Q3’16 Investment Commentary: On the Matter of Correlations

The third quarter was a strong one, with the S&P rising 3.26% and the Russell 2000 tacking on 8.03%. After several consecutive years of summertime volatility, the summer of 2016 saw an historic volatility compression. This certainly was not a summer to “Sell in May and Go Away” (while we are here invoking that line, it’s important to caveat that even were it a successful strategy—and it’s not—it runs entirely contra to our philosophy of finding and investing in high quality businesses).

All sectors were not equally strong, however, with notable weakness in the yield-sensitive areas.  In our May Commentary we told investors to have their “staple remover ready” and the point applies similarly to Utilities and REITs.[1] These three sectors (just last month the REITs officially became a sector of their own) share one very important trait in common: they have each become proxies or replacements for investors in the quest for yield amidst seven years of Zero Interest Rate Policy (ZIRP).

From our vantage point, some of these trends towards dividend investing involve conflation of several themes that have become popular in recent years:

  • Quality investing—what has become synonymous with the search for companies with consistently high ROICs and mid-single digits growth
  • Dividend—the increasing popularity for anything and everything with yield[2]
  • Low beta/volatility—people have gotten frustrated with the whipsaw moves in markets and have been isolating companies that are more immune than others.

When someone not steeped in the financial lexicon is overwhelmed with certain themes, it becomes all too easy for confusion to take over. It also becomes too easy to take what are good ideas with a solid foundation to an extreme far beyond reason.

The strength in these sectors over the past few years has been driven by allocators targeting certain levels of yield for portfolios and not by investors analyzing businesses and determining a fair worth.  This is an important distinction. Additional drivers have been a preference on the part of investors for lower volatility and a movement towards passive (from active) types of management. In the modern incarnation of passive management, portfolio managers seek to capture factor exposures in desired proportions generally via ETFs.

During the last quarter, there was an important change in the yield sensitive names that we think has gone largely unnoticed but will be meaningful going forward.  Since equities are long duration assets, and the short-term rates are set directly by the Federal Reserve Bank, we decided to use TLT as a proxy for long-term rates.  We first looked at the average daily returns and standard deviations of the S&P, TLT and the yield sensitive sectors over the past three, six and twelve months:

1

There are two important takeaways from this chart:

  • All but one sector—XLU (Utilities)—has a lower volatility (standard deviation) over the past three months than over the past year. This is a distinct change in character for the Utilities, a sector that generally is not very volatile.
  • The average daily return over the last three months in every yield sensitive area (Treasuries itself, and Utilities, Staples and REITs) has turned negative, while the S&P remains positive, on average, every day.

This was the first step in calculating the betas of yield sensitive areas compared to each the S&P and Treasuries. Here are those betas[3]:

2

Note that the betas of XLU (Utilities), XLP (Staples) and IYR (REITs) are greater with respect to TLT than they are with respect to the S&P. Further, in our timeframe comparison, these betas have actually lessened as time has gone on—the betas of these sectors verse the S&P are less over the past three months than over the past twelve months. In fact, the Utilities sector is slightly negative against the S&P over the past three months meaning that for each unit the S&P went up, the Utilities actually went down.

There is an extremely important takeaway here worth emphasizing:

If you are buying these sectors today, you are making an explicit wager on the direction of long-term interest rates.

While some may think they are engaging in some kind of investment, diversification or capture of yield, in reality they are wagering on the direction of interest rates. Yes, to an extent there will be some yield capture along the way, but one problem with low rates is how the sensitive the principal (your invested dollars) is to the change in yields. If it is yield you seek, we are afraid to tell you that this market does not offer much of it. If instead you are looking to make an explicit wager on interest rates, there are far better ways to do it than through these vehicles. Needless to say, we feel many investors are in these places right now for all of the wrong reasons.

You may have noticed that all this while, we have spoken about the “yield sensitive areas” without touching on XLF (the financials)—the other sector in our grids above. We are saving this for our conversation below.

Portfolio Update:

After an active first half of the year for portfolio activity, the second half has had a slow start. We made one notable portfolio change—we purchased shares in The Charles Schwab Corporation (NYSE: SCHW).  We love when a confluence of themes we believe in come together in one company, with a reasonable valuation.[4] Our business, our investment in Envestnet (NYSE: ENV), and now our investment in Schwab (NYSE: SCHW) all are at least partly premised on the big transition from a commission-based to fiduciary, fee-based wealth and asset management industry. Registered Investment Advisors continue to grow at the expense of the brokerage wirehouses, reporting double-digit annualized growth for over a decade.

At first glance, the online and discount brokers are typically associated with cheap commissions for retail clients. Yet at Schwab, this is a small and diminishing part of the story.  As recently as 2011, trading revenues accounted for more than 20% of the company’s total top line. Today, trading accounts for about 14% of revenues.  Net interest revenues have been the primary beneficiary in terms of total revenue share—rising from 37% to 40% of net revenues. Notably, net interest revenues have grown in share despite the persistence of the Fed’s zero interest rate policy and the corresponding waiver of money market fund management fees.

Despite the money market fee waiver headwind, Schwab has exhibited consistent operating leverage throughout the post-crisis period. Each year has seen an average of a 1% operating margin increase, with 2016 seeing an accelerating on the heels the December 2015 rate hike—the first since getting down to 0% in late 2008.

This growth is impressive and stems from the company’s consistent ability to provide value-added services to retail and institutional clients, fostering consistent double-digit asset growth and mid-single digit account growth.  A great example of this is the traction Schwab continues to make in its robo-advisor offering (what Schwab calls “Intelligent Portfolios). Assets now exceed $10b, with many of the clients coming from outside of Schwab’s existing clientele. Moreover, asset growth in this segment contributes to further growth in the company’s ETF offerings—an area where the company has become an increasingly formidable force alongside the likes of BlackRock and Vanguard. Per Bloomberg, “Five years ago, Schwab wasn’t even in the top 10 of ETF managers by assets. Now it’s ranked fifth, with $54 billion in its 21 ETFs.”[5] These are nice examples of a virtuous cycle at work, driving significant growth at the company. They are also evidence of steps Schwab has taken through the years to shift their business from trading, to areas that are growing in need and will continue to do so over time. In its illustrious history of driving value for small and retail clients, Schwab has exhibited an exceptional track record of anticipating and driving, rather than reacting to industry trends.

In the past year, the financial sector has traded inversely correlated to the direction of rates. This has been increasingly so in the past 3 months. Stated another way: as rates have gone up (down), financial stocks have gone up (down). Thus in some respects, a purchase of a financial stock seems like a bet that rates will go up. Further yet, over the past year, financials have appeared to be a levered bet (i.e. high beta) on the direction of the S&P. This relationship has been breaking down over the past three months and we think this change is both notable and enduring.  With respect to the Great Financial Crisis, we have often evoked the idea that it is safer to fly after a crash than before, because everyone in a position of accountability is on their highest alert for potential problems. The disdain for financials as a sector (as evidenced by their market low valuations and high volatilities) is an example of the market fighting the past battle instead of looking forward. The system itself is far more resilient and robust today than before the Crisis, yet people seem more worried now. This is a problem of perception.

We paid 26 times trailing earnings, though if interest rates normalize this would be more like a 15 times multiple. What we like about Schwab in particular is the evidence that the company has driven great results irrespective of the rate direction. Upside in rates, will lead to meaningful upside in the stock; however, a rate move notwithstanding, the company continues to drive immense value with its diverse offerings.  We are hardly the first to note this relationship between Schwab’s future earnings and the trajectory of rates. These moves have in fact been driving the stock over the past year. Where we think our perception is unique is with respect to the underlying diversity in quality and growth that Schwab has exhibited and how those forces will drive the business.

The stock has spent most of the past 20 years trading with a mid-20s multiple. If that stays constant (and rates never normalize), we think we will earn a double digit percent long-term return on the heels of strong account growth, robust asset growth and consistent operating leverage. Should the stock’s multiple regress to the market’s multiple (~17x) then we would still be looking at mid-single digit returns over eight to ten years.  If rates do return to levels above 1% on the Fed Funds over the next decade, upside and IRRs would be comfortably in the double digits, even with multiple compression.  As a result, there is the potential for something special here without taking on very much downside risk.

Housekeeping:

You may have noticed that we did not issue a monthly commentary over the past few months. In our internal talks and talks with many of you, we realized that the frequency of commentaries was creating two problems—one specific to us, and one for you, our clients. For us, we have been writing these commentaries for so long now that we have run out of unique general philosophical bits to share without getting overly redundant. For you, the frequency and lengths of some of our narrative resulted in a lower than expected read-count. Quarterly commentaries provide a solution to both: we can go in-depth on a well thought out topic without overwhelming your inbox.

To that end, we plan on approaching these with a different format than in the past.  Each will start with a general overview of something timely or relevant in markets, or a philosophical concept that we would like to delve into (often we anticipate an overlap between both). Next, we will do an update on the latest actions within your portfolios, and if there are none, we will focus on notable stock moves or news within the quarter.

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

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF, CGMA
Managing Director
O: (516) 665-1940
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-1942
M: (516) 729-5174
elliot@rgaia.com

[1] http://www.rgaia.com/may2016/

[2] Dividend investing got so extreme that in the MLPs in particular, investors were looking purely at screened “dividend yield” and ignoring dividend coverage. Dividend coverage is the extent to which net income (actual earnings) affords the company an opportunity to pay a dividend. Throughout this entire sector, coverage ratios were negative; meaning, dividends either had to be paid with balance sheet cash, increased indebtedness, or raising new equity (or some combination of the 3). It took worsening fundamentals for investors to painfully realize that what seemed like a dividend, was not actually a yield, but rather their very own invested capital returned at the expense of increased risk on the corporate level.

[3] In case you were wondering, there was one more step along the way: calculating the correlations between the various securities. We have not included that look here as the same general points are captured by the betas.

[4] Several of these themes were recently covered by Elliot in a presentation at the ValueConferences Wide Moat Investing Summit. http://www.rgaia.com/envestnet/

[5] http://www.bloomberg.com/news/articles/2016-10-06/schwab-s-etfs-are-gobbling-up-a-2-4-trillion-market?utm_content=business&utm_campaign=socialflow-organic&utm_source=twitter&utm_medium=social&cmpid%3D=socialflow-twitter-business

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.

