 will be a year for riding the trend, though to what extent it will flow we can never be sure.  The preference for contrarianism in calling tops and bottoms is part of human nature; however, the vast majority of the time, it is far more beneficial to follow, than to fight a trend. As of today, the economy is moving faster and in the continued process of acceleration. As we know from Newton’s Second Law of Motion, the greater the mass, the greater the force needed to change its direction.  When an economy the size of the U.S. is accelerating to the upside, it would take an extremely massive force to first, derail its momentum and second, change its course 180 degrees.  While such a force is not an impossibility, it is extremely unlikely in the coming months.

Let’s examine some of the more consequential happenings in 2013 that will set the stage for 2014:

The Credit Environment:

We have long emphasized that the Great Recession is an outgrowth of the de-levering (i.e. debt repayment) of the U.S. economy in aggregate. This becomes clear when we look at total credit as a percent of GDP.

Credit image 1

Ray Dalio of Bridgewater Associates has called this a “beautiful de-leveraging” for how smoothly the U.S. has combined austerity (a reduction in a sector’s annual deficit as a share of GDP), debt restructuring (the refinancing of existing debts to longer maturities and lower interest rates) and the printing of money (aggressive monetary policy).[4]

Within this broader context, it’s important to look at each of the individual private sector components. Household balance sheets stopped declining and in aggregate, essentially flat-lined.  When household credit neither grows nor contracts, but GDP does in fact grow, then household credit as a share of GDP declines.  This is subtle and important when looked at in terms of the gross levels, but clear as seen relative to GDP.  More violent contractions in household credit would come alongside equally more violent fissures in our financial market. As such, the subtlety itself is a core component of the “beautiful” nature of our deleveraging.

The following chart shows each of the key private sector components as a share of GDP:

GDP image 2

Importantly, the non-financial corporate sector (the green line) is moving upward/levering up for the first time in years, and it is the only sector to do so.  We have argued for some time this is the private sector arena with the greatest capacity for expansion in borrowing.  Companies have been well capitalized for a while now; building up massive stockpiles of cash due to a lack of good investment opportunities.  For now, much of this new debt has been used for repurchases of the existing equity stock.  While this is less beneficial than outright new investment, we think the re-levering of the corporate sector has afforded capacity for both households and our government (which is not included in this private sector snapshot) to accomplish their own deleveraging without leading to more pressure on the broader economy.  In our September 2012 Commentary, we highlighted two companies we invested in who took on greater leverage in order to smartly allocate the proceeds.[5]  One company opted for share repurchases, while the other made an aggressive acquisition.  Both increased their leverage and both saw their stocks appreciate at a faster clip than the market in 2013.

The normalization of credit spreads over the past year has been one factor to help the corporate sector take on new borrowings.  It also provides a nice snapshot for just how far the economy has moved towards normalization since the dawn of the Great Recession.

 Normal image 3

Fiscal Headwinds No More:

During the depths of the Great Recession, while the headline presses focused on the U.S. Federal Government’s increasing deficit, there was a rapid contraction in expenditures on the state and local level.  While state and local governments also ran deficits during this period, they were due exclusively to shortfalls in revenue instead of growth in expenditures. State and local governments were particularly at risk with the rapidly declining real estate market and employment situation.

As a result of constitutional restrictions mandating balanced budgets in these localities, state and local governments drastically cut spending in order to match their shrinking revenue base.  This placed an immense burden on the economy.  With the real estate market’s recovery and the employment situation finally starting to improve, state and local government budgets have quickly escaped deficit territory.  In aggregate, there is now a surplus. With a growing economy, there is ample room for expenditures on this level of government to rise at least as quickly as GDP grows.  What had been a headwind for the past five years now should turn into a true tailwind:

 S&L image 4

Last year was also one of the biggest contractions in the Federal deficit as a share of GDP in recent history.  Some estimate the “fiscal drag”—the headwind provided by a contraction in the government’s deficit as a share of GDP—was as high as 2.4% of GDP.[6]  This alone is more than our averaged annualized growth since escaping the Great Recession.  Considering 2013 was a positive year for GDP growth overall, it goes to show just how strongly the private economy is performing right now.

 fed image 5

Employment is the Key and it is Improving:

Importantly, people who have their jobs have been in a much more stable position than any time in the recent past.  This serves several critical roles including offering a much-needed boost to consumer confidence in order to enable spending, and affording workers the opportunity to seek out more attractive options without as much worry.  Workplace mobility is an important factor in helping workers seek out higher pay, career advancement and entrepreneurialism.

 MA image 6

As of today, we see signs of an improving wage environment for the first time since 2006. Hourly wages have finally started moving upward from trough levels and this is a trend which we look to continue and accelerate through 2014. Should that be the case, it would set the stage for a much healthier populace and economy. We will be watching this chart closely to confirm our suspicions that such a trend is afoot:

House image 7

What do we own?

This year we introduced a quarterly review that takes a look at our three best and worst performers during the covered time period. Since this is our year-end report, this edition of “What do we own?” will focus on our three best and worst performers for the year, with a twist: we will focus only on those firms that we still own today and not positions that have been exited during the year. With companies purchased in the calendar year, we will focus only on performance from the date at which we commenced our position. Our primary goal in introducing this section has been to help share with you the source of our interest in our portfolio companies—both the good ones and the bad—and not as an explicit means to highlight performance. Considering our low turnover, writing about new positions would often leave us without any companies to comment on. As a result, leaders and laggards provide a natural starting point for this conversation about what we own.

This was a very special year, for none of our three core equity positions in “The Laggards” actually went down for the year and/or from the point of our purchase (we do own bonds in some accounts and these did experience losses during the year, though they were modest in each position and immaterial on the portfolio level). Rather than an accomplishment, this is purely a stroke of luck—a stroke of luck which we would welcome time and again.

The Leaders:

Exor SpA (BIT: EXO) +88.43%

Exor is an Italian-based holding company, serving as the investment vehicle for the Agnelli Family—the founding family of Fiat.  Fiat itself was an exceptional driver of returns at the parent company, with its own impressive 66.33% return on the year, though it was hardly the only catalyst for our shares of Exor.  Our position commenced as a stake in the Preferred shares; however, in the first quarter, Exor undertook an initiative to streamline the capital structure and merge the preferred stock into the common.[7]  Since the preferred were trading at a discount to the common, this sparked considerable upside for our stake.  Further aiding shares were the merger of Fiat Industrial (formerly part of Fiat itself) into CNH and the successful sale of Exor’s stake in the Swiss-based SGS.[8] [9]  We were first attracted to Exor because of our interest in Fiat, Exor’s considerable discount to Net Asset Value, and its sharp management team behind a well-rounded portfolio. All factors continue to remain attractive into the New Year, despite the strong run-up in shares.

