Category Archives: 2015

February 2015 Investment Commentary: Long Term Investing

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

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

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

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

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

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

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

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

Warm personal regards,

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

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

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

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

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

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

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

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

January 2015 Investment Commentary: Pursuing the Energy Sector for Value Opportunities

The month of January saw a continuation of 2014 year-end market trends. Crude oil continued its decline, shedding another 12.5%. Energy-induced volatility helped drag down the equity indices, with the S&P dropping 3.0% and the Russell 2000 losing 3.3%. The 10-Year Treasury started the month yielding 2.17% and ended at 1.68%. Between the fall in the 10-Year Treasury yield and the fall in the S&P 500, last month marked a notable stock market occurrence. January 2015 will go down in the history books as just the fourth time since 1960 that the yield on the S&P 500 exceeded that of the 10 year Treasury.[1]

This is unquestionably a notable moment for the market. Context is particularly important. To that end, let’s examine the historical ratio of the 10-Year Treasury yield to the S&P 500’s dividend yield:

Screen Shot 2015-02-06 at 3.09.06 PM

                     (Source: Bloomberg)

Note that for most of the period between 1980 and 2007 the 10 year Treasury yield was between 2.0 times and 2.9 times that of the S&P 500. Many view this as a perversion, or distortion imposed on markets by the Federal Reserve Bank’s low interest rate policy. That may be a worthwhile debate for policy analysts to have (we think concerns about low rates are misguided, but that has been a longer conversation that we will leave out of this particular commentary), but as asset managers we must deal with the world in front of us irrespective of whether we think it is justified or not. Lower interest rates have a huge effect on companies. Too many express their disdain for lower rates alongside the boost they give to valuations without considering the micro consequences.

It is thus worth examining stock market performance after past incidence of this same yield crossover, as Bespoke Investment Group recently did:

Screen Shot 2015-02-06 at 3.09.19 PM

                   [2]

Note that each time the yield of the S&P 500 exceeded that of the 10-Year Treasury, the S&P has rallied strongly over most timeframes. A sample size of three is certainly not a robust data set; however, it is worthwhile to think about why this situation has been good for stocks in the past. A huge pool of global assets is managed with a pre-defined split between stocks and bonds that is rebalanced when allocations veer too far in either direction. As Treasury yields make a big move lower, the principal value rises. When this happens alongside a sideways or down stock market, there is a powerful bid in stocks from the reallocation. Further, consider the decision certain allocators who may not have pre-defined stock/bond splits but do have annual income targets face (an endowment fund might be an example of this). When the yield on the S&P is greater than that of longer-dated Treasuries, one can make more progress on your income goals, while adding potential capital appreciation to the portfolio in the stock market. As shown above, this opportunity does not present itself very often. The risk side of the coin is that such a fund may have more volatility in its value; however, a long timeframe mitigates that problem to an extent. None of these situations are clear-cut. Certainly many active allocators faced with such a dilemma make differing choices based on their own institutional constraints, but this effect is unquestionably a stimulus to stocks.

In a blog post last year written by Elliot Turner and David Doran, they explain this effect:

One must be a realist and look at the actual, factual influence that interest rates play in the cost of capital for a company. Low interest rates, as is evidenced in various arena, allow borrowers to tap into capital at a lower cost. Rates at some point will eventually rise and raise the cost of capital. However, given the length of time of low interest companies had ample time to finance themselves cheaply and lock in rates for the long-term. The early years in a rising rate regime will be somewhat mitigated by companies already having secured low rate financing….

Complain all you would like about interest rates being “artificially” low, but the reality of the situations is clear. So long as companies can and do tap into lower cost sources of capital, then the returns available to those companies will rise accordingly. We will let academics handle the debate about how and why interest rates are so low and instead we will focus on business analysis and looking at the ways in which low interest rates tangibly alter the math in valuing companies.[3]

What’s New?

In our 2015 Investment Outlook, we explained that we will no longer write out our leaders and laggards on a quarterly basis.[4] We asked for suggestions of better ways to incorporate an overview of the companies in our portfolio and particularly liked one suggestion we received from a client to briefly review new positions as we initiate them in portfolios.

