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August 2012 Commentary: Politics Are Short-Term, Focus Long-Term

August 2012 Commentary
Politics Are Short-Term, Focus Long-Term

August closed with equity markets spending 18 days in a tight consolidation—the S&P 500 spent most of those days with prices holding in a 1.5% range. For the month, the S&P added 2.5%, the Dow Jones Industrial Average tacked on 0.92% and the Russell 2000 climbed 3.5%. Notably, August saw substantially less volatility across global equity markets compared to the May through July period.

In both February and April of this year, we focused on the need for “digestion” after making large, volatile market moves. Once again, we believe this to be the prevailing near-term theme. What should now become immediately clear is after volatile periods, we tend to have periods of minimal volatility. We in the investment management business like to anthropomorphize markets, and this is true because markets often do have human-like characteristics.

People work exceptionally hard throughout the year, yet come August, we see many individuals take much-needed vacation time. It is during these down times that we set the stage for our next period of activity. Equity markets began this August with a continuation of the action that began in June—mainly a bounce-back rally from May’s decline—and ended with one of the longest streaks of apathy we have seen since the dawn of the Great Recession.

Along with digestion, there is one tangential and new theme we would like to highlight: lumpiness. Markets expend considerable energy in bursts around these periods of digestion. Not only do markets do this, but so too do stocks. Returns tend to occur in a very non-linear fashion over the short-to-mid-term time period. This sits in contrast to the many planners who draw hypothetical return scenarios which move neatly from the bottom left of a chart to the top right. The typical path moves in fits and starts, often for long stretches without any visible trend, before a powerful spurt moves the needle. The same came be said for the actual fundamental growth (or contraction) in the underlying earnings of equities.

This is a fact lost on many participants in, and observers of the financial industry. And it’s ever more true at the shorter time-frames. One of the foremost reasons we prefer long-term investment to short-term is that we can smooth out this lumpiness and mitigate what is referred to as “noise.” Operating over the long-term affords us the opportunity to focus on what we perceive to be only the most consequential of signals. It also allows us to focus more specifically on the trend of earnings in our core holdings, rather than monthly economic data, which correlates to intraday returns, but not long-term growth.
This highlights a key failing in the financial presses today. The pundits focus far more on heat maps and headlines than they do long-term trends, and strengths and weaknesses of actual businesses. In fact, there is very little focus on real businesses themselves, and even less a focus on the longer-term time-frames. This is one of the many reasons we prefer to focus on company-specific factors rather than broader economic ones. Note that this does not mean we forsake broader economic factors that drive our companies’ bottom lines. Instead it means we don’t make portfolio decisions based on guessing the direction of the economy, if/when there will be Federal Reserve Action, and we certainly do not hold positions solely on the basis of their placement in the broader economy.

Beware of the Macro Tourist and the Veiled Political Pundit:

There is a new phrase being slung around, and we couldn’t be happier to see it called out for what it is: macro tourism. Macro tourism is a term geared towards those investors who built long-term track records on the backs of prudent company-specific financial analysis, or arbitrage strategies, who now focus much attention (and risk capital) on broader economy-based trades. This macro tourism is both a cause and an effect of heightened market volatility and it poses significant dangers to investors. Economics is far more complex than the financial presses highlight and involve considerably deeper levels of understanding beyond purely the numerical analysis.

There are behavioral and social forces, and political processes which cannot be factorized by models like company-specific drivers are. Perhaps one of the largest causes of macro tourism today is the presence of a hotly contested political environment. Intense partisanship drives the desire to impose political beliefs on market facts. Which brings us to another point about both the state of the financial presses and investments today: beware of those with strong political opinions cited as the basis for an investment approach today. There are many examples of people attempting to pass political opinion for investment advice, and in this context it’s often hard to distinguish opinion from fact. We see this from those urging the indiscriminate selling of equities in order to avoid “imminently rising capital gains taxes” to those constantly harping about the “fiscal cliff.” It is no surprise that the rise of the political cooing happens as campaign season heats up, but it is frightening how little these harsh-sounding gripes truly dig into the economic realities of the situation.

Pursuing Long-term Value:

In times like these, with a heightened focus on the macro, we look for something specific and important in our portfolio companies. Our ideal company is one that we can buy today for its present earnings power value, with all the growth as a “free” option on top. There are a few terms here that require further definition. A company’s earnings power is the valuation of that business’ sustainable level of income. While sustainable income is typically a subjective metric, we have a great objective quantity to use in order to ascertain a worst-case-scenario income target—that objective numbers comes in the form of the Great Recession. As we all know, during this time period, company earnings were suppressed as the global economy went into tailspin-mode. The trough in earnings was the most severe since the Great Depression. We can use these numbers, with a look at five-year average earnings in order to confidently surmise a sustainable earnings power number.

Once we can comfortably quantify our sustainable earnings power value, we want to target the company’s stock at or near that price level, but preferably at a discount. When we buy a company at its earnings power value, we want to make sure that the company not only has been growing through the past, but has a reasonably high likelihood of continued growth. This insures that we will own at worst, a fairly valued company whose cash flow yield will justify its present valuation in order to generate a decent return for shareholders. Plus it leaves open the growth element to add incrementally on top of the bottom-line return.