Cree, Inc. (NASDAQ: CREE) + 88.31%

Shares of Cree were a first quarter “Leader” and third quarter “Laggard” in our portfolios, though the year itself was truly a breakout.  As of 2014, consumers can no longer purchase 40- and 60-watt incandescent light bulbs.[10]  Notice that this ban did not enter effect until 2014, yet Cree had a banner year in 2013.  Obviously the look-ahead to 2014 helped shape investor expectations about the stock, but most importantly, the fundamentals at Cree took a huge step forward ahead of schedule. Cree’s accomplishments are greatest on two fronts: they have by far the highest quality of light-bulb and they are able to offer this quality at an extremely competitive price, sans subsidy.[11]  With the introduction of an Edison-styled light bulb at Home Depot, Cree was able to quell concerns that the incandescent light bulb ban would result in a marked decline in the quality of indoor lighting around U.S. households and business.[12]  Innovation delivered quicker than any expected in this case, and to that end, Cree’s stock considerably outperformed our expectations.  Cree enters 2014 in great financial shape, though at a modestly expensive valuation.  Despite that, we think the growth trajectory for the company remains extremely favorable.

The New York Times Company (NYSE: NYT) +80.00%

We commenced our position in the NY Times on January 31, 2013. We viewed the Times as a sum of the parts situation involving three parts: 1) a valuable Manhattan skyscraper; 2) a run-off print newspaper business; and, 3) a venture capital-type Internet startup. When the Times was in distress during the Great Recession, they sold an interest in the NY Times building through a finance lease. This afforded the opportunity for the company to repurchase this valuable property fifteen years from the date of the sale.[13] As New York real estate breaks out significantly from the trough days of the Great Recession, the value of this repurchase option is levered to NY real estate prices and increasing accordingly. The market continues to under-appreciate this source of hidden value. Moreover, with a spate of aggressively valued media-based IPOs, premised on the potential for growth, we felt the NY Times online platform—itself on the receiving end of millions of global eyeballs—had the understated capacity to enhance monetization. The Times continues to innovate in digital display, with features like Snowfall, and the paywall continues to exceed all expectations, while setting the bar for its peers.[14]

The Laggards:

America Movil (NYSE: AMX) +7.2%

We purchased America Movil on July 1, 2013 and since then the stock has exhibited little movement. We spent much of the early summer looking for bargains in Emerging Markets as fears escalated over what the Federal Reserve Bank’s “tapering” would mean for EMs and whether China would be able to execute a “soft landing.” America Movil fit several qualities that we find extremely attractive: it has one of the best capital allocators (Carlos Slim) as an owner-operator buying more shares with his own cash; the company is repurchasing shares at a furious pace (over 7% of shares outstanding in 2013); and it operates in a recurring revenue business that is one of the last expenses any individual would cut even in the worst economic times.[15]  Sentiment is extremely low on this stock right now due to the uncertainty of the Mexican telecom regulatory regime and the aforementioned concerns related to EMs. We view this confluence of risk factors to be far more superficial than fundamental to the business, and think America Movil is in a great position to be a steady compounder over time. 2014 should be better than 2013 here.

Teva Pharmaceutical Industries (NYSE: TEVA) +7.74%

Teva was a member of the “Laggards” section in the third quarter, and obviously disappointed us considerably on the year.  The pharmaceutical and biotechnology sectors enjoyed a blockbuster 2013, while Teva languished in dark.  Mr. Market continues to look with scorn upon the impending patent expiration of Copaxone and in so doing, continues to ignore the valuable generics business. In our third Quarter note, we heaped praise upon Dr. Jeremy Levin as CEO, though in a surprising move, Teva and Dr. Levin decided to part ways.[16] In light of Dr. Levin’s departure, we spent considerable time revisiting our analysis on the company and remain convinced the value is extremely attractive. An Israeli activist investor, Benny Landa, has stepped up to provide an important advocate for shareholders and looks to close to securing a well-regarded “turnaround specialist” in Erez Vigodman as the new CEO.[17] [18] This would be exactly the type of catalyst this stock needs in order to get Wall Street’s short-term attention span focused on the future rather than the recent past and the next fifteen minutes.

Cisco Systems (NYSE: CSCO) +15.32%

Cisco had a disappointing 2013 on all levels. The stock had been performing fairly well until a huge warning on revenues in the November earnings release—between 8 and 10% sequentially.[19] Despite this ominous warning, Cisco stock remains very cheap.  However, as time marches on, our confidence has started to waver in John Chambers’ leadership as the company remains overcapitalized, continues to repurchase shares, and yet its share count fails to materially shrink. There is simply no excuse for the company’s lackluster effort to follow IBM’s template of smart capital allocation in technology. From our seat, it seems as though Chambers is more willing to use his excess cash position to trumpet political talking points (about his desire for a tax holiday on repatriation of foreign earnings) than he does for shareholder value. The reality is that the company would be a considerably more valuable and respected by the stock market had Chambers simply paid taxes to repatriate all of its cash and repurchased shares in a tender than engaging in public advocacy.  That being said, we continue to view Cisco as a great value with a substantial margin of safety, though should we not see further progress on capital allocation we might simply leave this investment for greener pastures in the coming months.

Only time will tell what this list will look like next year at this time.

Thank you for your trust and confidence, and for selecting us to be your advisor of choice.   We wish you and your families a healthy, happy, and prosperous 2014.  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.

 

 


November 2013 Investment Commentary: “Tapering”

In our May 2013 Commentary, we made our first reference to the potential for the Federal Reserve Bank to “taper” its policy of quantitative easing (QE). Specifically, we made two important points: first, the Fed would not commence tapering unless and until there were signs of a “sustainable recovery;” and, second, the Fed would “err on the side of pushing a little too far towards inflation rather than the other way around.” Based on this, we explained how there were tangible improvements in the state of the economy, but it remained unlikely for the Fed to conclude we were in a “sustainable recovery.”