An Envestnet for the Long Run

Elliot Turner was honored to present at the 2016 Value Conferences Wide Moat Investing Summit. He presented IMAX at the inaugural event three years ago followed by eBay/PayPal in 2015. At this fourth annual event, recognized value-investors presented some of their best investment ideas. Elliot presented on Envestnet.  We are excited to share his slides here:

June 2016 Investment Commentary: Brexit is No Lehman

As of last week, the story for this quarter was going to be different. We were going to highlight the more orderly recovery in stocks taking place after a chaotic first quarter. On Wednesday, the 22nd of June, the S&P closed within spitting distance of all-time highs. That narrative suddenly evaporated the night of Thursday June 23rd as votes were counted in the United Kingdom on whether to “leave” or “remain” in the European Union. In a flash, the British Pound went from its highest level of the year to its lowest level in thirty years:

1

What followed was one of the harshest days of selling in global markets, with our S&P falling 3.59% on that Friday, alone. The weekend did little to curb the selling pressure as market commentators wondered aloud whether this was a “Lehman moment.” Since Lehman’s failure marks the most cataclysmic event in financial markets since the Great Depression, we think it is important to address head-on this fearful reprise and bring a dose of reality to the conjecture, as the differences between Lehman and “Brexit” are far more consequential than any perceived similarities.

Mr. Market’s PTSD:

The invocation of Lehman here strikes us as a case of “recency bias”—a form of post-traumatic stress disorder that the humans who operate markets exhibit in the aftermath of extreme events. The cleanest definition for the recency bias is that it “is the phenomenon of a person most easily remembering something that has happened recently, compared to remembering something that may have occurred a while back.”[1] Ultimately it is easier to recall recent events, especially when a high level of emotion is involved. Ye the more emotion is involved, the harder it is to cleanly recall a sequence of events with a factual level of detail. This is why every time the markets have had a rough patch since the Great Financial Crisis, some investors wonder whether it will be the next acute phase of troubles. A reality that we often cite in these instances is that it is far safer to fly in an airplane shortly after a crash happens, than just before. This is true because those who are stakeholders in the security of flying are on higher alert for any potential problems in the aftermath of disaster. The same is true in financial markets, with one of the clearest signs today being the very safe capital ratios in the financial sector. If you will recall, the troubles at banks were the transmission mechanism through which problems in markets became a real economic calamity, and while we are never immune from problems in markets, they are far less likely to spread and become really deep when in such good shape.

The reason we are calling out the market’s recency bias is that a far more apt historical analogy does in fact exists and the set of circumstances around it are very similar to what is happening today. We will visit this example shortly, but it is important to first point out that without question, markets were taken aback and surprised by the vote. Herein lies the one similarity to Lehman—market commentators did not expect the powers-that-be to let Lehman fail. Yet, too much of the rhetoric focuses on the binary question of “whether the markets were wrong about the Brexit vote?” Markets do not think in terms of yes or no. Instead, they handicap likely probabilities, and clearly the expectation was too high that the Remain vote would win.

Moreover, we think labeling this a “Lehman moment” relies on the wrong paradigm for understanding Lehman’s failure. On the five year anniversary of Lehman’s collapse, we wrote our commentary suggesting that investors “beware of mistaking a symptom for the cause.”[2] Lehman certainly exacerbated problems, but the key feature of Lehman is that it was caused by really deep, underlying stresses in our financial system. According to the Federal Reserve Bank of New York’s own internal documents, released nearly three years after Lehman’s failure, the Fed essentially says that the bank run began around August 20th, 2008, nearly four full weeks before Lehman filed for bankruptcy.[3] This was the first bank run our country experienced since the Great Depression. Clearly Lehman was not the causal event, it was a symptom.

So how does this relate to Brexit? Beyond merely contemplating frightening events, it doesn’t relate in the slightest. As discussed earlier, it is far easier to contemplate horrible possibilities than to weight likely ones. Lehman had some obvious and immediate contagion effects. For example, within days of Lehman’s bankruptcy, one of the largest utilities in the country was on the brink of filing its own bankruptcy due to counterparty risk with Lehman.[4] Meanwhile, days after the Brexit referendum we remain unsure whether the UK will even exit the EU. From here, there will be no next step until at least October when a new Prime Minister is selected in the UK. Only then will we know if a two year (or longer) process for departure will in fact commence. While the uncertainty is challenging for markets to grapple with, the imminent prospects of financial stresses that could bring down companies and impact how the average American lives their life with regard to spending and investment is essentially non-existent. Importantly, despite the plunge in bank stock share prices since the vote, there are no real signs of stress in financing channels. In fact, credit indicators remain mostly constructive and are far more benign than they were a few short months ago.

If Not Lehman, Then What?

Recall that the recency bias lends more weight to recent events than to something that happened further back in time. There is truly a historically relevant comparison that we have hardly seen mentioned in the press at all following the Brexit vote. Many of you are probably aware that whereas countries like France, Germany and Italy use the euro as their currency, the United Kingdom uses the Pound. This is so despite all countries being members of the EU. As history would have it, the UK was supposed to be part of the euro currency until what is today referred to as “Black Wednesday” (Wednesday, September 16, 1992)— also known as the day George Soros “Broke the Bank of England.”[5] This event similarly happened at a crucial juncture on the pathway to European integration.

It is worth sharing the “aftermath” section from Wikipedia here in its entirety:[6]

Other ERM countries such as Italy, whose currencies had breached their bands during the day, returned to the system with broadened bands or with adjusted central parities. Even in this relaxed form, ERM-I proved vulnerable, and ten months later the rules were relaxed further to the point of imposing very little constraint on the domestic monetary policies of member states.

The effect of the high German interest rates, and high British interest rates, had arguably put Britain into recession as large numbers of businesses failed and the housing market crashed. Some commentators, following Norman Tebbit, took to referring to ERM as an “Eternal Recession Mechanism” after the UK fell into recession during the early 1990s. Whilst many people in the UK recall ‘Black Wednesday’ as a national disaster, some conservatives claim that the forced ejection from the ERM was a “Golden Wednesday” or “White Wednesday”, the day that paved the way for an economic revival, with the Conservatives handing Tony Blair’s New Labour a much stronger economy in 1997 than had existed in 1992 as the new economic policy swiftly devised in the aftermath of Black Wednesday led to re-establishment of economic growth with falling unemployment and inflation (the latter having already begun falling before Black Wednesday).

The economic performance after 1992 did little to repair the reputation of the Conservatives. Instead, the government’s image had been damaged to the extent that the electorate were more inclined to believe opposition arguments of the time – that the economic recovery ought to be credited to external factors, as opposed to good government policies. The Conservatives had recently won the 1992 general election, and the Gallup poll for September showed a 2.5% Conservative lead. By the October poll, following Black Wednesday, their share of the intended vote in the poll had plunged from 43% to 29%, while Labour jumped into a lead which they held almost continuously (except for several brief periods such as during the 2000 Fuel Protests) for the next 14 years, during which time they won three consecutive general elections under the leadership of Tony Blair (who became party leader in 1994 following the death of his predecessor John Smith).

Note that speculators quickly went on to attack Italy’s currency (then the lira) on the assumption that other similarly frustrated and vulnerable countries would be at risk of similarly troubling attacks in currency markets. This history is rhyming today as traders drive down global markets on speculation that yet again, Italy and other weak countries in the EU might host their own referendums to leave the EU, creating a troubling spiral of events. After Black Wednesday, the UK quickly fell into recession and took years to recover. This too will be the UK’s economic destiny today, and in our estimation, is the most likely consequence—a harsh reality for those in the UK, but not so much for us here in the United States.

The S&P chart from the beginning of 1992 to that same date one year later paints an interesting picture:

2

The S&P had been range-bound for months leading up to Black Wednesday. It dropped 4.3% over the next two weeks (once upon a time markets moved a little slower than they do today); recovered to 52-week highs within two months; and, one year later was up 9.4% from that of Black Wednesday. There is no reason to suspect that the S&P move from here on out will be similar. We are merely highlighting the aftermath to show that a traumatic political event out of the UK, with significant economic ramifications need not change the trajectory for the US economy or the US stock market. The biggest consequences today, as they were then, will be local and political, and while there could be some negative ripples that follow-through, we think it is imprudent to position based off of what these ripples might entail.

In sum: as of today, it remains unclear when, or even if, the UK will actually leave the EU, it is unlikely that there are any enduring economic consequences for us here in the U.S., and there are no imminent follow-on events that would tell us otherwise.

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

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF, CGMA
Managing Director
O: (516) 665-1940
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-1942
M: (516) 729-5174
elliot@rgaia.com

[1] http://www.davemanuel.com/investor-dictionary/recency-bias/

[2] http://www.rgaia.com/september-2013-investment-commentary-beware-of-mistaking-a-symptom-for-the-cause/

[3] http://www.nytimes.com/2011/04/03/business/03gret.html

[4] http://blogs.wsj.com/deals/2008/10/21/constellation-and-then-we-came-to-the-crisis/

[5] https://en.wikipedia.org/wiki/Black_Wednesday and http://www.investopedia.com/ask/answers/08/george-soros-bank-of-england.asp

[6] https://en.wikipedia.org/wiki/Black_Wednesday

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.

May 2016 Investment Commentary: Get Your Heavy Duty Staple Remover Ready

On August 25, 2014 the S&P crossed 2000 for the first time. We are nearly two-years past that milestone (now 21 months), yet the S&P continues to wrestle with the round-number level. In essence, very little has happened in the broader markets over this time. Yet, on the sector level the story is very different.

