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

September 2015 Investment Commentary: A Liquidation Move

In the third quarter, the S&P lost 6.9%. This was the worst quarterly decline since the third quarter of 2011 when the debt ceiling and Europe’s potential breakup loomed over markets. The third quarter was no kinder to bond markets. Toward the end of Q3, 2015 was shaping up to be the first time since 1990 where both stocks and bonds lost money in the same year.[1] In other words, the best performing global asset class thus far this year has been cash. While 2011’s route had clearly identifiable causes that warranted a repricing of risk, this year’s selloff came with vague explanations like “fears of a Fed rate hike,” “a hard landing in China,” and “Glencore is Lehman.”[2] [3]  In our opinion, these are merely convenient excuses that portend well for markets down the line.

First, as we have pointed out several times in the past two years: markets had risen too far in recent years compared to the progress in the real economy. Second, this market action is what we would call a “liquidation move” where a large seller, for non-fundamental reasons, rapidly cut their market exposure. We covered this first part in August’s commentary, so much of the space below will focus on what we mean by a “liquidation move” before circling back around to the valuation backdrop of the stock market.[4]

Commodity Losers Gotta Sell

Commodities are a sector wrought with leverage. This leverage exists on the company level—commodity extractors of all kinds tend to deploy considerable leverage in their capital structures—and on the trading level—futures contracts typically are levered over 10 times (ie for $1 of capital, someone can take $10 of positions). With commodity prices declining sharply, the stocks of these companies whose debt was predicated on higher levels were vulnerable to sharp declines. This is but one reason why high yield bonds had a rough quarter and energy stocks continued the decline which accelerated last Thanksgiving.[5]

In the prior decade, commodities and commodity companies were outstanding performers. This led many to believe the “hard stuff” deserved a permanent place in building a diversified portfolio. As so often happens, investors built these commodity positions after (not before or during) the outstanding decade. Since the commodity crash accelerated, we have been operating under the assumption that there would be a maximum point of pain these late commodity investors would be willing to take in their portfolios in the name of “diversification.” Since last year, we had been asking ourselves who would be in line to trim down risk tolerance in their portfolio because of how wrongly exposed to commodities they ended up. We looked at all kinds of hedge fund and mutual fund filings in an attempt to ascertain where the selling could come from. Once the selling in the markets began, we looked for particularly pained hedge fund portfolios and still did not identify an obvious seller.

In past selloffs we had a pretty clear idea as to where the selling originated. Studying the history of similar selloffs led us to look at 1998 as an example. 1998’s panic happened amidst a similarly strong fundamental US economic backdrop and a challenging Emerging Market landscape. Investors were at least somewhat aware that Long Term Capital Management’s positions combined with leverage left the markets vulnerable. This time around, we were mostly scratching our heads at the lack of a clear culprit. That was so until the Financial Times published a piece titled “Saudi Arabia Withdraws Overseas Funds.”[6] It turns out, we were asking the wrong question. We should not have been hunting for the hedge fund(s) exposed to commodities, but rather the much bigger global pools of funds with indirect, but meaningful exposure to commodity prices.

Per the FT, Saudi Arabia’s sovereign wealth fund, SAMA, was said to have liquidated over $70 billion of money from global equities and bonds within the past 52-weeks. This is a massive headwind for market prices to contend against. SAMA began 2015 as the third largest sovereign wealth fund in the world, managing over $700 billion. As of June 30, 2015, the last reporting period, SAMA’s assets were down to $671b. This was when markets were still up on the year. Between recent declines and the accelerated withdrawals that began in August, it’s reasonable to suspect that SAMA is now a sub-$600b fund.

Saudi Arabia came into the year with a projected $38.6b 2015 deficit.[7] We suspect they have a good grasp of the revenue side given their capacity to sell oil on the futures market (oil accounts for over 90% of Saudi government revenue) and there is little reason to suspect their expense side would have grown. SAMA exists to fund such deficits when necessary. The problem for Saudi is that the revenue side for 2016 will be considerably worse than 2015 given the futures curve in oil. We think much of the global selling was triggered by Saudi Arabia and other oil rich countries using their sovereign wealth funds to cover these budgetary holes. This aggressive selling from SAMA is a clear sign that Saudi Arabia is planning on covering deep deficits into 2016, and that Saudi’s plan to squeeze some newer sources of global oil supply (like American shale) out of the market is nearing its endgame.