The Market Skeptics Versus the Fed

Market participants have consistently been ahead of the Fed in expecting a step back from the aggressive policies implemented to lift our economy out of the Great Recession. This makes sense in light of how the economy as represented by the stock market has improved at a much quicker pace than the “real” economy—the so-called “Wall Street” vs. “Main Street” dichotomy. While this is a relevant distinction, it is not the only point missed by the discourse surrounding whether the Fed will or will not taper.  When Wall Street analysts speak of tapering, they are implying something deeper, which many market skeptics openly and regularly lament: there is this notion that tapering is a major risk to the stock market. The skeptical argument goes as follows. “The stock market is not rallying for fundamental reasons. The economy is not really improving. This rally is happening purely because of QE.” The follow-on logic is that as soon as QE ends (aka tapering begins), then the rally will all fall apart. Again, the embedded assumption here is that the real economy has not improved, but the stock market itself has rallied.

It is clear that something does not add up. The Fed has maintained it will not end QE unless and until we have a sustainable recovery, while the skeptics are arguing the end of QE will lead to a stock market correction because we have not had a sustainable recovery. These two positions are mutually exclusive, unless the skeptical argument is actually that the Fed will be fooled into thinking there has been a sustainable recovery, when in fact there has not. It is important to point out the inconsistency in the fact that those most skeptical of QE are calling for its immediate end now despite this contradictory reality. We think this sheds more light on the biases possessed by these skeptics than it does the state of the economy.

Alongside this skeptical refrain has been the meme-ification that “good news is bad news.” This amplifies the inconsistency in the skeptical argument against QE, for if this is all an illusory stock market rally due to QE, then good news would in fact be good news independent of any Fed policy path. This notion is a textbook example of absurdity. Yes indeed, good news is in fact good. It amazes us that such a simple point of fact needs to be said in this environment.

The Pen (or Microphone) IS Mightier than the Sword

With this heated discussion about taper, the Fed has effectively accomplished two things: first, the Fed has essentially completed the first round of interest rate hikes purely through the power of communication; and second, the Fed has also helped flush out what may have been overly speculative positions in bond markets in particular. Chairman Bernanke made an important observation regarding the former fact in a speech during November, which also addresses some points talked about above and sets the stage for our discussion of the latter:

Financial market movements are often difficult to account for, even after the fact, but three main reasons seem to explain the rise in interest rates over the summer. First, improvements in the economic outlook warranted somewhat higher yields–a natural and healthy development. Second, some of the rise in rates reportedly reflected an unwinding of levered positions–positions that appear to have been premised on an essentially indefinite continuation of asset purchases–together with some knock-on liquidations of other positions in response to investor losses and the rise in volatility. Although it brought with it some tightening of financial conditions, this unwinding and the associated rise in term premiums may have had the benefit of reducing future risks to financial stability and, in particular, of lowering the probability of an even sharper market correction at some later point. Third, market participants may have taken the communication in June as indicating a general lessening of the Committee’s commitment to maintain a highly accommodative stance of policy in pursuit of its objectives. In particular, it appeared that the FOMC’s forward guidance for the federal funds rate had become less effective after June, with market participants pulling forward the time at which they expected the Committee to start raising rates, in a manner inconsistent with the guidance. (emphasis added)

It is impossible to know whether this “unwinding” was willful on the part of the Fed, but it did in fact help set the stage for a reduction in the impact of a policy shift once tapering does in fact occur.

In our July 2012 Commentary, we marveled at how “Mario Draghi, the President of the European Central Bank, through muttering a few words, sent global markets higher by more than 2%. And you know what they say: ‘actions speak louder than words.’  Communication has played an immensely important role in the toolkit of central bankers in dealing with crisis. Since Draghi’s strong utterance, policymakers in Europe have followed through with some action, though the catalytic event remains simply the powerful statement towards “the irreversibility of the Euro.”  One of the hallmarks of Ben Bernanke’s tenure as Fed chairman has been his emphasis on clarifying and improving the Fed’s communication. We think one chart in particular highlights the real-world impact of this point nicely:

fred1

This chart shows inflation expectations since 1990 based on a survey conducted by the University of Michigan.  Expectations serve an important role, because they reflect what the average person thinks, rather than what actually and necessarily will transpire. In the Great Recession (2007-2009), the U.S. faced by far its greatest risk of a deflationary spiral, yet notice how inflation expectations never went negative, and never got close to the depths they did in the recession following the bursting of the DotCom bubble. Credit for this goes to Chairman Bernanke for how effectively he conveyed the role Fed’s policy would play in aiding an economic recovery.

In terms of how things have played out in markets, the tapering conversation alone looks very much analogous to an actual hike in interest rates. This is an important point considering the Federal funds rate set by the Fed remains at zero. In fact, we have long argued that the role of QE itself is to help the Fed communicate its intent to maintain the zero interest rate policy (ZIRP) for longer than the market has believed. This is so, because between each round of QE, the market has repeatedly turned its attention towards when the first rate hike would occur, despite the Fed’s language that rates would remain at zero for an “extended period.” With QE in place, all this consternation focuses instead on the QE debate, while interest rates have remained low throughout the yield curve, affording all sectors of the private economy ample opportunity to restructure their debts. This too gets at one of our favorite, most telling charts; the one which shows the household debt service as a share of income:

fred2

This highlights just how far household balance sheets have come. Balance sheets have quickly evolved from being overburdened by debt, to having even greater flexibility with financing than any point before the prior two boom periods.

Again we want to emphasize that this entire conversation about an imminent end to QE comes on the heels of improving economic data, and while some view these higher Treasury rates as cause for concern, we view them as a reflection of the underlying improvements. This is something that should make us all feel more comfortable about where the economy is, and is heading, and not something anyone should lose sleep over.

There is another point to make about communication. This year will mark the end of Bernanke’s term as Fed chairman, after which he will be replaced by Janet Yellen. Many credible Fed insiders have stressed Janet Yellen’s high regard for communication as a Fed policy tool and believe she will use it to an even greater degree than Bernanke has. This will be worth watching (and listening to) moving forward.

Moving Forward

While we never make decisions based on Fed policy, we think it is very important to address and add context to the many concerns hitting mainstream media about a potential shift in Fed policy. This is reflection of strength, not a projection of fear for financial markets. It is also important to remember that the stock market and the economy do not necessarily move in lock-step. Sometimes the stock market is ahead of the economy, and sometimes it behind. This is merely part of why picking tops and bottoms is a challenging task. Equally important is acknowledging the reality that when the stock market outperforms its long-term annual average return by a wide margin in a calendar year, it is pulling forward future returns. To that end, we do not expect future returns to be nearly as strong as they have been these past two years. This is a simple reality lost on many. Lastly with regard to the stock market, when a large coefficient of the return stems from an increase in the market’s multiple (P/E ratio expansion of the broader indices), then the protection afforded by valuation is inherently lessened. Higher valuation alone is not a risk in and of itself. Too many are making this misguided case. This reality simply means that in the event of a shock, the market has more downside risk than it has in the recent past. These points matter more in the context of how they should shape our expectations moving forward than they do in terms of the actual risks facing our companies’ earning power.