Below is a table showing the performance and delta in the P/E ratio for each of the GICS Sectors, the S&P 500 and the Russell 2000 since the market’s first move above 2000:

image 1

A few points stand out right away:

  • Energy’s P/E has risen substantially despite a 30+% drop in price. This is due to the collapse in energy shares and underlying earnings of the companies who operate in energy. Since the P/E we included here excludes extraordinary one-time items (charges against earnings that are non-recurring in nature), it is clear that markets are pricing in some kind of cyclical improvement for energy.
  • After Energy, Consumer Staples and Utilities are the only other sectors for which P/E ratios have risen since the S&P first crossed 2000. This is not because earnings growth has been robust in either sector. In fact, with staples, nearly the entire 16.34% return since 8/25/14 can be attributed to the change in its P/E and not to growth. This is a result of the sector’s historically robust and sustainable dividends being used as bond proxies in this era of low interest rates.
  • Health care and Consumer Discretionary each had their multiples contract while earning double-digit price returns. Both sectors benefited from robust earnings growth; however, the multiple contraction indicates that the markets anticipated this healthy growth and priced at least some of it in.
  • The S&P’s multiple expanded by nearly 8% despite generating less than a 5% return. In other words, for this time period, all of the market’s return and then some can be explained by multiple expansion rather than growth. We went through the sectoral components of growth in our September 2015 Commentary which further explains how and why this has happened.[1]
  • The Russell 2000 has had a huge amount of multiple compression. The Russell 2000 has been essentially flat (down less than 1%) since the S&P first crossed 2000, yet its multiple has dropped by an extreme 31%. What this means is that earnings at the Russell 2000 companies have grown tremendously while price has gone nowhere.

One reason for looking at the sectors in this way is to highlight how many moving parts there are when we talk about “the market.” There are significant divergences these days and unique drivers behind the action in market subcomponents. This leads to confusion and indecision. Confusion and indecision often result in sideways, volatile price action. As a result, it is no surprise that the time period encompassing this discussion has been sideways and volatile.

What exactly can we learn from the price action in Consumer Staples and Utilities? Only one simple fact has mattered as far as valuations go for these two sectors: On August 25, 2014, the 10-year yield was at 2.39%; it ended May at 1.84%.

Over this time, the dividend yield for Staples went from 2.71% to 2.61%, while the Utilities yield went from 3.69% to 3.54%. Below are the P/E ratios for these two sectors charted since 1990:

image2

The top of the chart shows the Staples sector, while the bottom is Utilities. Aside for the dot.com bubble period, Staples have never been as richly valued. Meanwhile, Utilities are as expensive as ever.

Of the four best performing sectors (Discretionary, Staples, Healthcare, Utilities), two experienced multiple contraction, while two experienced multiple expansion. We have often discussed the market’s multiple as the sentient component of valuation for how it embodies the character and emotion of market participants more so than any other single variable. The multiple is essentially how we measure “Mr. Market’s” mood. We can use some fundamental tools to determine a range of appropriate multiples based on several scenarios in an effort to triangulate what “fair value” for an index or security should be. What we can never do (nor will we do) is attempt to predict where a multiple will be any time in the future.

One of the simplest things we can say is that typically (and there are fair exceptions), a rising multiple indicates improving fundamentals, while a falling multiple indicates deteriorating fundamentals. With this heuristic, it would be fair to assume that Staples and Utilities had a much better forward outlook today than they did in the Summer of 2014, while the outlook for Healthcare and Discretionary deteriorated. There is an element of truth to this with respect to Healthcare and Discretionary; however, the opposite is actually the case with Staples and Utilities. In some respects, key components of these sectors are as fundamentally challenged as they ever have been and the truth behind these challenges is even more evident today than it was two summers ago.

In the market practitioner’s lexicon, when something in the market is boring and justifying of a low multiple, people call it a “utility.” These properties have become synonymous with the Utilities sector for a reason: it has slow growth, with predictably boring fundamentals and a historically high yield (i.e. low valuation). Financials are often labeled today’s “utilities” and we can see pretty clearly that they have been near the low-end of the market’s P/E for this entire digestive period. In the market practitioner’s lexicon, “growth” has been synonymous with high multiples. Meanwhile, today, one of the sectors with the worst growth profile (Staples) has the highest multiple of any sector.

By the end of this year, three of the five platforms we highlighted in our January commentary will have lower P/Es than the Staples, despite their robust growth rates.[2] By the end of 2017, all will have lower P/Es. That could change with our stocks moving higher, Staples moving lower, or a little bit of both. Clearly by virtue of our positions we expect our stocks to move up irrespective of market or sector action. In the meantime, we will continue to search for opportunities in some of the more unloved sectors of the market like Healthcare and Financials, where multiples have either contracted substantially or already were much lower than average.

The strength of Utility and Staples sectors are part of the fallout from the Financial Crisis. While yield alone explains the multiple expansion here, the Financial Crisis itself has created a misguided sense of “buy what’s safe” in the retail investment world. This credo has become agnostic to pricing and valuation. As Howard Marks once said, “when everyone believes something embodies no risk, they usually bid it up to the point where it’s enormously risky.”[3] Marks is telling us here that at a certain point, price itself becomes the risk. When people become price-agnostic in a given area, smart investors should run the other way every time.

Moments ago we said we would refrain from making predictions about market multiples. Right now we will make a prediction, albeit with a twist. We are not sure when exactly this will happen, but we are confident that Staples will lose their place as the market’s most richly valued area with limited likelihood of ever recouping that status.

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

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF, CGMA
Managing Director
O: (516) 665-1940
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-1942
M: (516) 729-5174
elliot@rgaia.com

[1] http://www.rgaia.com/a-liquidation-move/

[2] http://www.rgaia.com/robust-networks-for-the-long-term/

[3] https://www.oaktreecapital.com/docs/default-source/memos/2015-09-09-its-not-easy.pdf?sfvrsn=2

March 2016 Investment Commentary: You Can’t Smooth the Lumps

“Charlie (Munger) and I would much rather earn a lumpy 15 percent over time than a smooth 12 percent.” – Warren Buffett

We called February a “tale of two halves” and the same can be said of the first quarter. The S&P finished the quarter up 1.3% after selling off by 10.7%. The Russell 2000 ended the quarter down 1.5% after dropping 16.6% in straight-line fashion to start the quarter. The reversal was led by a bounce in last year’s most down-trodden sectors: energy, mining and industrials. The 10 year Treasury yield ended 2015 at 2.27%, but headed steadily lower to close the quarter at 1.78%. The staples and utilities sectors stayed strong throughout the quarter’s volatility as a proxy for the move in rates. Valuations in the staples are really starting to concern us, and we will speak more to this point in future commentaries.

Take your lumps along the way:

The lead quote from Warren Buffett is perfectly suited for a conversation about this past quarter and the “lumpy” nature of returns in the stock market. Over the very long run, individual stocks and stock markets follow the path of earnings; however, in the short run, there can be significant disparities between an earnings stream and its trading price (this applies equally to indices as it does to common stocks). This disconnect is embodied in the multiple investors are willing to pay for a given earnings stream. When investors are enthused (concerned) about the future, this multiple rises (falls). Multiple compression is the phenomenon whereby earnings continue to grow while the multiple investors are willing to pay contracts. Oftentimes multiple compression results in an extended period of range-bound, sideways price action for a security.

The following chart from JP Morgan offers a great visualization of multiple compression in action:[1]

1

We highlighted the relevant portions in red. Notice that the market traded sideways for years at a time. There were four such periods in the U.S. markets since 1900, with the most recent one having lasted from 2000 through 2013. While the price action hardly felt sideways in real-time—with two crashes in the midst—the improved perspective that hindsight offers highlights this period for what it is: multiple compression.

People love saying that “the stock market has averaged 6.7% real returns over the last hundred years.” This is good and we encourage such a long-term perspective. At the same time, this view must be grounded in reality. Returns are anything but linear.  Bernie Madoff’s hedge fund returns were the closest example of linear returns that we’ve seen in a century, and we all know how that result was achieved. Ultimately market returns are very lumpy. Time alternates between rewarding investors and testing their patience.

Since the end of 2013, we have argued that markets rallied too far in the short-run and were due for a breather, with the most likely path being a sideways period.[2] We felt ‘sideways’ was more likely than an outright decline for one key reason: big declines typically happen alongside a turn in the economy, and the economy has been accelerating and improving throughout this entire sideways period. Oil threw a small curveball in this assessment, as the decline in oil-related investment threatened to throw the economy into recession. Our thesis that the tailwind to consumer spending wrought by cheaper oil would ultimately outweigh the investment decline is finally looking like the most likely path.

Don’t depend on a straight line in your path:

Per Wikipedia, path dependence in markets “explains how the set of decisions one faces for any given circumstance is limited by the decisions one has made in the past, even though past circumstances may no longer be relevant.” Path dependence is a concept from physics, borrowed by economics. One application to markets is the notion that the trajectory a price takes is determinative of the underlying’s value in the future. The trajectory also can influence the decisions stakeholders make with regard to their own economic choices or the asset itself.

This relates directly to the idea that markets move in lumpy fashion. An investor who expects a smooth 6.7% annualized real return cannot expect to earn that return in accordance with any calendar. If however the investor plans on spending a portion of his or her investment assets each year, premised on a linear return, the path markets take would very much matter. Were markets to drop before rising, there is the potential for a shortfall relative to a need right away. Further, in selling to meet the spending need in the face of the initial drop in asset prices, this investor would be in line to fall short of the 6.7% real return from their starting point even if markets did in fact deliver this return over the long run.

This would be so even if markets went sideways instead of down to start, but the result is even more pronounced when initial losses are incurred. Some numbers will help make clear why this is true. Let’s say we have two investors, each with $1,000,000 to invest. Each also will spend $100,000 at the end of every calendar year. For simplicity’s sake, let’s also assume the expected return is 6.7% annualized (leaving aside real or nominal considerations) and that there is no tax obligation. Investor 1 was blessed with the capacity for straight-line 6.7% annualized returns, while Investor 2 must face Mr. Market’s fluctuations along the way, yet still, for the purposes of this write-up, he is guaranteed 6.7% annualized returns over “the long term.” In year one, Investor 1 earns $67,000 in income. After spending the $100,000 he will be left with $967,000. Investor 2 meanwhile is dealt bad luck for year one and loses 10%. At the end of the year, after spending $100,000, Investor 2 is thus left with $800,000.

