Category Archives: 2013

December 2013 Investment Commentary: Our 2014 Investment Outlook

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

A Look Backwards:

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

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

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

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

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

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

The Credit Environment:

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

Credit image 1

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

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

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

GDP image 2

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

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

 Normal image 3

Fiscal Headwinds No More:

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

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

 S&L image 4

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

 fed image 5

Employment is the Key and it is Improving:

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

 MA image 6

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

House image 7

What do we own?

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

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

The Leaders:

Exor SpA (BIT: EXO) +88.43%

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

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

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

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

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

The Laggards:

America Movil (NYSE: AMX) +7.2%

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

Teva Pharmaceutical Industries (NYSE: TEVA) +7.74%

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

Cisco Systems (NYSE: CSCO) +15.32%

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

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

Thank you for your trust and confidence, and for selecting us to be your advisor of choice.   We wish you and your families a healthy, happy, and prosperous 2014.  Please call us directly to discuss this commentary in more detail – we are always happy to address any specific questions you may have.  You can reach Jason or Elliot directly at 516-665-7800.  Alternatively, we’ve included our direct dial numbers with our names, below.

Warm personal regards,

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

Elliot Turner, Esq.
Managing Director
O:(516) 665-7800
M: (516) 729-5174



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



November 2013 Investment Commentary: “Tapering”

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

The Market Skeptics Versus the Fed

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

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

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

The Pen (or Microphone) IS Mightier than the Sword

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

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

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

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


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

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


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

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

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

Moving Forward

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

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

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

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

Warm personal regards,

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

Elliot Turner, Esq.
Managing Director
O:(516) 665-7800
M: (516) 729-5174

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

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

What is Active Management?

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

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

Consequences of High Turnover:

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

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

Randomness vs. Investing:

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

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

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

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

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

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

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

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

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

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

Warm personal regards,

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

Elliot Turner, Esq.
Managing Director
O:(516) 665-7800
M: (516) 729-5174

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

October 4, 2013

Beware of Mistaking a Symptom for the Cause

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

Reflections on 5 Years Past

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

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

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

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

sectoral leverage

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

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

Lessons learned for investors

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

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

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

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

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

Where we stand in the Long Run

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

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

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

Getting Micro

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

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

Not every

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

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

What do we own?

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

The Leaders:

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

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

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

ING Groep (NYSE: ING) +24.86%

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

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

Siemens AG (NYSE: SI) +21.92%

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

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

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

The Laggards:

Cree Inc. (NASDAQ: CREE) -5.70%

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

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

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

Teva Pharmaceutical Industries (NASDAQ: TEVA) -3.62%

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

The company’s shares continue to suffer under the pressure of replacing its lead product—Copaxone—once its patent expires. We think the market is overly punitive in its estimation of the loss of earnings from Copaxone. Moreover, Teva remains the largest global manufacturer of generic products, and in the hands of new CEO Dr. Jeremy Levin, we think the possibilities for improved results are tremendous. Dr. Levin is one of pharma’s premier capital allocators and is one of the key reasons why his former companies, Novartis and Bristol-Myers Squibb find themselves better positioned than other large-cap pharmaceuticals in the face of the dreaded “patent cliff.” Dr. Levin’s experience as a doctor, a business-model innovator in pipeline development and as a private equity-based biotech investor make him the perfect guide for Teva’s transition from a growth company to a value-based steward of shareholder capital.
Thank you for your trust and confidence, and for selecting us to be your advisor of choice. Please call us directly to discuss this commentary in more detail. You can reach Jason or Elliot directly at 516-665-7800. Alternatively, we’ve included our direct dial numbers with our names, below.
Warm personal regards,

Jason Gilbert, CPA/PFS, CFF
Managing Director
M: (917) 536-3066

Elliot Turner, Esq.
Managing Director
M: (516) 729-5174

August 2013 Investment Commentary: Tesla Motors

September 10, 2013

Tesla Motors: A Disruptive Company but Speculative Investment

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

Disrupting Disruptive Innovation

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

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

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

Drivers of Value

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

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

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

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

Lumps along the way

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

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

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

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

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF
Managing Director
M: (917) 536-3066

Elliot Turner, Esq.
Managing Director
M: (516) 729-5174



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

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

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

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

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

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

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

July Commentary Chart

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

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

Feedback Loops:

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

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

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

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

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

A Global Portfolio

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

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

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

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF
Managing Director
M: (917) 536-3066

Elliot Turner, Esq.
Managing Director
M: (516) 729-5174

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


June 2013 Investment Commentary

The positive momentum for the stock market carried through from the first quarter to the second.  The S&P 500 led the way with a 4.3% gain on the quarter, the Dow Jones Industrial Average added 4.0%, and the Russell 2000 tacked on 3.6%.  As we discussed in our May commentary (, the most notable move during the quarter was in the bond markets, with rates rising rather quickly.  While this move is substantial compared to where rates have been, some historical context is necessary—in the grand scheme of things, this rise in interest rates is fairly small.  This chart clearly shows just how small:June 2013 Investment Commentary

Despite the bigger picture context, the move was large enough in scale to seriously disrupt certain classes of our capital markets.  Over the past few years of zero interest rate policy (ZIRP) and quantitative easing (QE), investors sought relative yields in areas not traditionally associated with income.  Dividend yielding stocks are one area where this phenomenon was particularly stark, and during the second quarter, higher yielding stocks lagged the indices by a wide margin.