Despite the market’s continued rally, we see little reason to change our overall positioning. As we explained in recent months, we have a healthy allocation to equities in Europe, which are only impacted indirectly by Fed policy, and we already trimmed our lower conviction US positions.  Our cash balance remains rather plush. If the market keeps grinding higher, it is all but certain some of our remaining positions will pass the upper reaches of our fair value range at which point further selling would be warranted, though there are no guarantees.

One market disconnect that we have bought into is the muni bond market. We will look to increase our stake in this area over the coming months. This asset class is sensitive to interest rates considering its long duration, though through the use of vehicles like Closed End Funds, many of which are trading at steep discounts to their net asset values, we think we can both mitigate risk and put ourselves in position to generate a nice return.

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.  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

October 2013 Investment Commentary: Our ‘Actively Passive’ Investment Strategy

In our last commentary, we highlighted the relationship between the market’s earnings yield and its long-term average return of approximately 6.67% since 1925. In response, several clients have asked us whether this should be viewed as an endorsement of passive, rather than active investing. This is a popular question in financial literature today, with many suggesting the recent financial crisis provides unequivocal proof that a passive approach is better than active. However, in order to offer a proper answer, we need to first define the essence of the question. What people mean today when discussing passive versus active investing is really whether one should “index” or “pick stocks?” As is often the case, we think this is the wrong question to ask. As we explain why this is wrong, we hope to answer both the right and wrong questions at the same time.

What is Active Management?

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

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

Consequences of High Turnover:

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

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

Randomness vs. Investing:

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

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

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

  • “Portfolio turnover. As a whole, this group of investors had about 35 percent turnover in 2006, which stands in stark contrast to turnover for all equity funds of 89 percent. The S&P 500 index fund turnover was 7 percent. Stated differently, the successful group had an average holding period of approximately three years, versus roughly one year for the average fund.’”

  • “Portfolio concentration. The long-term outperformers tend to have higher portfolio concentration than the index. For example, these portfolios have, on average 35 percent of assets in their top ten holdings, versus 20 percent for the S&P 500.”

  • “Investment style. The vast majority of the above-market performers espouse an intrinsic-value investment approach; they seek stocks with prices that are less than their value. In his famous “Superinvestors of Graham-and-DoddsviIle” speech, Warren Buffett argued that this investment approach is common to many successful investors.”

  • “Geographic location. Only a small fraction of high-performing investors hail from the East Coast financial centers, New York or Boston. These alpha generators are based in cities like Chicago, Memphis, Omaha, and Baltimore.” (More than You Know, Michael Mauboussin).

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

While we have discussed this over time, it’s worth repeating for the sake of completeness: our active twist is thinking about companies as businesses, running them through our checklist, and asking ourselves “what would a rational businessman pay in order to own this company’s cash flow?” When we find companies that Mr. Market is offering us for less than what a rational businessman would pay, then we have the makings of an 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. 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

September 2013 Investment Commentary: Beware of Mistaking a Symptom for the Cause

October 4, 2013

Beware of Mistaking a Symptom for the Cause

“If you can heal the symptoms, but not affect the cause, it’s quite a bit like trying to heal a gunshot wound with gauze.” – Trey Anastasio, Phish

Reflections on 5 Years Past

The month of September marked the five-year anniversary of the Lehman Brothers bankruptcy. For many, especially those in financial circles, September 15, 2008 is “a day that will live in infamy” for bringing to the fore the fragility of our financial system. Yet here we are five years later, and the anniversary of the event itself is convincing proof that we as a society have not learned the appropriate lessons. Nearly every mainstream news outlet featured a “5 Years After the Financial Crisis” headline (Washington Post , Fox Business , Bloomberg Businessweek , Forbes), insinuating that the crisis started punctually upon Lehman’s collapse. While not every outlet shared the same message, they all made the same crucial mistake: the collapse of Lehman Brothers absolutely, positively did not cause the financial crisis; it was a symptom of a crisis set in motion several years prior.

In Fooled by Randomness, Nassim Nicholas Taleb taught us that often what seems a tight connection is merely coincidental, with the randomness mislabeled until it’s too late. Lehman Brothers wasn’t even the first casualty of the financial crisis (Northern Rock fell before Bear Stearns), so how could it possibly be the cause? Some might argue had Lehman survived that fateful weekend, the crisis would have been less bad, though we caution that such a claim is impossible to prove. Moreover, with the placement of Freddie Mac and Fannie Mae into conservatorship, the government and Federal Reserve Bank’s intervention in AIG, Merrill Lynch’s sale to Bank of America and the accompanying stock market panic all would have taken place with or without Lehman’s failure.

In fact, even at the time, and in hindsight, one of the most shocking facts of the Lehman failure was how much of a slow-motion train wreck it all ways. The failure of Lehman seemed inevitable the moment Bear Stearns writing hit the wall, with the only “out” being a sale of the company, something CEO Dick Fuld viewed as unfathomable. It is maddening and frustrating to hear talk to the contrary and for the crisis narrative to shift to where these five years of economic stagnation would not have happened were it not for Lehman. This new narrative is designed purely to suit the political desires of certain constituencies and Wall Street interests whose own messages and business models would face severe disruption were we to acknowledge the true nature of our financial system’s problems.

Lehman’s collapse was due to the excessive buildup of leverage in our economy, and the financial sector in particular. Households also took on leverage, but it was the concentration of leverage in financial institutions that really blew things apart. In chart form, this is most clear on both the way up, and the way down (note, please open PDF to see image):

sectoral leverage

The blue line represents total debt in the financial sector, the red line represents household debt, and the green line non-financial corporation debt. We can clearly see that the blue line has the steepest trajectory on both the way up and the way down, yet it still remains the dominant domicile for the concentration of debt in our private economy. Since the onset of the crisis, we can also see that households have deleveraged (please note: the deleveraging of both financials and households would be more pronounced shown as a percentage of GDP, we are looking merely at gross values), mostly by flat lining in terms of total liabilities outstanding. Non-financial corporations have been the biggest beneficiaries of the low interest rate environment by issuing increasing amounts of debt.

Our point here is rather simple: leverage had gotten extreme in our financial sector, Lehman was one of the more levered financial institutions, and as such, its failure was merely a byproduct of a deeper systemic problem. To make matters worse, leverage was simply too high throughout our private sector of the economy and had to be brought down (with the government stepping in to fill the gap, though this is a discussion for another time).