In year two, Investor 1, with a 6.7% gain and $100,000 expense, is left with $931,789. Investor 2’s luck reversed and he earns a 26.5% return. This is the exact return needed to offset last year’s 10% decline and return to the 6.7% annualized pace Investor 2 is guaranteed. After the 26.5% gain and the $100,000 expense, Investor 2 ends the second year with $912,000. This amount is $19,789 less than Investor 1. Even if from here on out both investors earn a smooth 6.7%, Investor 2 would end up behind Investor 1. The path thus consequentially changed the outcome for these two different investors. We take the concept of path dependency very seriously when constructing portfolios for clients who may be vulnerable to its consequences.

We are also attuned to path dependency on the company level when we do our bottoms up analysis. So far this year, hardly a day goes by without a headline pertaining to Valeant Pharmaceuticals (NYSE: VRX). This stock in many respects is the perfect embodiment of path dependency in action. In May of 2015, Bill Ackman made a presentation entitled “45x” at the Ira Sohn Investment Conference in New York. This number represented the spectacular returns earned by two “platform companies” (Jarden and Valeant) up to that point in time.

Here is the chart introducing Valeant in Ackman’s slide:

2

Valeant generated the 45x return for shareholders who held the company from February 1, 2008 to May 1, 2015. The stock continued to trade higher into early August 2015, before its chart turned into a cascading waterfall.

Here is what the Valeant chart looks like from May 1, 2015 through the end of Q1 2016:

3

Note that the stock is down 87.88% in the above timeframe. Much ink has been spilled over Valeant, and we could continue to write about this company and its stock ad nauseam. Since your time is sparse, we will focus on what we think is the important and broadly applicable take-away. Both the rise and fall in Valeant were directly related to the path dependency inherent to its business model. Leaving aside some of the secondary sources of growth, Valeant’s primary means for achieving its growth target was via acquisition. In order to finance these acquisitions, the company used a combination of equity and debt. As the stock price rose, Valeant had a growing “currency” in the form of its shares to use for acquisition financing. With a rising stock price, also came increased debt capacity. On its ascent, each acquisition by Valeant further boosted its share price. Each extra boost in its stock price created greater equity and debt capacity for financing future acquisitions. This enabled the company to make larger acquisitions every step of the way—as is evident on Ackman’s slide above highlighting the main events in Valeant’s history. As a result of its success, investors priced in growth premised on Valeant’s continued ability to make value-enhancing acquisitions.

For a variety of reasons, Valeant’s stock price started falling. It started slowly and subtly. The stock kept falling and the narrative and sentiment eventually started turning sour. A moment of truth occurred in October 2015 when Roddy Boyd of the Southern Investigative Reporting Foundation unearthed some unscrupulous practices happening at the company’s wholly owned, specialty pharmacy Philidor.[3] From that point on, it became clear that Valeant would be essentially incapable of completing another acquisition until it patched some holes in its trove of businesses.

The exposure of problems at the company alongside a falling stock price categorically changed the fundamentals of the business. This is important to grasp, for it was not the business that changed, thus pulling the stock with it—as is typical in the stock market. Instead, it was the stock dragging the business down. We think this would have happened to the company irrespective of what the precise catalyst was. Why? First, these problems precluded another acquisition, thus “pricing out” any potential growth via M&A from the stock. Second, they precluded the company from using its existing practices to squeeze out growth from their products. Third, all of these factors collectively forced doctors, patients and the other health system stakeholders to question whether they should even use Valeant’s treatments at all when safe alternatives were possible.

These factors all led to a second big moment of truth in March, when the company reported earnings and guidance that missed consensus estimates by a significant amount.[4] The forces at work here, whereby the stock price influences fundamentals and vice versa is something we covered with respect to MLPs, oil and ETFs. This relates back to George Soros’ notion of reflexivity and the prevalence of positive feedback loops, another physics concept adopted by finance to better understand financial markets. We are speaking about these concepts again here, because this quarter was exceptionally volatile in financial markets and Valeant is a widely covered story in the media. Both factors have created sympathy selling in our holdings that are in the same sector as Valeant—Teva Pharmaceuticals (NASDAQ: TEVA), Sanofi Aventis (NYSE: SNY) and Vertex Pharmaceuticals (NASDAQ: VRTX). None of these stocks share the features that have impacted Valeant on the way down and it is only a matter of time before the strong fundamental backdrop for our holdings reasserts itself.

What do we own?

Returns reflect US dollar denominated returns over our holding period.

The Leaders:

GrubHub Inc (NYSE: GRUB) +26.9%[5]

Priceline Group (NASDAQ: PCLN) +17.7%[6]

PayPal Holdings Inc (NASDAQ: PYPL) +6.6%

The Laggards:

Vertex Pharmaceuticals (NASDAQ: VRTX) -36.8%

DXP Enterprises (NASDAQ: DXPE) -23.0%

Exor SpA (BIT: EXO) -21.6%

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

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF, CGMA
Managing Director
O: (516) 665-1940
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-1942
M: (516) 729-5174
elliot@rgaia.com

[1] https://am.jpmorgan.com/blob-gim/1383280028969/83456/jp-littlebook.pdf

[2] http://www.rgaia.com/december-2013-investment-commentary-our-2014-outlook/

[3] http://sirf-online.org/2015/10/19/hidden-in-plain-sight-valeants-big-crazy-sort-of-secret-story/

[4] http://www.cnbc.com/2016/03/15/valeant-pharmaceuticals-reports-fourth-quarter-2015-earnings.html

[5] Position commenced intra quarter

[6] Position commenced intra quarter

February 2016 Investment Commentary: The Yield Curve is Flat Wrong

On the month, the S&P lost 0.19%, while the Russell 2000 shed a modest 0.22%. On the surface, February appears to be an uneventful market month. In reality, the month was a tale of two halves. At one point, the S&P was down 6.52% intraday, while the Russell was down 9.05%. Throughout, the market’s correlation with oil (highlighted in our January commentary) continued.[1] In essence, the market lends itself to the conclusion that it bottomed because oil did. This relationship is neither actionable nor enduring. We remain resolute in our conviction that markets are being driven by liquidity needs of sovereign wealth funds in oil-rich nations (or shall we say oil poor these days?) and the portfolio effect of large investors whose portfolios became too tied to the energy sector.

Markets driven by liquidity needs ignore the underlying fundamentals at the company level. In the short-run this creates risk, while in the long-run it creates opportunity. As a result of this action, we have greatly increased our turnover in the past few months. We assure you, this is a temporary occurrence and it will normalize in the not-too-distant future. In our October 2013 commentary describing our “’Actively Passive’ Investment Strategy” we highlighted some statistics from John Bogle, the founder of Vanguard that are worth repeating today:

“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![2]

There are robust performance, behavioral and tax reasons to keep turnover low and believe this is a core tenet of quality long-term investment.

The Yield Curve is Flat Wrong

Last month we spoke about the market’s (micro) mistakes in valuing some great companies that distinctly benefit from strong network effects.[3] Here, we will focus on a macro mistake. The yield curve is both an important determinant of economic activity as well as an indicator. When the yield curve is steepening (flattening), the market is expressing increasing (falling) inflation expectations. We can get further into the nuances of the shape of the curve, but this basic explanation is sufficiently important. So far this year, the yield curve has flattened substantially. A visual of then (1/1/2016) verse now is helpful:

22016

(Source: Bloomberg LP)

Given the relationship between the yield curve and forward expectations of inflation, one would expect inflation to be falling alongside, or shortly thereafter a flattening of the yield curve. We went through the case for rising inflation in our 2016 Preview, premised on a tightening labor supply, a tightening housing supply, and increasing flexibility for discretionary spending on account of the oil dividend.[4] That case has only strengthened so far this year on all fronts, despite what the yield curve is telling us. We caveat that this reemergence of inflation is healthy. It is not an event to be feared. Instead inflation reflects the normalization of our economy after a period of tumult. The Fed has ample tools at its disposal to keep inflation from getting to the point where it would be a concern.

If inflation is not falling, then what forces are driving this action in the yield curve? We think there are two explanations:

  1. Traders are being tricked by oil. This happened when oil was rising in years past too; with Jean Claude Trichet, the former ECB President “falling for it.” As Matt Busigin explains so nicely in a piece entitled, “only Bernanke knew oil is not inflation.”[5] In reality, the fall in oil will ultimately be inflationary as consumers start spending their savings on discretionary items. This is a contrarian view today; however, we expect time to prove us right. We simply have to wait out the time lag between the short term pain and the long-term gain.
  2. Negative Interest Rate Policy (NIRP) around the world. When Japan shocked the world and joined Europe in adopting NIRP, a wave of slippery slope thinking took hold of the financial world. Traders started speculating about which country would be next, and how long it would be before NIRP came to the US. Additionally, global investors and institutions who need to find yield were likely to find the US increasingly attractive on a relative basis, leading to further flows (and thus downward pressure) on the yield curve here. With the aforementioned inflation backdrop, any conversation about NIRP in the US is misguided.

Mr. Market’s Collective Memory

In the 1960s, some old-timers on Wall Street—the men who remembered the trauma of the 1929 Crash and the Great Depression—gave me a warning: “When we fade from this business, something will be lost. That is the memory of 1929.” Because of that personal recollection, they said, they acted with more caution than they otherwise might. Collectively, their generation provided an in-built brake on the wildest forms of speculation, an insurance policy against financial excess and consequent catastrophe. Their memories provided a practical form of long-term dependence in the financial markets. Is it any wonder that in 1987, when most of those men were gone and their wisdom forgotten, the market encountered its first crash in nearly sixty years?[6]

The safest time to fly is in the days following a plane crash. Everyone involved in the safety processes, from the ground crew to the pilots are on heightened alert in an effort to avoid any further mishaps. In markets and economies, this is no different. Finance is far healthier in the aftermath of a crash, because the excesses have been wrung from the system and the actors have been humbled.

For those who recently saw The Big Short, you would have been reminded about how few people in position to do so actually saw a crash coming. In fact, those who warned about a crash were all outsiders, viewed with a degree of scorn by the mainstream in finance. Now, hardly a day goes by without another publication referencing the potential for “another 2008.” The fresh wounds from 2008 are exactly the kind of collective market memory for preventing another 2008 from happening. This does not mean we won’t have more recessions and bear markets—we will—however, it does mean that they will be different and that the consequences for the economy will be far less ominous. The fact is: unless we live a very long time (which hopefully we all will!), we will only experience a “once-in-a-lifetime” crisis once in our life—2008s.