There are different kinds of reserve-driven selling. Many investors have raised concerns about China’s reserve drawdown and its consequences on global liquidity (including David Tepper, who we respect to the extreme).[8] In our estimation, the Chinese reserve drawdowns are far more benign (and possibly supportive of global asset prices) compared to what with the action out of Saudi Arabia. China is drawing down its reserves in order to counter cash outflows from citizens. Chinese citizens have been buying property and assets outside of the country as a response to their domestic economic woes, and China was using its accumulated global savings in order to maintain a desired exchange rate between the Yuan and the dollar. Saudi’s global selling is going directly into domestic Saudi expenses, whereas China’s drawdown is a net neutral on global liquidity. By nature, Saudi’s drawdown on reserves is extractive of global liquidity.

Fundamental Valuations, Contd.

Last month we spoke about how the market’s P/E ratio was now well within a “zone of reasonableness.” That conclusion is in some respects predicated on the direction and magnitude of earnings growth. This year looks like one in which earnings will neither grow nor shrink; however, that’s somewhat misleading. Energy sector earnings will drop around 36% year-over-year, while the S&P excluding energy will grow at about 3.25%. This is pretty decent growth. We did an exercise extrapolating forward S&P earnings on a sector-by-sector basis. For each sector we calculated the 10 year compound annual growth rate (CAGR) and the year-over-year change in earnings. We picked the lower of the two and extrapolated that forward 10 years, simply to paint a picture as to what the S&P earnings might look like moving forward. Bare in mind, this middle of this timeframe includes the Great Recession. As such, it’s hard to claim these past ten years were an outlier featuring strong growth. The only sector where we afforded ourselves an exception to picking the lowest growth rate was in energy where the -36% would have been far too onerous. Instead, we used the -7.66% 10-year CAGR the sector has experienced. This is what the picture looks like (forward multiple was based on the S&P’s quarter-closing price of 1920, all data is from Bloomberg, using S&P 500 operating earnings):

Fwd multiple based on S&P qend closing 1920

Please note: this is not a forecast, it is simply an exercise. We would be shocked were the S&P earnings to have any real correlation to these numbers. Instead, this is merely an attempt to visualize what kind of long-term earnings yield we are paying for in today’s market as long-term investors. We think this is hardly exuberant.

Our Portfolio Activity is Correlated with Market Volatility

There is one fundamental reality of our long-term, low-turnover strategy: the more markets move, the more moves we will be inclined to make. That held true this past quarter, as we chopped several positions, concentrated the portfolio deeper into a few of our favorites, added two new positions and built a deep watchlist which already afforded us the opportunity to commence one more new position between quarter-end and the publication of this newsletter. In effect, this quarter justified more action than the past two years combined. We look forward to elaborating on these new positions in our commentary over the coming months.

What do we own?

The Leaders:

Google (NASDAQ: GOOG) +16.9%

Markel Corporation (NYSE: MKL) +1.5%

Walgreens Boots Alliance (NASDAQ: WBA) -1.2%

The Laggards:

Howard Hughes Corp (NYSE: HHC) -20.1%

Bed Bath & Beyond (NASDAQ: BBBY) -17.3%

IMAX Corporation (NYSE: IMAX) -16.1%

On a personal note: we want to give a warm thank you to Ryan King, our 2015 Summer Intern, who has now returned to the University of Michigan for his sophomore year at the Ross School of Business. Ryan’s work this summer was crucial in preparing our watchlist for the market turmoil. He did a deep dive into the semiconductor sector which will have value for our firm for years to come and helped expand our knowledge-base on numerous companies within the vertical. We wish Ryan a fun and inspiring year back at Michigan.

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.marketwatch.com/story/in-a-quarter-century-cash-had-never-beaten-stocks-bondsuntil-now-2015-09-25

[2] http://www.zerohedge.com/news/2015-10-07/shocking-100-billion-glencore-debt-emerges-next-lehman-has-arrived

[3] We apologize for linking to Zerohedge in the above footnote. Typically we would refrain from doing so; however, this meme has drawn enough mainstream attention as to justify our mention.