Lessons learned for investors

This distinction between symptom and cause is an important one, for how can we learn any lesson if cause and effect are reversed? In markets, the relationship between causation and correlation is inherently tricky business. One fact is clear: even with the crash, those who focused on investing in sound businesses performed far better than those who relied on trading or market timing strategies. Even people who invested in indexes have once again earned a positive return from the pre-dawn of the crisis up to today, while many who anticipated and sold before the crash have missed out on more gains than losses saved. It was those who invested with leverage, or those who could not handle the behavioral element that is a prerequisite for risking capital in financial markets who suffered the worst fates.

In our January 2013 Investment Commentary we highlighted the concept of “myopic loss aversion” whereby investors cost themselves a significant portion of their long-term return by checking stocks too frequently and reacting too emotionally to volatility. While one of the core foundations of the Efficient Market Theory holds that volatility is risk, in actuality, the human response to volatility is what makes for risk, not the volatility itself. One of the easiest ways to mitigate this risk is by separating our analysis of a business from the idea of the “stock market” itself. We will speak to this point directly below, but first it’s important to digress and ask ourselves, what exactly the existential purpose of markets is? In a broader sense, we all know that markets are about the allocation of scarce resources.

Insofar as the stock markets are concerned, the answer is far more nuanced and many may disagree; however to us the answer is abundantly clear. Stock markets are here to provide companies a means through which to raise capital in order to invest in their businesses, and investors to allocate capital in order to generate a return. Many argue that markets are a “zero-sum game” meaning that one participant’s gains (loss) is another’s loss (gain). In essence, this is simply not true. When companies use markets to raise capital, they can (and should) benefit their existing investors and new investors alike. It is only in the more abstract world of short-termism and trading that markets are zero-sum.

In the decade leading up to Lehman’s collapse, the proliferation of trading-based strategies became completely distorted and abstracted from the basic purpose of markets themselves. Many were making more money trading spreads and leveraging minimally profitable strategies while appearing to generate enormously safe returns without ever acknowledging that the former was merely supposed to be a lubricant for investment, not to be mistaken with investment itself, and the latter was merely the magnified effect of leverage. We speak of these two in the same sentence, because things went most wrong where the two phenomenon of trading and leverage were combined, like in Long-Term Capital in the late 1990s, and Lehman Brothers a mere five years ago.

The existential question is a particularly important one because markets have moved so far past their intended purpose that most fail to even acknowledge the role of boring, old-fashioned business investment. That’s precisely what we’re here for.

Where we stand in the Long Run

Here we must take a second digression before getting to the real question of what it means to invest in businesses as separate and distinct from the stock market. In our 2012 Investment Outlook, we highlighted how the Dow Jones Industrial Average’s long-term total return since 1925, even when counting both the Great Depression and the Great Financial crisis was 6.58% annualized. Since that time, the Dow’s annualized return from 1925 to today has improved to 6.74%. There is an important connection to make between the market’s average P/E of 15 over the long run, and the market’s long run return. Another way to think about a P/E ratio is as an earnings yield, (we calculate this by taking the inverse of the number, i.e. E/P, or in this case, 1/15). It just so happens that the inverse of the market’s long-run P/E ratio is 6.67%, amazingly close to the 6.74% long run return experienced since 1925.

We find the market’s earnings yield particularly important, as it is the best proxy for conceptualizing a stock investment like one would a bond. The 6.67% earnings yield is analogous to a coupon on a bond, and given this relationship, as the earnings yield and long-run return are strikingly close, it seems clear that the bond-like element of stocks is the generator of long-run returns, not capital appreciation (aka the rise in share prices) as many would suspect.

Interestingly, despite periods of deflation and inflation, the market itself has generated a fairly consistent annualized yield for investors. While 6.74% is the long-run return, there have been years with returns far in excess of the mean (this being one of them) and years that not only fall short, but destroy significant amounts of capital if not handled appropriately(like 2008). Investing for the long run is the greatest hedge against a bad year, for a conviction in your timeframe affords the opportunity to capture the easy part of the return the market has to offer. Meanwhile, within all of these years, there is substantially wide dispersion between stocks themselves, and not all stocks rise and fall in unison, to the point where prudent business analysis can make a big difference in mitigating the depths of downturns and enhancing the rewards that good times have to offer.

Getting Micro

One fact we feel is significantly underemphasized is the capacity of sound businesses (thought of as separate and distinct from the market) to generate meaningfully better returns than the market itself. Over the past decade, which covers the tail end of the dot.com bust and the full extent of the Great Financial Crisis, 455 stocks in the Russell 2000 have returned at least 15% annualized. That means that nearly 1 in 4 stocks in our broadest market index have over doubled the market’s annualized long-run return. While it would take a significant stroke of luck and at least modest skill to have a portfolio full of only 15% annualized returners, we do think it’s possible for a portfolio to be heavily weighted towards the big gainers and we think there is a tried and true method to doing so.

To that end, we never think of ourselves as buying “stocks,” rather we think it’s our job to analyze and buy fractional interests in businesses. This requires far more analysis, diligence and patience than does investing in strategies that try and capitalize on fluctuations and speculations in the market. It involves a holistic analysis into the drivers of a business, its industry situation, relationships with consumers and suppliers, management’s incentive structure and the price that financial markets are offering us compared to a rational intrinsic value.

Not every

investment in every company will work according to plan, and that is where the benefits of building a diversified portfolio of businesses plays a role in mitigating risk. We purposely seek to build a basket of businesses, each exposed to disparate risk factors and unique reward catalysts, operating globally and in geographic niches, with short and long durations. Our favorite businesses are those with a solid valuation, with the consistent ability to compound capital, and the added chance for something to go asymmetrically right. This added idea of asymmetric opportunities is important, for it is what over the long run can set apart a great portfolio from a decent one.

We are not alone in this pursuit, and our philosophy is founded on the principles of investment greats like Benjamin Graham, Warren Buffett, Phillip Fisher, and more, though we are constantly surprised by how many would rather base investment decisions guesses on policy direction in Washington, and presumptions about where other speculators will move their money next. To that end, when we want to know how our companies are performing, we never check the price of a share first; rather, we check the results of the business itself against our investment thesis. If the results are sound and reflective of our thesis, though the market itself has not moved higher, our conviction increases as the price to buy is more attractive; while alternatively if the market price of our stock rises and the fundamentals have not followed our expectations, our conviction diminishes and we are likely to sell. The point here again is quite simple: when we follow a business, we first and foremost follow the performance of the business as an owner would, and only secondarily look at the stock’s chart.