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

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF, CGMA
Managing Director
O: (516) 665-1940
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-1942
M: (516) 729-5174
elliot@rgaia.com

[1] http://www.rgaia.com/robust-networks-for-the-long-term/

[2] http://www.rgaia.com/october-2013-investment-commentary-our-actively-passive-investment-strategy/

[3] http://www.rgaia.com/robust-networks-for-the-long-term/

[4] http://www.rgaia.com/mixedmessages/

[5] http://www.macrofugue.com/only-bernanke-knew-oil-is-not-inflation/

[6] Mandelbrot, Benoit. The Misbehavior of Markets: A Fractal View of Financial Turbulence. Location 2676.

January 2016 Investment Commentary: Robust Networks for the Long Term

January 2016 got off to a fast start in the wrong direction. The first trading day of the year saw the S&P fall 1.4% and the selling continued from there. The S&P ended the month down 5.0%, though halfway through the month the index was down over 10% year-to-date. In the last 30 years, for the first month of trading, only January of 1990 and January of 2009 fared worse.  Meanwhile the S&P 500 in many respects masked a lot of the stock-specific carnage. The Russell 2000 was down 8.5% on the month, with many stocks down in excess of 20%. The performance of a handful of Consumer Staples and the Utility sector helped the S&P appear better than the performance of its constituents.

As the month pressed on, the S&P essentially traded in lockstep with crude oil:

GRAB

In effect, the fortunes of the market thus far in 2016 have been tied directly to the price of oil. One of the points we have emphasized with regard to oil for some time now is that the benefits of the pronounced drop in price happen in a nuanced way over time: people don’t immediately spend their “oil dividend” but they do receive it, and either save it (which is supportive of longer-term investment), or eventually spend it on extra discretionary items. Meanwhile, the negatives are immediate and pronounced: investment in new oil capacity and from industrial companies servicing the sector drops quickly and precipitously.

We think the timing of the selloff this year is suggestive of a force we first referenced in our September commentary entitled “A Liquidation Move.”[1] With the turn of the calendar comes a new budget year for countries. Oil wealth nations in need of maintaining their expenditures thus had to come up with a way to patch the hole in their budget deficit created by the sharp drop in oil prices and the rolling off of existing hedges. These states are filling widening budget deficits with the proceeds from the sale of global assets.  These flows overwhelm the balance between supply and demand across markets in the short-run.

As markets kept declining, concerns evolved from the oil effect to China and now the banking sector, particularly in Europe. We are hyper-alert to broader economic risks, but maintain our case from the 2016 Preview that strength in the consumer and financial sector balance sheets and the employment situation create a strong buffer against the downside risks in the economy and are supportive of continued growth.[2] We are reminded of renowned economist Paul Samuelson’s following quote: “Wall Street indexes predicted nine out of the last five recessions! And its mistakes were beauties.”

Where are the market’s mistakes?

Over the past few months we have given a certain kind of company a central role in our portfolios. While as of now we appear early to these investments, we think they are some of the most unique long-term opportunities in the market today. Collectively, we think of them as dominant business and commerce platforms for the future, with proven business models, robust cash flows and large growth runways. We subscribe to the philosophy of buying “Growth at a Reasonable Price” (GARP) and to that end, we think we have found some extremely compelling growth at prices that over the next three to five years should prove very reasonable.

Before listing the companies, let us introduce the traits that they each have in common:

  • Two-sided networks—these companies all unite sellers of goods or services with consumers, at a scale that is on the one hand, large and defensible, and on the other, very lucrative.
  • Capital lean—these networks require very little incremental capital investment. There is little CAPEX needed for either maintenance or growth. Most of the actual investment flows through the operating line (R&D in some cases, marketing in others), thus actually suppressing what we believe to be the true long-term earnings power of each of these businesses.
  • High margin businesses—despite investment flowing through the operating line, these companies generate substantial operating profit margins and/or have the capacity to ramp these margins as the businesses further scales top line growth. Further, each incremental customer who buys or a good or is serviced on these platforms has very little incremental cost to the platform itself. As such, revenue growth has two effects: 1) the ramp of growth itself; and, 2) an upward pull on margins.

Here are the companies in alphabetic order:

  • eBay (NASDAQ: EBAY)
  • Envestnet (NYSE: ENV)
  • Grubhub (NASDAQ: GRUB)
  • Priceline (NASDAQ: PCLN)
  • PayPal (NASDAQ: PYPL)

Three of these are large cap companies, while two of them are small cap companies. Notice that while these businesses have the aforementioned similarities, all are very different and serve unique end markets with little overlap in the drivers of demand and thus macroeconomic risk. The end products are general goods and services, asset management, food delivery, travel and payments.

The most sensitive of this batch to the economic and market actions of January is Envestnet since it generates a material portion of its revenues from asset-based fees.  Declining asset prices puts downward pressure on investment manager’s billings, which is a near-term concern; however, the secular growth driver of brokers and their assets shifting to Registered Investment Advisors offsets these short-run market declines. Plus, licensing revenues with very sticky, recurring relationships (upwards of 95% renewal rates) have been growing as a share of the business, cushioning the reliance on asset prices. eBay, Priceline and PayPal are global companies with exposure to currency fluctuations. While these moves are a headwind to growth in the near-term, currency effects have a strong tendency to balance out over the long-term.

Importantly, all of these companies benefit from secular trends that will persist regardless of what happens to markets or the economy in the short-run. In fact, certain kinds of economic disruption could further advance the businesses of the two with financial exposure (Envestnet and PayPal) as people look to new solutions for old problems that are not being solved by the legacy players. All have relatively low multiples and are cheap using conservative assumptions within an appropriate timeframe in our Discounted Cash Flow (DCF) analysis. Each has multiple drivers of growth (typically users and activity per user) which compound on each other and offer extra leverage to revenues moving higher.

In markets like these, people sell what they can, not what they want to. In our November 2014 commentary, we first warned of “the oil investors who don’t even know it.”[3] While recognizing this reality was a helpful lens through which to view potential troubles in High Yield in particular, we did not anticipate the extent to which everyone would effectively be an “oil investor” at the behest of Sovereign Wealth Fund sell orders. Needless to say, it has created some unique opportunities where investors are throwing out some precious babies with the dirty bathwater.

In our October 2013 Investment Commentary[4], we referenced 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.” We noted that, 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.  During these days of uncertainty, fear, and randomness, one must focus on the long-term, with an emphasis on the fundamental values of businesses that are best positioned for tomorrow.

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

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF, CGMA
Managing Director
O: (516) 665-1940
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-1942
M: (516) 729-5174
elliot@rgaia.com

[1] http://www.rgaia.com/a-liquidation-move/

[2] http://www.rgaia.com/mixedmessages/

[3] http://www.rgaia.com/the-oil-investors-who-dont-even-know-it/

[4] http://www.rgaia.com/october-2013-investment-commentary-our-actively-passive-investment-strategy/

December 2015 Investment Commentary: Mixed Messages

Our 2015 outlook was the second consecutive to include the notion that markets would be weaker than the broader economy. Specifically, we said that “we continue to expect markets to be weak and volatile compared to the economy”[1] and this is largely what happened. If one checked the S&P 500’s price at the close of December 31, 2014 and not again until the close of 2015, it would appear that not much happened on the year. The S&P 500 had a -0.81% price return, alongside a 1.23% total return. The Dow dropped 2.19% pricewise, but added 0.09% in total. Global markets and small caps were particularly weak, with the MSCI All Cap World Index shedding 4.58% on price (-2.15% total return) and the Russell 2000 dropping 5.85% (4.40% total return) respectively. The most notably poor performing asset class was the High Yield Corporate Bond Index (as represented by HYG) which had a negative total return of 4.75%.

While the S&P 500’s performance was seemingly flat, the underlying performance in specific stocks tells a vastly different story. Through the course of the year, 534 total stocks were in the index at some point (due to corporate actions, compositional changes, etc). The average return of those 534 stocks was a negative 3.94%. 301, or 56% of the stocks in the S&P ended negative. 200 stocks experienced double-digit losses, compared to 142 double-digit gainers. 11% of the stocks in the S&P lost one-third or more of their value, versus 5% that gained more than one-third in value. Fourteen stocks shed over half their value, while 5 added that much. There are two notable points worth emphasizing:

  1. Dispersion between the winners and losers in 2015 was extreme.
  2. If you look around the market, there was far more pain than there was gain to be had.

This was the second consecutive year of markets littered with minefields. We feel good that in our commentary last year we forewarned “the death of commodities as an investable asset class” and saw “much pain” in the MLP space. While we are not wavering longer-term in our conviction that “the benefits [of cheaper commodities] in nearly all respects outweigh any reason for concern [about declining capex],”1 we think we missed an opportunity to approach this belief with more patience. In several cases, we thought the investor base in some high quality, non-energy companies would be willing to look past some of the nearer-term headwinds.

Investors spent most of the year wondering if and when the Federal Reserve would raise interest rates, thus ending the Zero Interest Rate Policy (ZIRP) that commenced in an effort to stave off the Great Financial Crisis. It took until halfway through December to get an answer and after seven years, rates finally moved up to 0.25%. We long argued that the first rate hike would be a reflection of economic strength and with the November unemployment rate at 5.0% (we do not know year-end as of the time of this writing), that certainly is the case.

Throughout the year, market commentators blew a lot of hot air prognosticating about “the FANGs” and concerns about China’s long-term GDP growth rate. In case you have not heard of The FANGs (you would be better off for it), that is the acronym coined for the four most significant standout performers in 2015: Facebook, Amazon, Netflix and Google (the company formerly known as Google, now Alphabet, but who would let a technicality ruin a good narrative?). One of these is not like the other ones (hint: it’s the one we own). In fact, it is so different as to render the narrative a vapid, but marketable headline.