Moreover, investors chased yield with increasing leverage in order to earn returns previously associated with a “normal” environment.  A recent favorite has been the “Risk Parity” strategy, which levers each asset class in order to obtain an investor’s targeted return in each respective market. For example, an investor who targets equity like returns (let’s say 7% annualized) in a Risk Parity fund would lever up the 1.81% yields on the 10 year Treasury at the start of this quarter in order to capture the 7% target.  With rates so low, leverage in these strategies increased apace.  When the pendulum flipped from falling to rising rates, this leverage compounded the losses experienced in bonds.  As a result, this category of funds was amongst the hardest hit, though it should be noted that not all Risk Parity funds are created equal, and some are in far better position to weather the storm than others (for those in the know, the “pun” on weather was indeed intended).

Meanwhile, the Municipal Bond (“muni”) market was one segment of the yield universe that experienced the worst pain.  This was largely due to structural reasons, as the muni space has longer durations (in other words, there are greater price sensitivities to changes in interest rates), and less liquidity.  The lesser liquidity is due to the Federal tax-free status of these bonds and its correspondingly limited pool of potential investors.  We used this mini-panic as an opportunity to buy a closed-end fund of municipal bonds at a 10% discount to its net asset value (NAV), locking in a 6.1% cash yield, or a 9.4% tax-equivalent yield.  As bonds within this fund pay coupons and/or mature, the fund will reinvest incoming cash flows at higher yields moving forward.  This should inevitably lead to even better yields in the coming months.  While there is room for rates to rise further (and principal values to fall), we think the disconnect in municipal bonds went far beyond the rate of change in the underlying fundamentals, creating an opportunity for a more favorable yield investment in what remains today’s ZIRP environment.

Since we are at the mid-point of this year, this is a great opportunity to briefly revisit our outlook for 2013[1].  There is one glaring weakness in our outlook: the technology sector remains sluggish year-to-date compared to the broader market, despite our belief that its performance would catch up.  Yet, this weakness has become increasingly illusory as Apple, the largest component of the sector remains in the doldrums. The majority of the sector’s companies are performing at least in line with the broader indices.  Beyond technology, our outlook is playing out within our expectations, including the healing of Europe’s financial markets, improving household balance sheets, resurgence in real estate, and the move towards energy independence.

What do we own:

Now we’ll turn to our second edition of What do we own: the Leaders and the Laggards.   Last quarter we were fortunate enough to have only one laggard down more than 1%.  While we were not as lucky this time around, the strength in our leaders was particularly noteworthy, as two stocks returned more than 50% for our portfolios in the quarter.

The Leaders:

iRobot Corp (NASDAQ: IRBT) +54.99%

This is iRobot’s second consecutive appearance in The Leaders section. While we attributed the first quarter’s strength largely to “regression to the mean following a challenging 2012,” this quarter, the company actually showed very real signs of strength.  iRobot’s rally gained steam in April when the company beat its already raised earnings guidance, while further increasing its full year earnings outlook[2].  Further, the company’s development of a telepresence robot for healthcare applications continued to move forward, and towards the tail end of the quarter, iRobot announced a partnership with Cisco to use a similar technological platform for a telepresence robot in office buildings[3].

Power-One Inc. (NASDAQ: PWER) +52.66%

Last quarter, Power-One appeared in The Laggards section so we were especially pleased to see the it rise to the leaderboard this time.  The stock surged 56% when ABB announced it will buy the company for $6.35 per share[4].  While this deal certainly helped boost the company’s share price, we believe it still deeply undervalues the company’s true fundamental worth.  At the take-over price, 37% of Power-One’s market cap is cash on the balance sheet, and the solar sector appears to be emerging from a severe trough.  During the solar sector’s woes, Power-One was the only solar-related business that did not report substantial losses, while steadily earning positive free cash flow throughout.  The sale to ABB was most likely driven by Silver Lake’s (a private equity company that owned a significant portion of Power-One and held 2 board seats) desire for liquidity on its investment, as much as it was an effort to reverse a sinking stock price. Our best hope for a fairer price at this point is the prospect of another strategic buyer swooping in to offer a higher price.