What do we own?

With the 3rd quarter in the history books, it’s time to continue our glimpse into your portfolio by looking at the leaders and laggards during the quarter, and how their respective stock performances stack up to our fundamental thesis.

The Leaders:

Given Imaging Ltd. (NASDAQ: GIVN) +37.16%

After buying Given towards the end of the second quarter, the stock wasted no time impacting our portfolios in a positive way with three excellent catalysts. Given makes a swallowable capsule (called the PillCam) designed to take images of the gastrointestinal tract in a more comfortable, minimally invasive method for patients than traditional processes. The first catalyst was approval for the PillCam’s use for colonoscopies in Japan, the second largest market for colonscopies in the world, followed by better than expected earnings, and lastly, by the approval of a newer generation of the PillCam in US markets that should offer improved and expanded functionality for doctors.

Given embodies the type of company discussed above with a solid valuation and the potential for asymmetrical returns. The valuation is justified based on its existing status as the first-line treatment for diagnosing GI bleeding, and its asymmetry comes from the potential to reinvest earnings into improving the technology with the aim of completely disrupting the colonoscopy. While this will take time, this quarter, the company demonstrated tangible steps towards making the asymmetrical possibility a reality.

ING Groep (NYSE: ING) +24.86%

ING was one of the laggards in our first installment of “What do we own” from the first quarter. Since that time, ING has recouped all of its losses and then some. This quarter’s strong performance was on the heels of an improving macro-environment in the Eurozone (see last month’s commentary on one year since our foray into European investments ), on improving earnings at ING itself, and on the successful evolution of ING’s plan to restructure around core European operations in order to pay back the bailout money provided by the Dutch government.

During the quarter, ING completed the spin-off of its U.S.-based asset management business, ING U.S. (NYSE: VOYA). The company took in nearly $550 million in cash proceeds that will be used to shore up its balance sheet and build up a stash to repay the Dutch government. As VOYA shares have risen steadily since the IPO (up 52.8% to-date), ING has divested itself of yet more shares, bringing its total ownership interest to 71%. By the end of 2014, ING will sell yet more shares, targeting an ownership stake of less than 50%, at which time, the company will also have repaid the full extent of its bailout. Once this is done, ING should be able to reinstate a dividend and commence buybacks, offering further opportunity for upside.

Siemens AG (NYSE: SI) +21.92%

Siemens was another laggard in our Q1 report who has been a leader of late. While also a beneficiary of Europe’s resurgence, Siemens did have some news of its own. During the quarter, the company warned on its annual profit and margin goals, then proceeded to fire CEO Peter Loescher before replacing him with CFO Joe Kaeser. Kaeser has a long history with Siemens and thus far has been perceived by the market as the right person to restore many of Siemens operating segments to industry average profit margins. While only time will tell whether this judgment by the market is correct, should Kaeser succeed, the company will be worth well in excess of our present fair value targets.

Siemens is a diversified conglomerate, which under Kaeser will continue its focus on shedding non-core and non-performing divisions. In the past quarter, the company spun off its lighting division—Osram—and sold its joint venture interest in Nokia Seimens Networks. Both initiatives took loss-generating divisions out of the company’s responsibility, and should help a focus on improving operational efficiencies in the remainder of the company.

We love the role a stock like Siemens plays in our portfolio. The company has a really stable non-cyclical business that is a stellar sector in and of itself (healthcare), a well-positioned, but underperforming cyclical businesses (Cities and Infrastructure), and although there is substantial European exposure, the company has a global revenue base.

The Laggards:

Cree Inc. (NASDAQ: CREE) -5.70%

Some context is necessary in Cree’s place as a “laggard,” for the stock is up 77.13% on the year, and was our top leader in the first quarter’s Leaders and Laggards. There is little new to add to our points made on the company in the past. We simply need to reiterate that the fundamentals in this stock continue to move in the right direction, though it’s clear that in the short-term the stock’s price had accelerated ahead of the growth in intrinsic value. This is not a company we would call “downright cheap,” though it is one that is a worthwhile hold for positions established in the 20s and 30s. All along we have been anticipating 2014 as the year for acceleration in LED demand, and Cree’s technological prowess has pulled forward some of this demand into 2013. This is a great thing, for when we discount cash flows, money earned today is worth more than money one year hence and 2014 remains on track to be a breakthrough year for the LED lighting industry.

Berkshire Hathaway Inc. (NYSE: BRK.B) -3.70%

Berkshire has been a slow and steady gainer for us. During the quarter, we took the opportunity to trim from a high conviction 5% position in core accounts to a 3% normal sized allocation. This was simply due to the stock’s appreciation towards our estimation of fair value. We are all familiar with Berkshire, and of course, its Chairman and CEO, Warren Buffett. We view Berkshire as one of the penultimate collections of supremely high quality businesses, across diverse sectors of the U.S. economy and expect the company’s culture to drive continued compounding of shareholder capital regardless of when old age catches up with Mr. Buffett. In the meantime, we will remain patient with the stock as a normal-sized, core position.

Teva Pharmaceutical Industries (NASDAQ: TEVA) -3.62%

This is Teva’s first appearance in the laggard’s section, though on the year, it has been our single most disappointing investments. The pharmaceutical sector has enjoyed a quiet resurgence, while Teva has been left behind. Despite this, our conviction has not wavered on the company and we view this stock as a form of time arbitrage, where we are essentially paid to wait. Teva has an earnings yield on its equity of greater than 10% and will use half of that money to return capital to shareholders in the form of dividends and share repurchases.

The company’s shares continue to suffer under the pressure of replacing its lead product—Copaxone—once its patent expires. We think the market is overly punitive in its estimation of the loss of earnings from Copaxone. Moreover, Teva remains the largest global manufacturer of generic products, and in the hands of new CEO Dr. Jeremy Levin, we think the possibilities for improved results are tremendous. Dr. Levin is one of pharma’s premier capital allocators and is one of the key reasons why his former companies, Novartis and Bristol-Myers Squibb find themselves better positioned than other large-cap pharmaceuticals in the face of the dreaded “patent cliff.” Dr. Levin’s experience as a doctor, a business-model innovator in pipeline development and as a private equity-based biotech investor make him the perfect guide for Teva’s transition from a growth company to a value-based steward of shareholder capital.
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. 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
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, Esq.
Managing Director
M: (516) 729-5174
elliot@rgaia.com

August 2013 Investment Commentary: Tesla Motors

September 10, 2013

Tesla Motors: A Disruptive Company but Speculative Investment

August saw markets largely churn. A brief rally to start the month faded into a panic-free selloff on the war drums beating towards a Syria intervention. Bonds did the inverse of stocks, with yields ending the month about where they began. Throughout the month there has been one story completely captivating the attention of market watchers like no other: Tesla Motors astonishing rally. In August, Tesla tacked on another 25.85%, bringing its year-to-date gain to 498%, up nearly five times from its 2012 close.
Following this impressive run, we have been asked by countless clients and interested observers whether we would buy the stock today. Due to the overwhelming interest in this question, we decided to use this commentary in order to explain our answer. We highlighted “following” at the beginning of this paragraph for a reason; for why is it that such intense interest in a stock only develops after it has had an impressive run? The answer is human nature, and this fact alone should be a key tell as to where we stand on the bigger question of whether to buy Tesla stock today.