In our first two sections below, you will see that there is a yin and yang side to each of the major themes from this past year and how they setup for the future. Each strength came alongside a form of weakness. These forces do not truly offset each other and we will attempt to wrap it all together for you.

Consumer Tailwinds:

The Prolonged Benefits of Low Rates, Part 1:

The benefits of cheaper financing aren’t going away. One of our favorite charts for a few years has been household debt service as a percent of disposable income:

1

The difference from 2006 to today is massive and serves as one of the clearer lenses through which to see a primary force behind the Great Financial Crisis: household expenditures on the interest component of debt was at its highest level in recent history. This improvement is consequentially related to the low interest rate policy at the Fed. Many overemphasize gross debt levels as a source of risk, to their detriment. The debt service situation for households is as healthy as it has been in over three decades.

Let’s talk through the benefit of low rates even further: people who bought houses or refinanced their mortgages to longer duration, lower rate structures have locked in prices for the single largest annual household expense. Per the BLS, the average household with a married couple dedicated 30% of their total expenditures to “Housing.”[2] Housing includes more than just shelter; however, shelter accounts for somewhere around 60% of that amount. This means the average household that owns a home spends 18% of their budget on shelter, or what would be covered by mortgage principal and interest payments. With just shy of 64% of households owning houses, the affordability of housing will improve every year for two-thirds of American households.

A little exercise helps highlight the long-term benefits. Let’s take a sample household, who for the sake of simplicity spends $100 per year. Assuming the 18% spent on shelter is in a fixed mortgage.  Each year, $18 will go towards housing and $82 to everything else. The Fed sets its target rate of inflation at 2%. On one hand, average inflation over the past century has been closer to 2.5%; on the other hand, we have been below trend for the past decade. For arguments’ sake, let’s set the inflation rate at 2%. With this, we will assume that wages grow at the inflation rate, and further that expenditures grow at the same rate as wages. In 10 years, the sample household will have $121.89 available to spend. $18 will still go to housing, but now $99.96 will go to everything else. In effect, this household will have about 0.3% per year extra to spend on the “everything else” category, which over 10 years adds up to 3.23%. This might not seem like a lot, but in 10 years, given the average household spent $53,495 in 2014, this will leave an extra $1,727.88 for households to spend in other areas. Multiply this by the 115 million plus households in America and that is a big number for the economy. These benefits increase quickly if inflation accelerates above 2%.  For context, here is average hourly earnings versus core CPI:

2

When the yellow line is above the blue, workers are benefitting from real wage growth. Real wage growth means the purchasing power of the average employee is rising quicker than his or her expenses. Note that since 2000, average hourly earnings have grown at a faster clip than CPI excluding food and energy. Thus we think this scenario outlined for an average household above is a modest example of the benefits that will accrue to nearly two-thirds of American households.

The Oil Dividend

The longer-term impact of low rates combines nicely with 2015’s second biggest story for consumers. In 2014, the average weekly price for gasoline was $3.358. In 2015, this average fell to $2.429 and a gallon ended the year at $2.034. On average, gasoline was 27.7% cheaper in 2015. If gas prices stay flat in 2016, they will effectively be 39.4% below the 2014 level.  According to the BLS, the average household spent $2,468 on “gasoline and motor oil” in 2014. At 27.7% cheaper, this is a $683.64 savings per household, and at 39.4%, it is a $972.39 savings. This understates the true savings from cheaper energy, as heating bills, energy bills, and several other expenses tied to energy decline apace.

It takes time for people to judge whether the oil savings are a temporary or long-term effect. Now that we are more than one year past the most severe portion of the decline, people are beginning to accept cheaper gas as a normality. The Atlanta Fed, on its Macroblog, put out a great piece last year on the consequences of the energy price decline and they conclude that as far as consumption is concerned, “there is a short-run drag before the longer-term boom”(the short-term drag is misleading considering “consumption” measures all expenditures including those on gas. If gas declines and all other spending stays constant, consumption in aggregate will decline). [3] We see evidence that consumers are embracing cheaper gas when we look at vehicle miles traveled:

3

Only this past year did Americans drive more than the pre-crisis level and this enthusiasm was backed up by continued strength in car sales, with SUVs a notable standout.[4]

The Strong Dollar, Part 1

Last year we jokingly labeled a section “The Strong Dollar Yellen Fed (take THAT conventional wisdom)” and lo and behold, the strong dollar got even strong. Our jab was meant to be ironic considering many were concerned that Yellen was too willing to embrace policies that were negatives for the dollar. Thus far we can draw one of two conclusions:

  1. Yellen is actually a hawk in disguise.
  2. Fed policy matters less than meets the eye, especially in the short run.

Good thing that we believe in nuances and that such dichotomies are not truly mutually exclusive options. On the year, the trade-weighted dollar index rose 23.1%:

4

Since we import a lot of consumer goods into the US, the strong dollar helps improve the affordability of many items that households buy on a regular basis.

The Earnings Recession

The Prolonged Benefits of Low Rates, Part 2: The Hunt for Yield Turns Sour

This is one of the most nuanced topics out there today. In part this section could have been written as a strength; however, it’s important to speak to some of the risks right now. Cheaper financing will be a part of many companies for a long time. Financing is not going to get materially more expensive—despite the rate hike—anytime soon. A chart showing net debt to EBITDA on the corporate level is the equivalent of our household debt service chart above for companies:

5

This is a similarly constructive setup, especially when combined with our discussion from last year about how non-financial corporations were the sector of the economy most ripe to add leverage.

So far, everything we said is a positive, so why is this in the “yang” section? If you will recall our letter entitled “The oil investors who don’t even know it,” we expressed concern about the extent of exposure in high yield bond indices to energy.[5] This year, that exposure came back to bite in the form of a significant widening in energy-specific spreads, but also a broader de-risking in the high yield bond space. The best way to show this is with the spread of high yield debt over Treasuries:

6

The impaired values of energy sector bonds have taken their toll on other sectors by decreasing investor willingness to buy new high yield issues.

Oil (ex-) Dividend,The Earnings Recession:

High yield bonds were not the only victim of corporate energy’s woes. The earnings in the S&P will actually register a decline (also known as an “earnings recession”) in 2015 (the yellow line in the chart below):

7

The market tends to follow the direction of earnings over longer timeframes. You can see in the above chart the gravitational pull of this relationship. Excluding energy, the S&P will register modest growth in 2015; however, the 36% drop in energy sector earnings was too much to outweigh everything else. Take a look at our September commentary for a deeper look at the sectoral breakdown of earnings.[6]

Oil’s impact spreads beyond the energy sector through the industries that help service and build out energy production and transportation capacity. In the aforementioned Atlanta Fed piece, they offered an estimate of the near-term woes in capital expenditures and when to look for a leveling off. While this was published after the most acute phase of the oil decline, prices continued to drop throughout the year:

8

The effects of this capex shock will begin to subside early in 2016 and will be gone by 2017. With the economy near full employment, the potential for a negative feedback loop should be contained, as workers laid off from energy-impacted jobs can transition to other areas of need.

The Strong Dollar, weak profit:

The strong dollar was the other force conspiring against S&P earnings growth. The U.S. is home to many multinational companies who do considerable business abroad. When the dollar rises, the value of foreign earnings declines proportionately.

When earnings growth declines, investors take down the multiple they are willing to pay for a given earnings stream. This was particularly acute in the August selloff.[7] Investors en masse went from paying a near 19x multiple of forward earnings to just shy of 17x during the month. This down move and subsequent snapback represent some of the uncertainty and angst on the part of investors. Will the woes in the oil, mining and industrial sectors spread into deeper economic contagion? Or will the benefits of cheaper goods accrue to consumers and create a virtuous cycle for the economy?

A corollary of the strong dollar is how multinationals based outside of the US actually get an earnings tailwind from a falling currency. This has been one of the key premises behind our interest in high quality European companies who do most of their business outside of the Eurozone. While the currency translation has been a drag on stock performance in the short run, we have finally started to see accelerating earnings growth attract higher multiples from investors.

Where does the next recession come from?

Last year we proclaimed the following:

Importantly, we think the next recession will come from an economy that accelerates too much and must be slowed down via a tightening of monetary policy, rather than one where a credit contraction puts us on the precipice of deflation. In other words, the next recession will be of the run-of-the-mill variety, which are never fun, but are far less troubling than once-in-a-lifetime financial crises.[8]

With a rate hike behind us, we are increasingly convinced this will be the case. This is especially true given how tight the unemployment situation is today and the tailwinds that will support consumer spending for some time thereafter. This is exactly what was needed to get inflation back to the Fed target. The question from here begs whether the Fed will let inflation get ahead of target to make up for lost time spent deeply below it, or whether they will try to cool things off before they get even hotter?

As the calendar turns to 2016, market participants are focused intently on the risks out of China. Many of you clients live on Long Island and are probably more attuned to a major trend than the average person: there has been a big flow of Chinese money (and to an extent wealthy people) out of the country, and to the US (with Long Island real estate experiencing a huge influx of both). We can see some signs of this in looking at two lines from China’s Balance of Payments:

new

We do not have end-of-year data for this yet; however, as of the third quarter, a net total of $330 billion of dollars has left China in “Other Investment” and a total of $162 billion has left via “Net errors and omissions.” Roughly speaking, China has offset some of this outflow by using its reserves to defend the Yuan and we can see that in the form of the largest reserve drawdown as a percent of total reserves China has seen since opening its economy and accumulating US dollars (see chart on next page):

10

Two points are worth noting:

  1. In late 2014 when the outflows started hitting the Balance of Payments, and the reserve drawdown began, China opened its domestic equity market “A” shares to foreign ownership.[9] Previously, foreign investors had to invest in China either via Hong Kong listed shares, or foreign domiciled proxies. This opened the floodgates for inflows. While foreign purchases of equities temporarily held the net outflows in check, it was a mere pause before a big acceleration. In many respects, the opening of shares was a sinister ploy to improve the Balance of Payments more so than a move in the direction of financial openness. This is further evidenced by the huge valuation premium assigned to Chinese A shares verse their Hong Kong counterparts, and what at that point were soaring and obscene market valuations relative to any prudent measures of value.
  2. This money flowing out of China has to go somewhere. While China is selling dollars and Treasuries (note, both have gone up despite the China selling pressure, thus the fears about China spiking US rates seem misplaced), Chinese private sector players are buying global properties and building bank accounts abroad. In effect, this money is going from passive, low velocity reserves, to active, high velocity assets and goods.