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

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

[6] http://www.ft.com/intl/cms/s/0/8f2eb94c-62ac-11e5-a28b-50226830d644.html?ftcamp=published_links%2Frss%2Fglobal-economy%2Ffeed%2F%2Fproduct#axzz3mxcGbfiD

[7] https://www.mof.gov.sa/English/DownloadsCenter/Budget/Ministry’s%20of%20Finance%20statment%20about%20the%20national%20budget%20for%202015.pdf

[8] http://www.cnbc.com/2015/09/10/david-tepper-good-time-to-take-money-off-the-table.html

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

August 2015 Investment Commentary: Zones of Reasonableness

Our 2015 Investment Outlook was built around the following expectation:  “… 2014 concluded with the U.S. economy on as solid a foundation as it has been in years, though we continue to expect markets to be weak and volatile compared to the economy. It is important to remember the economy and the stock market do not necessarily move in tandem.”[1] We first introduced this idea in our 2014 Outlook premised on how the stock market’s outstanding 2013 “borrowed” returns from future years. This was explained as follows:

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

As of this writing, since that time, the S&P has returned a total 8.9% (inclusive of dividends) for an annualized return of 5.3%. We have often highlight how today’s index or stock price (hereinafter just index, as we’re discussing the S&P) can be broken down into two components: earnings and the earnings multiple, commonly referred to as the P/E ratio. In equation form we have Stock Price = E x P/E. When the market goes down it is because earnings are going lower, the multiple is going lower, or both (note: the market can go up with P/E going lower, though it requires the earnings growth outpace the multiple contraction). In 2007-09 both headed, driving the severity of the decline. Today, while the energy sector is a major drag on earnings growth, S&P earnings are not actually declining. This leads us to conclude that the market’s P/E has taken a dive in this recent volatility. We can show this in visual form as follows:

grab 1

The chart above shows the market’s P/E over the past 5 years. You can see the impact in 2011 from the combination of the Debt Ceiling and European Crisis on the S&P’s multiple. That was an acute “repricing of risk” as the market attempted to handicap the likelihood of a U.S. default or the breakup of the European Monetary Union. 2013 was the year the S&P methodically priced in the likelihood of normalization in the U.S. economy following the crisis period. Note that the down moves are swift declines over very short timeframes while the expansions take their sweet time. This is the reality behind the cliché that “markets go up on an escalator and down on an elevator.”

For the rest of this commentary, we try to piece together the context around today’s market multiple. In a soon-to-follow interim commentary, we will take a look at the “E” component of our Price = E x P/E equation. A P/E tells us how much investors are willing to pay for each dollar of earnings. A 16.9 P/E implies investors are willing to pay $16.9 for each $1 in earnings. In other words, investors expect an earnings yield on their investment of 5.91% (=1/16.9). So long as the multiple stays constant over our holding period, this would be our expected annual real return excluding any growth or change in the share count. Over the long-run, S&P earnings have grown nicely; however, we will leave the additive nature of growth for our follow-up piece on the “E” side of the equation. The multiple also happens to be the means through which emotions influence market prices. When Benjamin Graham told the parable of the “Mr. Market” as a manic-depressive business partner, he essentially he was saying that the “very pessimistic” Mr. Market was offering low multiples, while the “wildly euphoric” was offering high ones. Certain macroeconomic factors can and do influence multiples; however, no one force is as influential as the “Animal Spirits” (or lack thereof) in the investor community.

There are tools we can use to figure out justified multiples given variables like the return on equity, growth and the cost of capital (we used one such formula to work backwards and figure out the market’s implied growth, as laid out in our February 2014 Commentary).[3] These are helpful and give us a general sense of where fair value might be. The challenge however is that all of these calculations are done in a dynamic world with countless feedback loops, where inputs are constantly changing and no one output is a “right” answer. As a result, we analyze these situations in terms of “zones of reasonableness” and look for ranges of possible outcomes. This is especially helpful as it pertains to multiples. When we look at specific stocks, ultimately our goal is to buy a good earnings stream, with a multiple that is near the low-end of a range of possible outcomes, leaving the P/E more likely to expand rather than contract over time.