Disrupting Disruptive Innovation

The Tesla Model S is an amazing car, Tesla Motors is a disruptively great company, and Elon Musk is the most visionary and adept leader for technology of this era. Musk has masterfully navigated nearly a handful of startups, in controversial sectors, to multi-billion dollar market capitalizations, but what he did with Tesla in particular is nothing short of a miracle and will be the subject of case studies in innovation for years to come.

The auto industry is one with immense barriers to entry and high capital requirements. Trying to enter the market with an electronic offering was thought of as a certain failure, with many established car players flopping in their own efforts. As our smartphone addictions demonstrate to us on a daily basis, battery technology has failed to keep pace with technological advances in processing power, let alone with the storage capacity of carbon-based energies. Due to this reality, many assumed a mass-adopted electric car would never work, or if it did, that it would emerge from a 1970s-like fuel price shock.

Undercutting price would have fit neatly within the prevailing paradigm of innovation. For much of the past decade, the S-curve of innovation, introduced and elaborated on in the Innovator’s Dilemma , has been the blueprint for disrupting an existing market. The S-curve highlights how new innovations tend to undercut the existing market in both price and features, in order to bring a new spectrum of buyers into the fray. The incumbent firms view the innovative product as “worse” or lacking in features its customers hold dear, while the innovative company uses the earnings from new buyers it can draw into the market in order to invest in, and improve the technology. These improvements take the new entry to a point where it can “tip” the entire existing market into its hands.
While we are strong believers in the S-curve model for innovation, and have adopted it as one of our core “mental models” around which we assess different investment situations, we think Elon Musk has done something phenomenal in pulling a 180 on today’s conventional wisdom in disruptive innovation. Whereas most viewed savings over carbon-based energy as the natural path to electric car adoption, Musk saw an opportunity in a high-end luxury experience worthy of outcompeting the Mercedes S Class, the BMW 7-series, or even sports cars like Aston-Martin. This is no small feat, for even established car companies (established in terms of a sales base and profitability), like Hyundai have been trying to break into the high-end market for years now to little or no avail.

Drivers of Value

There has been a confluence of powerful forces driving Tesla’s stock to-date: 1) Tesla has virtually eliminated the risk of failure from the range of possible outcomes; 2) a large short-interest premised on political, rather than technological considerations, has been forced to cover its shares on a rapidly rising stock; and 3) The Model S has already captured 8.4% of the US luxury market as of halfway through 2013 and is outselling the BMW 7-series, the Mercedes S Class, and the Audi 8 series. Consumer Reports assigned the Model S its highest test score, while musing whether it is “the best car ever.” This is no fleeting accomplishment.

All this has been accomplished with capacity constraints preventing the company from matching orders with supply. But—and you knew there had to be a “but” after heaping all this praise— the company is priced not just for greatness, but for perfection. Aswath Damodaran, a prominent NYU professor on valuation analysis summed it up best: for the company to be worth $67.12 a share, one would have to “assume that Tesla will grow to be as large as Audi, while delivering operating margins closer to Porsche’s.” Audi is the 13th largest car company in the world, while Porsche boasts the fattest operating margin of all the big players.

It is certainly within the realm of possibilities for Tesla to justify today’s valuation, though it is highly unlikely. As the past decade has taught us, stock prices are particularly vulnerable to herd-like behavior, and often shoot up far past rational fundamental levels only to then collapse well below fair value. Should Tesla be a merely “great” company, it would take over a decade for a buyer of Tesla’s stock today to own a company with an intrinsic value matching its stock market value today. A company with Audi’s sales and Porsche’s margins would be pretty great, though it would also be worthy of a 60% haircut to today’s market value.

While we are neither averse to investing in growth, nor the auto sector, and do have notable investments in both, the prospect of buying Tesla today is pure speculation. It is a wager that someone will be willing to pay more than today’s price in hope of the company continuing to exceed expectation. As everyone should know by now, hope is not a viable investment strategy. We often stress that prices which have traveled too far, too fast, correct in one of two ways: either price (by the stock dropping) or time (by the stock traveling sideways for an extended period). Most often it’s a combination of the two, and while it’s certainly possible that Tesla corrects by merely moving sideways, we think the risk of downside is simply too great and the opportunity cost of sideways for a decade too steep.

Lumps along the way

We certainly expect Tesla to become a staple of the automobile landscape, though the path to such an outcome remains very unclear. There are varying degrees of “staple” status in autos, with a wide range of possible outcomes In order to achieve the market’s implied growth targets necessitated by today’s price, the company will have to invest considerable sums of capital in both design and capacity. To date, Tesla has invested over $1 billion to get to a 20,000 annual run-rate in sales and a push past breakeven when subsidies are taken into account. Since we know further growth will have to come with expanded offerings beyond high-end luxury, and that subsidies will not continue in perpetuity, it’s safe to assume capacity will have to rise in order to grow revenues profitably. Capacity must be built with incremental investment moving forward, and this will eat up a considerable portion of the company’s operating cash flow over the next several years.

Further, any valuation of Tesla is long in duration (in other words, the valuation is based on projections looking many years forward), and such valuations are inherently sensitive to assumptions. In such cases, the slightest of tweaks to a model could have the largest of consequences. Models also have a straight-line bias, assuming that growth will happen in compound fashion, while many forget that growth tends to be lumpy (which just so happened to be our theme in last year’s August investment commentary) . Higher growth will certainly “lump” around the new model launches and price cuts for Tesla, with more sideways action in between. These pauses in momentum will lead to uncertainty over assumptions and pressure on share prices.