Howard Hughes Corp (NYSE: HHC)

In perusing the energy sector for value opportunities, we asked ourselves “what are some companies or sectors that have been unjustifiably punished alongside the carnage in oil?” The answer had us exploring several alternative energy companies, a few banks, and one real estate company that looked particularly attractive: Howard Hughes Corp (NYSE: HHC).

Howard Hughes came into being as a carve out from General Growth Properties’ bankruptcy reorganization. The founder and Chairman is Bill Ackman, one of the best hedge fund managers today. Ackman and insiders own about 13% of the company, with Horizon Kinetics owning 13% awe well. In other words, there is a stable, long-term oriented investor base.

HHC owns several unique properties that are undergoing transformations right now, making it very challenging to model exactly what their future income stream will look like. Regardless of the exact path, we do know there is immense value. Overall, the risk long-term is fairly low, though when and how the upside materializes is challenging to say with precision., This is a company that cuts at the distinction between risk and uncertainty, where risk is defined as situations in which we know what the distribution of potential losses looks like, while uncertainty is when we do not know what the distributions look like. We like low risk, high uncertainty situations where it’s clear there will be value, but unclear exactly how much.

The properties, in order of their potential value that attract us to this situation are: the South Street Seaport in Manhattan, the Woodlands in Houston Texas and the Ward Center in Hawaii (which the company describes as their “crown jewel.” In addition, HHC owns a slew of other properties, including a valuable Master Planned Community in Howard County, Maryland and major tourist attractions like the Riverwalk in New Orleans. The South Street Seaport is undergoing extensive renovations and will be re-leased to premium shops starting in late 2016, early 2017. It is conceivable that five years down the line, the Seaport alone, with its potential 600 square feet of leasable space ends up worth more than the entire market cap of the company today.

The Woodlands in Houston is one of the finest Master Planned Communities in the country, yet, this property is specifically why the stock has been so hard hit of late. The company’s own build-up of net asset value and analyst estimates put a value on The Woodlands at near one-fourth of HHC’s total asset value. Houston is associated with the energy boom and people fear there will be further pain for energy companies. Mr. Market has essentially written off the value of the Woodlands. While we do think energy companies are in for a tough go, it is important to think about who HHC’s tenants will be. Exxon’s new 10,000 acre campus is starting to open and will be fully operational next year. They are pre-committed to a lease that will generate $15m in annual net operating income for HHC. Exxon’s credit, despite the energy woes, is as good as they come. Some neighboring residential properties may be at risk of lower realizable values, but the market has simply moved too aggressively in discounting HHC’s “energy exposure.” All in all, we think the energy-related risk is largely overstated, and the elite properties the company owns in Houston will yield considerable growth down the line.

The Ward Center in Hawaii already generates over $25m in annual net operating income. More interestingly HHC is building residential developments that have pre-commitments of purchase for 75% of the units. Deposits already in (which are counted as liabilities today, but will shift over to revenue once done) are over $100 million, with purchase commitments of over $700 million. There will also be additional commercial space available for lease.

As of today, HHC is not organized as a REIT. This is so because the company is using its income in order to invest in these transformational properties. This is a shrewd move, as it affords maximum flexibility to take advantage of the over $300m in net operating losses received in the carve-out from GGP. Once the transformations are done and the NOLs are used, the company then can convert into a REIT, which will greatly lower their cost of capital and turn HHC into an excellent yield vehicle to own. As we have done with several investments, we like to look at the out-year earnings and yield potential and see a huge opportunity for time arbitrage.

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

Warm personal regards,

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

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

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

[1] http://www.marketwatch.com/story/stock-dividend-yields-are-above-treasury-yields—-and-thats-bullish-2015-01-20

[2] http://www.raymondjames.com/images/inv_strat/150120_5lg.gif

[3] http://compoundingmyinterests.com/compounding-the-blog/2014/2/27/the-markets-betting-line-a-look-at-implied-growth-1.html

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