We look for this to be the case independent of where the market’s multiple is; however, we must embrace the reality that in the short to medium-term our stocks move with the market. Consequently, the market’s multiple is a useful gauge for determining whether we are likely to be working with a tailwind or headwind from Mr. Market. The following is a helpful visual:

SP500 PE analysis chart

This chart shows the market’s P/E on a quarterly basis over the past 60 years relative to the average P/E over the timeframe. The shaded blue upper and lower lines show the average P/E plus and minus one standard deviation. Somewhere within these upper and lower lines is what we would call “the zone of reasonableness” for the market’s multiple. The market spent most of the 1970s beneath the lower end of this zone—that is extreme cheapness. This is what happens when stocks confront rampant inflation. Meanwhile, the market spent most of the 1990s above the upper band. That is what “irrational exuberance” looks like in visual form. Following August’s severe correction, the market is sitting right near its 60 year average P/E of 16.37. In other words, the market went from an above-average P/E to an average P/E over the past week. You may have noticed that the right side of the chart has higher P/Es than the left. Over the past 20 years, the market has averaged a 19.25 P/E, so in this light, today’s number looks on the low side of normal.

Interest rates and inflation are important factors influencing the direction of market P/Es. When inflation and interest rates are high (low), P/Es tend to be low (high). Right now, we have low inflation and low interest rates which would justify P/Es that were either at or above the longer-term average. The economy has continually strengthened, with initial jobless claims at their lowest level since 1973, strong corporate and household balance sheets, and manufacturing output humming along.[4] The “excuse” for this market action is directed at China’s collapsing stock market and multi-day depreciation of the Yuan; however, in the grand scheme of things China’s stock market remains up on the year, the Yuan’s move was hardly steep in contrast to other emerging market depreciations, and US exports to China in 2014 amounted to a mere 0.71% of GDP. Meanwhile, US imports from China accounted for 2.7 of GDP.[5] With the Yuan getting cheaper, the net effect of Chinese troubles and a cheaper currency should ultimately benefit US consumers who buy plenty of goods made in China.

Think of what happened in markets this August like an earthquake where what cracked was the market’s multiple. We had a big initial shock, followed by a series of aftershocks. These aftershocks get progressively smaller over time before equilibrium is restored and normalcy resumes. Out of this all, we have the most ripe opportunity set we’ve seen since early 2013 and that won’t be going away fast. In other words, it takes time for these things to work themselves out but markets ultimately will find their footing and start working for us again sooner rather than later.

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

Warm personal regards,

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

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

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

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

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

[4] http://www.reuters.com/article/2015/07/23/us-jobless-idUSKCN0PX1EO20150723

[5] https://www.census.gov/foreign-trade/balance/c5700.html

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

June 2015 Investment Commentary: Deja Vu

The S&P spent the entire second quarter locked in a tight range, ending essentially flat. Markets would have registered modest gains were it not for the pronounced selloff on the last day of the quarter. It might sound “like deja vu all over again,” but Greece once again was the catalyst. June marks the fifth consecutive summer in which headlines from the so-called “Cradle of Democracy” created volatility for global markets.

Many of us remember the first really big Greek-driven market event when split-screens showed the Flash Crash juxtaposed against dramatic riots in Greece (for full effect, watch the CNBC broadcast from that day):[1]

 flash crash

At its worst, the S&P was down just shy of 9%.  A quick snapback helped markets close a mere 3.3% lower.  While Greece was not the only catalyst behind the Flash Crash, it’s safe to say that each subsequent year has seen less volatility than the prior on account of Greek worries.  Today’s volatility pales in comparison to 2010.  This is a poignant reminder that this market, which many call “an uninterrupted bull market” has been anything but.  Before we continue further with the topic of Greece, it is important to emphasize that despite anything we say about the country, the humanitarian situation on the ground is terrible and the hardships felt by the Greek people are very real. On a human level, this is a terrifying crisis.  For the purposes of this commentary, it’s important to speak in terms of how Greece impacts your portfolios and not from the perspective of policy analysts seeking the best possible outcome for all stakeholders.  We do have strong opinions on this matter and welcome that conversation, but we will absolve from doing so through this medium.  Feel free to reach out to either of us should the topic intrigue you.

There are a few reasons behind the declining volatility in today’s Greek drama that are worth discussing.