Lastly, we also know that automobiles are a cyclically sensitive business, dependent on a strong economy. As we witnessed over the past five years, the auto business experiences deep slumps during economic contractions. While we remain of the belief that a recession is not imminent, we do know that a recession is inevitable at some point. Considering Tesla’s market cap today relies on straight-line revenue growth in excess of 20% for over a decade, and since the Post-World War II US economy has experienced a recession at least once in each decade, it’s clear that the company’s stock price will be particularly vulnerable to any recession within that timeframe. One bad year during which Tesla executes its strategy perfectly, but the economy stagnates will seriously derail the assumptions underlying today’s optimistic stock price and lead to a sharp drop in its share value. This is a ‘when’, not ‘if’ question and such a happening along with forced selling is most likely what it would take for us to own this stock in the future.

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. 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
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, Esq.
Managing Director
M: (516) 729-5174
elliot@rgaia.com

References

(1) http://www.amazon.com/The-Innovators-Dilemma-Revolutionary-Business/dp/0062060244
(2) http://evworld.com/news.cfm?newsid=30937
(3) http://www.consumerreports.org/cro/magazine/2013/07/tesla-model-s-review/index.htm
(4) http://www.consumerreports.org/cro/news/2013/05/video-the-tesla-model-s-is-our-top-scoring-car/index.htm
(5) http://aswathdamodaran.blogspot.com/2013/09/valuation-of-week-1-tesla-test.html
(6) http://www.rgaia.com/august-2012-commentary-politics-are-short-term-focus-long-term/

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.

July 2013 Investment Commentary: Europe, One Year Later: Our Conviction Remains

August 7, 2013
Europe, One Year Later: Our Conviction Remains

Since 2010, each summer has come with a different shade of panic. In 2010, we had the Greek crisis and riots sparking the Flash Crash. The summer of 2011 was scarred by the “Debt Ceiling Crisis” and S&P’s downgrade of the U.S. Government’s credit rating alongside continued European woes[1]. 2012 saw an escalating round of fears in the E.U. shake markets until Mario Draghi declared he will do “whatever it takes” to ensure the Euro lasts as a common currency[2].

After the fixed income torrent in June, many pundits warned a spike in interest rates would cause this summer’s sock. Meanwhile, markets calmed substantially during July. Interest rates rose moderately on the month, while the Russell 2000 led stocks forward with a 6.86% gain, and the S&P tacked on 5.16%. The major headline economic data continued its positive momentum, with continuing unemployment claim registering new recovery lows, indices of manufacturing production (the ISM and PMI both) accelerating to levels not seen since the initial bounce-back from recession, and consumer confidence recording a post-recovery high. This sits in stark contrast to the path of the last three summers to the point where the calm warrants our acknowledgment.

Just last summer, we made clear our contrarian stance towards the EU crisis in our commentaries, and by buying cheap, multinational European businesses, including two financial firms (one bank, and one bank/insurer)[3] . Our conviction level in these businesses continues to increase as time marches on, and only now are many catching on to the attractive opportunities out of Europe. The move upward in these markets since last year was reflective of Europe taking a step back from its abyss, while the economies themselves continued to contract and/or deteriorate.

Today, we can finally say that economies are improving in Europe. In July, the Eurozone Purchasing Managers’ Index (PMI) came in at 50.5, improving upon June’s 48.7 number[4].

July Commentary Chart

This is important, because a PMI greater than 50 is associated with economic expansion, while a number below 50 is contractionary. Significantly, this is the first positive PMI for Europe in two full years and it was drive by tangible improvements in some of Europe’s weakest economies.

Just this month, Barron’s featured its call for European economies to “rebound” on its front pages, arguing that the ECBs actions have helped stabilize the financial sector and the rally in U.S. equities has left Europe particularly attractive in relative terms[5]. The positive feedback loop driven by the US economy’s consistent improvements is but one of the key drivers for Europe. We remain positioned accordingly.

Feedback Loops:

Feedback loops play important roles in markets, and only recently has the negative cycle broken in Europe. We are at a possible positive inflection point, though by no means is that a certainty. Last July, we observed the following about the negative feedback loop out of Europe:

The second substantial factor is Europe’s role in emerging markets. Europe is a major end market for China in particular, and further, European banks are some of the primary financiers to the emerging world. European banks are far more global than our American institutions and with market dislocations plaguing the Eurozone, banks are reigning in on their activities outside of their home domiciles. Some of this is pure risk management, while some is mandated action at the hand of concerned regulators. With Europe slumping, many of these emerging markets have stagnated in growth due to the drop in demand.

This was an important observation at the time, and many still take for granted Europe’s role as lifeblood for global finance. As of July, Emerging Markets (as represented by the EEM) are down 10.73% year to date. These economies are slowing for various reasons, including the managed transition from an investment to consumer-driven economy in China, though rarely will one hear about the role Europe’s own travails play in the emerging market woes.

Latin America is one region in particular where European institutions have been selling assets and pulling out capital. In our opinion, this is starting to create some very interesting opportunities, with emerging markets as attractively valued on a relative basis to the U.S. as they have been in over a decade. With the break in Europe’s negative feedback loop, we can see a path to Emerging Markets regaining favor, though we approach this part of the globe with far more suspicion and uncertainty than we did Europe.

There are several unquantifiable risks, including serious questions about the rule of law in some domains. As such, we pursue exposure to these areas primarily through U.S.-based multinational firms that enjoy earnings leverage to Emerging Markets, without risking permanent impairments to earnings should Emerging Market growth not play out as planned.

A Global Portfolio

We are not purposely neglecting the U.S., but rather, we are simply seeing far more attractive opportunities globally on both an absolute and relative basis. As U.S. markets have continued their strong 2013 through July, the cheap values at home are fewer and farther between. This is a good thing! Our economy here continues to improve, and just might reach “escape velocity” from the financial-crises doldrums in the not-to-distant future. U.S. equity markets are certainly starting to anticipate such an improvement.

In this day and age, with tightly integrated global economies, a global portfolio is no panacea against economic troubles in one region; however, it is a way to diversify some of the correlations and risks to which our portfolio is exposed, and is a means through which we can allocate towards only the most sensible of value-based opportunities.

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. 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
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, Esq.
Managing Director
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://online.wsj.com/article/SB10001424053111903366504576490841235575386.html
[2] http://blogs.wsj.com/marketbeat/2012/07/26/stocks-jump-on-draghis-whatever-it-takes-comment/
[3] http://www.rgaia.com/july-2012-commentary-bulls-and-bears/
[4] http://www.cnbc.com/id/100938465
[5] http://online.barrons.com/article/SB50001424052748704093404578613863100842212.html#articleTabs_article%3D0