These forces collectively create volatility for global financial markets, but what they do not do is change the trajectory for the US economy. Oil is the primary mechanism through which the US economy does get impacted, and as we discussed above, that is a nuanced effect with lower capital expenditures hurting investment in the short run, but the greater consumer purchasing power accelerating growth in the mid and long-term. Despite these concerns about the global economy and industrials, the US economy continues to chug along. What we said two years ago is still relevant 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.[10]

We discussed rising wages above. Two further forces bode well for the US economy in the coming year the end of the fiscal drag and the tightening housing supply. Both are supportive of increasing employment. With the fiscal drag ending, the US government (Federal, States and Municipalities collectively) will increase spending for the first time since 2010: [11]

11

As the chart above shows, from 2011-2015, this has been one of the larger forces holding back the economy. In fact, 2013 saw government spending chop over 2% from GDP growth. The inflection point from negative to positive offers a nice accelerant. Meanwhile, housing supply creation has now been below population trends for longer than it was above it during the housing bubble. In other words, over the fuller cycle, we have underbuilt what is necessary to support demand. Housing starts should continue to surge:

12

Employment is already tight with the unemployment at 5%, yet the end of the fiscal drag and continued expansion in housing starts will keep demand for workers strong and help offset the pain that energy-related industries will experience.  Herein lies the problem: these forces will push inflation upward in the coming year. This is exactly why the Fed commenced a rate-hiking cycle with the global economy looking uncertain. We will thus repeat, because it is so important: the next recession will come from inflation accelerating to the point where the Fed is uncomfortable and must act to stop it. China is merely a sideshow, but an important one nonetheless.

What do we own?

Much like with broader markets, performance dispersion across positions was the major theme for our holdings. Our European positions generally performed well, even when translated into dollars; however, for the second year in a row our considerable overseas holdings exposed us to the drag inflicted by a strong dollar. Two of the three losers no longer appear on our position roster (Bed Bath and Beyond and Siemens), while each of the winners remain.

Returns reflect US dollar denominated returns over our holding period.

The Leaders:

Alphabet (NASDAQ: GOOG/GOOGL) +46.6%

Groupe SEB (EPA: SK) +42.6%

Markel Corp (NYSE: MKL) +29.4%

The Laggards:

Bed Bath & Beyond (NASDAQ: BBBY) -36.7%

Johnson Outdoors (NASDAQ: JOUT) -29.0%

Siemens AG (OTC: SIEGY) -27.1%

We wish you and your families a healthy, happy, and prosperous 2016. Thank you for your trust and confidence, and for selecting us to be your advisor of choice.  Please call us directly to discuss this commentary in more detail – we are always happy to address any specific questions you may have.  You can reach Jason or Elliot directly at 516-665-1945.  Alternatively, we’ve included our direct dial numbers with our names, below.

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF, CGMA
Managing Director
O: (516) 665-1940
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-1942
M: (516) 729-5174
elliot@rgaia.com

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

[2] http://www.bls.gov/news.release/cesan.nr0.htm

[3] http://macroblog.typepad.com/macroblog/2014/12/the-long-and-short-of-falling-energy-prices.html

[4] http://www.bloomberg.com/news/articles/2016-01-05/fiat-chrysler-rides-jeep-to-u-s-gain-as-nissan-beats-estimates

[5] http://www.rgaia.com/the-oil-investors-who-dont-even-know-it/

[6] http://www.rgaia.com/a-liquidation-move/

[7] http://www.rgaia.com/zones-of-reasonableness/

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

[9] http://www.wsj.com/articles/china-opens-doors-to-foreign-investment-in-stocks-1415604267

[10] http://www.rgaia.com/december-2013-investment-commentary-our-2014-outlook/

[11] http://www.wsj.com/articles/dont-celebrate-the-end-of-austerity-1452101357

November 2015 Investment Commentary: Fade Disruption

“It’s tough to make predictions, especially about the future.”

“The future ain’t what it used to be.”

–Yogi Berra

How will the future look in fifty years? In his latest book, Antifragile, Nassim Taleb gives us a clue: Assume that most of the technology that has existed for the past fifty years will serve us for another half century. And assume that recent technology will be passe in a few years’ time. Why? Think of these inventions as if they were species: Whatever has held its own throughout centuries of innovation will probably continue to do so in the future, too. Old technology has proven itself; it possesses an inherent logic even if we do not always understand it. If something has endured for epochs, it must be worth its salt…Fifty years into the future will look a lot like today…

When contemplating the future, we place far too much emphasis on flavor-of-the-month inventions and the latest “killer app” while underestimating the role of traditional technology. In the 1960s, space travel was all the rage, so we imagined ourselves on school trips to Mars. In the ‘70s, plastic was in, so we mulled over how we would furnish our see-through houses. Taleb traces this tendency back to the neomania­ pitfall: the mania for all things shiny and new.[1]

–Rolf Dobelli

In our December 2012 Commentary featuring our expectations for 2013, our last chart series started with the following:

We are living in the technology age, yet for some reason, no sector in the stock market is more unloved than technology. In fact, industrials, perhaps due to the natural gas renaissance in America, are far more loved at the moment.[2]

How far things have come: today the exact opposite is true.  If you noticed a theme in our extended lede, you might think this could not possibly be a commentary written by the very same people who professed their love of technology just a few short years ago. As often happens, the pendulum of sentiment has swung from one extreme to the other without even a brief stop in the middle.

Two years ago when we professed our love for technology, people were gawking at the perceived lack of innovation.  Peter Thiel wittily summed up this notion with his quip that “We wanted flying cars, instead we got 140 characters”—a reference to how in his childhood people dreamed of flying cars, yet the most profound innovation at the time seemed to be Twitter.[3] Fast forward to today and people are talking about the imminence of self-driving cars, artificial intelligence overtaking human thought and drone delivery.

Self-driving cars is an area close to heart given we own a leader in self-driving car technology (Google) and a mass-market automaker (Fiat-Chrysler). We find the rhetoric on the imminence of disruption particularly extreme. Not long ago, our long-term holding in Google was admonished for “betting the farm” on “speculative” projects with self-driving cars the poster child.[4] Just a few months ago, an auto analyst we greatly respect proclaimed that Tesla should be worth $60 billion on account of a possible self-driving Uber-like service.[5] In other words, the rhetoric has shifted from suggesting that a multi-million dollar bet at a centibillion dollar company with a modest valuation (Google) was impairing its long-term value by billions of dollars to the potential for another company (Tesla) to do the very same thing doubling its already lush valuation. All it took was three years and a creative imagination.

We like that Google is making these kinds of investments for how it leverages their strengths in data aggregation, organization and analysis, so we certainly will not complain about a future with driverless cars. Google is a great vehicle for gaining exposure to these kinds of asymmetric opportunities. They have a cash cow in the form of search, a growing one in YouTube and a slew of high risk/high reward bets where the wagers are quite small relative to the company’s value, but rewards enormous. We are optimists who love seeing innovators dream big, yet we think the enthusiasm with which people see the future of disruption has taken a turn for the misguided in the stock market.

The hype cycle is a good framework through which to think about the relationship between expectations and reality:

6

[6]

Valuations in some pockets of tech stocks are now overenthusiastic to the point where success will be rewarded with little return for investors. Meanwhile, valuations of some old dinosaurs have become far too cheap amidst vague proclamations of disruption’s imminence. When we are talking about issues over half a decade out, not only is there great uncertainty as to the “if” but also the “how.” Even if we are certain that these disruptions are coming, we can never know in advance how they will change things. A few years into the iPhone’s existence, no one would or could have predicted Uber.

We have twice highlighted the irrationalities of some valuations in the technology space. First, we broke down the speculative assumptions behind Tesla’s valuation in our August 2013 commentary. Next, we pointed out the “pockets of momentum” in high growth stocks in February 2014.[7] [8] These commentaries focused on the excessive valuations in technology stocks, but through it all we remained heavily allocated to the technology sector. This is unlikely to change.  However, in the meantime, there has been a profound change in how people are talking about technology and its impact on the future.  Investors have become too blasé in dismissing a sector as bound to be disrupted without quantifying when and how that impact will take place.

We can do a little math exercise to give a general sense of how disruption impacts a dinosaur company’s market cap today. Let’s say a company has $100 in cash flow that will continue in perpetuity and a 10% cost of capital. This results in a net present value (NPV) of $1,000. Here is what that $100 cash flow stream would be worth if segmented into various time frames:

npv

The assumption here is that the $100 in cash flow will not grow over time. Further, the cash flow will not fizzle, but will simply drop to $0 in the stated year.  If a disruption will hit a company in 5 years, that company today is worth 62% less than were it treated as a perpetuity. Meanwhile, were a disruption to take 30 years to pan out, it would only justify a 5.7% discount to the perpetual value. Another way of phrasing this is that disruption “a decade out” should result in the disrupted trading at about a 38% P/E discount to the market. With the market at approximately a 17x P/E then that justifies an 11x P/E. At an 11x P/E the implication would be that the disruption has a 100% chance of happening in a decade. Were the chance merely 50% instead, the justified P/E relative to the market would be 13.8x. The point here is rather simple but we think the illustration is powerful: the longer a disruption takes to actually come to fruition, the less it should impact the companies at risk of disruption. Further, the less certain the disruption, the less impact its potential should have on the disrupted’s value. If something will ultimately “take decades” to happen (as the conversation about self-driving cars acknowledges), then its impact today is almost negligible on an old company compared to thinking about it as a perpetuity.

There are a few important qualitative points to make alongside this basic math:

  • Disruption typically comes from where it’s least expected. As such, predictions of disruption are often wrong. Such is the essence of disruption.
  • A lot of what is presented as disruption today is merely using existing things in different ways.
  • The expectation of disruption in a sector can change the behavior of management such that a company’s business is more resilient to future threats.
  • Conversely, when disruption does occur, institutional imperatives often result in companies burning cash rapidly to protect what is left rather than unwind the business and release its capital. Many of the risks of disruption thus result from human biases.