First: markets are a discounting mechanism.   They take all known information and try to fairly price the balance between risk and reward.  In essence, this is the efficient market theory in action.  We have often invoked the distinction between risk and uncertainty in markets (most recently in our January 2015 Commentary pertaining to Howard Hughes Corp).[2]  When a situation like Greece first arises, people do not know the extent to which other market participants are exposed to trouble.  Some don’t even know the extent of their own exposure.  As traders learn more about Greece, what formerly was uncertain can become quantified as risk.  For example, many banks formerly had exposure to Greek sovereign debt.  This debt has since been written off to zero.  Were a default to have happened five years ago, there would have been severe losses recorded on balance sheets.  These losses have effectively been taken gradually over the course of five years, such that in today’s default scenario, these banks will not in fact realize further haircuts.  Once the extent of risk is understood, the potential negative outcomes become much more manageable.  You might hear talking heads on the news reference the ECB’s capacity to “firewall Greece” and what they are referring to are policy measures taking since Greece first arose as an issue to prevent contagion from spreading beyond Greece’s borders. It remains to be seen whether all of this will “work” in preventing any rippling negativity, but it does help take many of the worst case scenarios off the table.

Second: developed world economies are in far better shape today than when Greece first stoked global fears.  Most significantly, the USA is in as good an economic position as it has been in years.  While this does not mean economic momentum is immune from getting derailed, it does mean that the economy is more resilient to exogenous shocks.  In our 2014 Outlook we made the following point that remains as strong today as it did then:

As of today, the economy is moving faster and in the continued process of acceleration. As we know from Newton’s Second Law of Motion, the greater the mass, the greater the force needed to change its direction.  When an economy the size of the U.S. is accelerating to the upside, it would take an extremely massive force to first, derail its momentum and second, change its course 180 degrees.  While such a force is not an impossibility, it is extremely unlikely in the coming months.

The acceleration in the economy has not stopped. It surely will at some point, though momentum will persist beyond the end of the acceleration.  Can Greece be the kind of “massive force” which can derail the economy?  Not in and of itself.  It would take far greater vulnerabilities and we just do not see that on the horizon today. One related point worth emphasizing: the “event” which people often attribute as the cause of harm (for example, Lehman Brothers’ collapse) is far more often a symptom than a cause of much deeper problems.  It is no different with Greece.  There are some potential deeper vulnerabilities in Europe, but not for the US economy and the firewall constructed over these past five years designed to maintain contagion is far more robust now than it ever has been.

Driving Profitability at Auto Dealers:

We got interested in the auto dealers during the sector as the economy accelerates and consumer confidence expands alongside it. Formerly, dealers made much more of their bottom line on the hair-thin margins they earned on actual auto sales. As such, these were not necessarily outstanding businesses. Several things have changed over time. First, dealers have consolidated steadily over the past two decades as small family businesses cashed out to better capitalized public players. Second, cars became increasingly complex where less of the parts and service (P&S) work could be done economically at local repair shops. This has started a trend whereby dealers are doing increasing amounts of the high margin work, cultivating long-term relationships with their customers. While P&S accounts for a mid-teens percentage of the revenue at the publicly traded dealers, it generates over half the bottom line private. This is what really intrigued us.

Since the past five years saw sluggish car sales, dealer parts and service income was even understated compared to the potential revenue generation once five year sales trends normalize and move upward. We are now near that positive inflection point. The particular dealer we find most interesting is Sonic Automotive (NYSE: SAH) and this is the one purchase we made over the past quarter. SAH has the highest concentration of luxury—a sub-sector where P&S spend is especially high—and its dealerships are primarily in the rapidly growing Sunbelt states. With its luxury and geographic footprint,

SAH has historically traded at a premium valuation to the sector, yet today it trades at a discount. This is a closely held company with the founding family and one outside investor (Paul Rusnak) collectively owning over half the stock. Rusnak built his own wealth through a network of privately held dealers and bought into Sonic during the crisis. Collectively, ownership and management have an outstanding track record, but investors today are concerned with two big undertakings at the company: 1) SAH is investing heavily in the technological infrastructure to simplify pricing via the One Sonic, One Experience platform; and, 2) SAH is building EchoPark, a used car dealership platform using simplified pricing and a hub-and-spoke model to cover each target region. These two initiatives have dampened profitability, though the company continues to earn copious amounts of cash and the P/E multiple has more than fully priced in these concerns.

Rather than fearing these initiatives like much of Wall Street does, we love them! Tom Russo introduced the idea of owning companies with “the capacity to suffer.”[3] By that he means companies with a stable ownership structure and the ability to make decisions based on the very long-term interests in mind rather than the need to meet analysts’ quarterly expectations. This is exactly what SAH is doing here. In introducing a simplified pricing structure, removing the annoying hassling that many associate with car dealers they are taking a business risk that sure has quarterly earnings weakening in the short-run, but also introducing the potential for significant long-term benefits. Sonic should be able to take share from their competitors, because after all, no one likes the negotiation process inherent to buy a car.