Fiat SpA (OTC: FIATY) + 32.77%

Fiat is a name many global car aficionados know well.  The historic Italian automaker builds cars under various brand names, including Fiat, Alfa-Romeo and Maserati, and owns substantial stakes in Ferrari and Chrysler. Fiat rose on the back of continued strength in Chrysler (of which it owns 58.5%) and the US auto market, and on a more secure outlook for the company’s financing of its acquisition for the 41.5% of Chrysler it does not already own.   In our outlook for 2013, we talked about the prospects for an improving auto market in the U.S., and this is certainly playing out as hoped.  We think Fiat will continue to benefit from this trend, but also, we think once the overhang of the if/when/how of completing the combination with Chrysler is lifted, there is substantially more upside ahead for this position.  While it’s unclear exactly when Fiat will resolve its dispute with VEBA over what price to pay for the remainder of Chrysler, we think it is an inevitability which likely could happen by the end of calendar 2013.

The Laggards:

Starwood Property Trust (NASDAQ: STWD) -9.11%

Starwood is a commercial real estate (CRE) REIT, which both invests in and originates CRE loans. The management team is led by Barry Sternlicht, the founder of Starwood Hotels (hence the common name), and an immensely capable real estate investment team.  Starwood’s portfolio of loans is full of premium, high quality properties and the company continues to evolve, as evidenced by the recent acquisition of LNR Property[5], a special servicing business from Vornado.  Starwood’s stock turned lower as interest rates started rising.  This is due to real estate’s sensitivity to the level of interest rates.  We think the magnitude of the selloff was unfairly large, and that the recent disruption in markets actually increased the pool of potential investments for Starwood more than it hurt the existing portfolio.

Devon Energy Corp (NYSE: DVN) -7.69%

Devon Energy has been a dog throughout the year.  The company engages in oil and natural gas production in North America and has been hurt by the challenging price environment for natural gas in particular.  During the quarter Devon released what we perceive to be some good news in announcing its intent to form a midstream master-limited partnership[6], though the market greeted the announcement with a snooze.  Further, the company will repatriate $2 billion in overseas cash in order to use this idled capital strategically to invest in increasing production and/or to repurchase its cheap stock[7].  We see the newsflow over the past quarter as largely constructive, and expect a turnaround of the recent woes during the second half of 2013.

IMAX Corp (NYSE: IMAX) -7.00%

It’s surprising to see IMAX on this list considering so many of our small cap companies fared rather well during the quarter.  IMAX suffered a series of negative days after a perceived competitor in RealD announced its own large screen theaters[8].  Investors would be mistake to take this as a real threat to IMAX, for RealD’s theaters are purely about size, not size, quality and immersion, and RealD’s large screens do not offer the integrated approach that IMAX has built with the studios and theater companies alike.  Early in the quarter, we published our detailed investment thesis on IMAX and we would urge all with an interest in this particular holding to read it for more depth on the company[9].  Right now we are in a seasonally strong period for IMAX’s box office take, which just so happens to correspond with the stock’s seasonally weak period.  We expect these near-term fears to subside, and for the company to continue the growth of its theater network into the indefinite future.

Thank you for your trust and confidence, and for selecting us to be your advisor of choice.  Please call us directly to discuss this commentary in more detail.  You can reach Jason or Elliot directly at 516-665-7800.

Warm personal regards,


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.


May 2013 Investment Commentary

Those who simply sold this May to go away missed out on a decently strong month. The strength was most pronounced in the Russell 2000 and the Nasdaq, two indices with broad-based membership known for their leadership status in markets, adding 4.5% and 4.3% respectively. The S&P and Dow trailed, tacking on 2.6% and 2.2% gains respectively.

The most notable move across markets was the rise in yields on the long end of the Treasury curve. The 30-year Treasury yield started the month of May at 3.15% and closed the month at 3.27% (this rise has since continued into June).

April 2013 Investment Commentary: The Market at an All-Time High

Last month, we pointed out the significance of all the major market indices (sans the NASDAQ) surging to record highs. April was an interesting month in a very different way. While the major indices digested their gains, there was absolute carnage in the commodity space. Most notably, gold, the safe-haven of choice for investors over these last few tumultuous years, shed 7.57% on the month. In one day alone, gold lost 9.6% of its value. Many continue to blame the decline in gold on some sinister plot or dismiss it as a warning sign for the broader economy. We think these explanations are far more indicative of the religion around gold as an asset, than it is of something meaningful for the economy; we discussed this in our February 2013 Investment Commentary. To that end, we attribute the decline in gold to two important forces: 1) golds failure as a safe-haven during the worst of the Euro crisis, during which the price actually declined; and, 2) the markets continued resilience at all-time high levels. Today, we would like to focus on this second point and what it means for the broader investment environment.