One of the points captured by the Rolf Dolbelli excerpt above is the power of inertia. Things that have worked for people for a long time, tend to continue working for a long time. Disruption is both a risk and an opportunity. Given this nature, we have wagers on companies that are disruptive forces in their sectors and an increasing number of wagers that certain areas will be disrupted far slower than the market expects to be the case. All involve a careful assessment of the value that is already attachable to the business’ ongoing operations and the implied odds that disruption will derail the prevailing inertia. These are themes we will continue to spell out over time.

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

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF, CGMA
Managing Director
O: (516) 665-1940
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-1942
M: (516) 729-5174
elliot@rgaia.com

[1] The Art of Thinking Clearly, by Rolf Dobelli. Page 207.

[2] http://www.rgaia.com/wp-content/uploads/2013/08/December-2012-Investment-Commentary.pdf

[3] http://www.newyorker.com/magazine/2011/11/28/no-death-no-taxes

[4] http://www.huffingtonpost.com/2011/06/03/google-larry-page_n_870797.html

[5] http://www.businessinsider.com/morgan-stanley-raises-tesla-price-target-2015-8

[6] https://www.pastel.co.za/blog/four-ways-the-gartner-hype-cycle-revolutionises-the-way-we-do-business/

[7] http://www.rgaia.com/august-2013-investment-commentary-tesla/

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

October 2015 Investment Commentary: Decreasing Correlations and Our Investment in Envestnet, Inc.

At the end of last quarter, we called the market selloff “a liquidation move.”[1] During October, stocks recovered much of their losses from the prior few months. This is often how a bounce back from liquidation selling transpires. Once the forced seller stops, markets recover. While October was a strong month, it’s important to caveat that when markets move really fast in a short period of time, they inevitably require a breather. It would be healthy to see some digestion here with more volatility compression. Further, we remain in an environment where some individual stocks are getting thrown out of the window on bad news. We need to see a stop to the number of stocks with large hedge fund ownership dropping 15+% in one-day moves before a healthy, broad-based uptrend resumes. So long as this kind of carnage is out there, funds will have to continue reducing gross exposure, thus creating a headwind for markets.

CBOE S&P 500 Implied Correlation Index

One consequence of the recent market action has been a sharp drop in implied correlation as evidenced by the CBOE S&P 500 Implied Correlation Index (source, Bloomberg):

Here’s the description of the index from CBOE:

Using SPX options prices, together with the prices of options on the 50 largest stocks in the S&P 500 Index, the CBOE S&P 500 Implied Correlation Indexes offers insight into the relative cost of SPX options compared to the price of options on individual stocks that comprise the S&P 500.[2]

When this index is rising (falling), it means that correlations amongst the 50 largest S&P stocks are rising (falling). In other words, the higher this index, the more in unison stocks move, and the lower the index, the more stocks move independently of each other. There’s a saying that “all correlations go to 1 in a crisis,” which means that everything tends to move in unison when things are bad. A drop in correlations, as we’re seeing now, is just another healthy step towards putting the Great Financial Crisis in our rearview mirror. This is a phenomenon we have noticed in our portfolio and is something we believe should benefit us as time progresses. We long for a market where individual securities perform based on merit as opposed to knee-jerk market reactions to macro headlines or index-driven fund flows.

A new stock in your portfolio:

During the month of October we commenced a new position that we are excited to share: Envestnet Inc. Envestnet has two main business lines, each with outstanding business models, catering to the growing Registered Investment Advisor (RIA) landscape. The main business at Envestnet is the asset-based fee segment (the “AUM/A business”). The second is a software licensing business.  Collectively Envestnet provides one of the most robust back-end technologies for investment advisors, one of the fastest growing segments of the financial services industry. We’ll focus most of the following conversation on the AUM/A business.

Envestnet’s AUM/A business allows financial advisors and asset allocators to connect with fund managers and specific investment strategies.  Envestnet’s software helps construct the allocations for advisors based on each individual client’s needs, after which the advisor can use some of Envestnet’s own solutions or external managers who offer their services through Envestnet’s platform (this is a multi-sided network that works great for all parties). As of the end of the third quarter this year, AUM/A was at $250 billion, from which the company earned a fee of ~13.25 basis points. By our estimates, this fee has varied overtime from around 11.3 basis points up to 14, but has generally hovered around 12. We use 12 in our model.

There are three key traits we love about this business:

  • The AUM/A business tend to be very sticky and benefits from inertia. People don’t frequently change the decisions they have made with respect to their advisor unless something goes very wrong.
  • The allocation of Envestnet’s AUM/A is by nature very diverse. Considering much of these assets are in traditional “wealth management” the AUM/A viewed as a portfolio most closely approximates a 60/40 allocation between stocks and bonds. Plus there should be portfolio inflows equal to the average household savings rate. Taken together, as the company has explained, the growth in AUM/A should be approximately three times the rate of inflation. Note that this is purely the intrinsic growth of the asset business itself, not the growth that Envestnet can tap into from expanding the number of advisors who use its platform.
  • In aggregate, the AUM/A is stylistically agnostic. There are all kinds of managers on Envestnet. If a style like “momentum” is replaced with “value” in popularity, Envestnet will capture this transition.

Beyond these natural drivers of stickiness and growth, we think Envestnet has a major runway for future growth.  There are three key leverage points that we focus on:

  • Growth in advisors on the Envestnet platform
  • Growth in accounts per advisor
  • Growth in dollar value per account (which relates to point 2 above)

The Great Financial Crisis and changing regulatory landscape have helped accelerate the investment management industry’s transformation from the broker / dealer (b/d) model that made money off of commissions to the fee-based, independent model that makes money off of a small percentage of assets under management. Importantly, the pivot from the b/d model to the RIA platform has also come with the growth of a fiduciary standard, whereby managers must put themselves in the shoes of their clients when making decisions (as an aside, it is shocking how resistant wealth managers at b/ds are to the idea of a fiduciary standard. Do they not think it natural for to expect their own interests to be tantamount to the advisor’s generation of fees?).

In a Cerulli Associates study of the asset management landscape, they presented the following information on recent growth of the RIA platform:

RIAs experienced the strongest growth among the independent channels in 2013. According to Cerulli, the channel increased 17.1% in 2013 to $1.67 trillion in total assets and expanded its asset marketshare from 9.2% in 2007 to 11.9% in 2013, which equates to a compound annual growth rate of 8.3% and a $600 billion boost in assets on a base of $1 trillion.[3]

We are thankful to have played our small part in the existence of this trend and expect it to continue indefinitely into the future. We like that no matter which way you slice it assets of advisors who use Envestnet’s platform; RIAs; or, RIAs + broker/dealers, Envestnet has captured a mere hair of the total addressable market.

In addition to fee-based revenue, Envestnet also sells a software platform called Envestnet Tamarac, a direct competitor to the Black Diamond platform you are all now familiar with.  We can speak a lot from the customer perspective of the relative merits of Tamarac vs Black Diamond. Nevertheless, we think Tamarac is an outstanding product, which benefits from its own kind of stickiness and a long runway of growth.  Advent, the parent company of Black Diamond, recently sold for 18x EV/2015 estimated EBITDA. This juicy multiple is reflective of the high margin nature of these businesses, the extended pipeline of growth, and the stickiness of existing customers.

The AUM/A and licensingbusinesses have another common trait we have yet to mention: very little capital intensity. Neither of these businesses need to invest significant capital expenditures to grow, and both of them do most of their “investing” in the form of R&D and scaling headcount, which flow through operating expenses. These operating expenses are not capitalized, despite the fact that the costs actually produce material benefits for years down the line. This is one of the key reasons we expect operating leverage out of Envestnet each subsequent year alongside its robust top line growth.

All this begs the question as to why Envestnet is cheap. In the short-run, the company is sensitive to asset prices. When markets decline as they did in the third quarter, it is a headwind to Envestnet achieving their growth targets. The third quarter’s decline will be most visible in the company’s fourth quarter earnings report and investors were anticipating this pain. Most consequentially, Envestnet announced it will be acquiring Yodlee, a financial account aggregation and data service.[4] Alongside the acquisition, Envestnet indicated that organic growth would not reach the 20% annualized top line the company had hoped for, but rather settle in the high teens. This dual-shock amidst the intense August volatility sent the stock tumbling. It didn’t help that Envestnet made the acquisition in-part with stock, thus incentivizing merger arb funds to sell Envestnet while buying Yodlee.

In our estimation, Envestnet had been aggressively valued earlier in the year, and as so often happens, the correction “overshot” past fair value into the domain of cheapness.  Just this past year the company hit the point in its growth curve where revenues flow through at a greater rate to bottom line profitability. Right now it is trading at around a 10x EV/2017 estimated EBITDA with top line continuing to grow at upwards of 15% and EBITDA growing at least 5% greater than the top line. In our model, we focused on what core Envestnet was worth pre-Yodlee acquisition. We see the top line compounding in the high teens, generating an extra 150 BPS of operating leverage per year and a 3% terminal growth rate, which results in a fair value of $40. Given that this analysis excludes Yodlee’s revenue and earnings contribution, but includes the cost of the acquisition (and given that we underplay the growth and operating leverage inherent to the business model), the price today around $30 looks incredibly attractive. This kind of growth is hard to find in any sector where the business quality is so outstanding and sticky for the long-term and the operating leverage so obvious and imminent. It is exceedingly rare to find such a company at this modest a multiple given the evidence of quality and growth. With these kinds of properties, we look forward to Envestnet being a core holding for the long run.

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

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF, CGMA
Managing Director
O: (516) 665-1940
M: (917) 536-3066
jason@rgaia.com

Elliot Turner, CFA
Managing Director
O: (516) 665-1942
M: (516) 729-5174
elliot@rgaia.com

[1] http://www.rgaia.com/a-liquidation-move/

[2] https://www.cboe.com/micro/impliedcorrelation/

[3] http://www.thinkadvisor.com/2014/12/19/ria-dually-registered-assets-to-reach-28-market-sh

[4] http://www.envestnet.com/press/envestnet-acquire-yodlee