As for EchoPark, SAH is launching an initiative to compete with CarMax (NYSE: KMX). It’s hard to say anything negative about KMX from an investor’s perspective, but it is also clear from a consumer perspective that more competition on both the buy and sell side in the used car market would be a positive. This is what happens when a company creates too good a profit opportunity for itself, as KMX has done. SAH is perfectly positioned to compete here given its large geographical reach, access to used cars from its dealer network, and investments in price discovery and transparency.

It will take some time to see the results from these new initiatives, but we see the worst case scenario being the company stops them, leaving us with the cheapest, but highest quality car dealer. If these initiatives succeed, then not only do we have the cheapest car dealer in our portfolio, but we’d also have the fastest growing one. In either case, Sonic deserves a higher multiple moving forward.

What do we own?

The Leaders:

Groupe SEB (EPA: SK) +26.8%

IMAX Corporation (NYSE: IMAX) +19.46%

ING Groep (NYSE: ING) +14.42%

The Laggards:

Johnson Outdoors Inc. (NASDAQ: JOUT) -28.72%

Corning Inc. (NYSE: GLW) -12.51%

Fiat Chrysler Automobiles (NYSE: FCAU) -10.91%

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

Warm personal regards,

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

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

[1] https://www.youtube.com/watch?v=IJae0zw0iyU&feature=iv&src_vid=Wpx5gBvHNGk&annotation_id=annotation_271975
[2] http://www.rgaia.com/value_opportunities_in_energy/
[3] http://www8.gsb.columbia.edu/rtfiles/Heilbrunn/17d1d82c-3701-0000-0080-9870cef8a602.pdf

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

eBay PayPal Split Analysis: Buy Two Moats for the Price of One

Elliot Turner was honored to present at the 2015 Value Conferences Wide Moat Investing Summit. He presented IMAX at the inaugural event two years ago. At this third annual event, recognized value-investors presented some of their best investment ideas. Elliot presented on eBay and the spin-off of PayPal. We are excited to share his slides here:

May 2015 Investment Commentary: Driving Towards Greater Returns

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

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

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

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

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

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

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

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

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

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

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

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

Warm personal regards,

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

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

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

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

April 2015 Investment Commentary: ETF Fund Flows

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

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

“More Buyers than Sellers” – or not.

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

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

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

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

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

The QQQs:

qqq

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

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

QQQ PLUS

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

The IBB:

IBB

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

The USO:

USO

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

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

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

Warm personal regards,

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

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

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

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

March 2015 Investment Commentary: Negative Feedback Loops

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What do we own?

The Leaders:[6]

Fiat Chrysler Automobiles (NYSE: FCAU) +40.9%

Fanuc Corp (OTC: FANUY) +32.8%

Howard Hughes Corp (NYSE: HHC) +31.6%

The Laggards:

America Movil (NYSE: AMX) -7.8%

Groupe SEB (OTC: SEBYF) -3.0%

Siemens AG (OTC: SIEGY) -1.0%

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

Warm personal regards,

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

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

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

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

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

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

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

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

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

Investment Strategy Overview

Please click here to view the RGA Investment Advisors LLC Ashland Firm-wide Verification Letter

Please click here to view the RGA Investment Advisors LLC Core Value Composite Annual Disclosure Presentation

Please feel free to download our Investment Strategy Overview here

Investment Overview:

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

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

Investment Objective:

The following represent our core investment objectives:

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

Markets as Complex Adaptive Systems:

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

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

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

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

Investment as an Actively Passive Endeavor:

What is Active Management?

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

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

Consequences of High Turnover:

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

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

Randomness vs. Investing:

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

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

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

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

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

Idea Generation:

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

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

Valuation analysis:

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

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

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

Our Checklist:

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

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

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

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

Portfolio Construction:

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

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

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

Risk Taking

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

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

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

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

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

Risk Management:

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

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

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

Always move forward:

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

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

Disclosures:

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

 

February 2015 Investment Commentary: Long Term Investing

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

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

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

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

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

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

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

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

Warm personal regards,

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

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

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

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

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

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

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

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