A simpler way of stating this is we like to buy growing companies who are fairly valued based on today’s earnings and zero future growth. The reason we took the time to elaborate is that it’s an opportunity to provide a little more insight into how we think about investment situations, and to demonstrate that we approach this analysis as conservatively as possible in order to protect our downside, and put ourselves in position considerable upside. When things are bad, companies tend to be valued on their worst case scenario—typically the earnings power value sans growth for a “growth” company. Companies that are fairly valued based on their sustained earnings tend to have rapid revaluations when growth opportunities are reincorporated into a stock’s price.
And that takes us back our point about lumpiness from earlier in this letter. We aim to expose ourselves to one particular kind of lumpiness and that is the fairly valued business, priced for no growth, which gets “repriced” to once again reflect its growth prospects. When we see such companies, the change in price happens exceptionally fast and need not require a commensurate market move. It takes much patience waiting for the fairly valued business to work out the issues of perception that lead to an attractive valuation, but over long stretches of time it is an effective investment strategy through which to mitigate risk and gain exposure to superior returns.

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF
Managing Director

Elliot Turner, Esq.
Managing Director

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 2012 Commentary: Bulls and Bears

The Month of July

The month of July saw the Bulls and Bears engaged in a brutal bout of tug-of-war on two crucial battlegrounds: the global macroeconomic and the US earnings landscapes. Each battleground saw neither side gain a crucial edge, although we believe there was a crucial qualifier that deserves attention. From April to May, expectations amongst analysts and investors alike took a beating. The prophets of doom and gloom (like Nouriel Roubini) once again plugged their microphones into the mainstream presses, leading to financial commentary with a decisively negative tone around the globe.

As of the end of July, according to a survey by analysts at Bank of America Merrill Lynch, strategists held the most decisively negative tone on equities in their recorded history, which goes back to 1985. This includes events like the 1987 Crash, the Savings and Loan Crisis, the Gulf War, the bubble and bust, the Great Recession and the Flash Crash. Never has it been more negative than today, and that is something that we view as highly constructive.

There is a reason why we view such gloomy predictions through a contrarian lens: first off, contrarianism is well documented to work in capital markets over time, second, and perhaps most importantly is the role of markets generally speaking. Markets are a discounting mechanism. They are supposed to discount the known, and herein lies the essence of the efficient market theory (please note: we are not subscribers to the EMH, but we do acknowledge some of its merits). When all information is known and available, markets price things relatively fairly compared to their value (this statement cuts at the distinction between price and value, a very important distinction which we will elaborate on over time).

Whenever something is well known by market participants, understood, and foreseen, it will not move a market. For this reason, we have sayings like “it’s priced in” and happenings like “buy the rumor, sell the news.” What moves markets then? Well, it’s the unknown, it’s the unforeseen. This is precisely why today the doom and gloom is inescapable, whereas in 2007 economic pundits were slinging around terms like “the goldilocks economy?” In 2007, no one knew what was about to hit them. Today there are thousands of pontificators with well-articulated negatives.

Again, we reiterate that this is not to say that all is well in the global economy and that stocks can only go up. Rather, we are merely pointing out that known negatives are not the problem, it is the unknown negatives that keep us awake at night. Moreover, when expectations skew so strongly in one direction (i.e. the negative), it is only natural that the next surprising moment will swing the pendulum in the opposite direction of what the crowd expects. This is how it almost always works. Surprises, by and large, run counter to the general tone.

The Tug-of-War:

Let’s turn our attention on the battlefields of July. On the global macro front, we had one of the worst months on record of economic activity throughout much of Europe, including England, and persistent weakness in Asia, albeit with signs of improvement. Further, we had the U.S. economy itself show continued signs of deceleration, driven primarily by events from abroad. What does this all mean? Well things are about as bad as they can be on a global level. It’s as simple as that. And typically when things deteriorate like this globally, we get coordinated action from both governments and central banks. The problem at this juncture is that the Europeans are incapable of navigating through what we continue to describe as a Constitutional crisis.

The entire continent is handicapped by the fact that the bodies, which should have the capacity to counteract the pervasive weakness, simply don’t have the necessary authority to take action. Towards the end of the month, 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.” One can simply deduce that with the capacity for action to back up his words, Draghi could reverse a serious coefficient of the problem that is plaguing Europe right now. Herein lies the predicament of the asset allocator: how much faith should be instilled in the European leaders to do the right thing at the end of the day? There are countless competing constituencies in Europe, and while U.S. politics are messy with just two competing parties, imagine a continent of competing countries with their own chaotically messy competing parties.

How does it ever end? We think the end looks a bit like the month of July. We are most likely not quite there yet in Europe, but what’s happening takes us substantially closer to the end game—cementing the “irreversibility of the Euro,” to borrow a phrase from Draghi. The end, in our opinion, involves the core countries (those that are relatively ok economically and low cost of government borrowing) joining in on the pain and this is happening on several levels. First, with the decline in the price of the Euro, the core countries are losing much of their purchasing power. Second, and most importantly, with the continued collapse of the periphery in Europe, the core countries are losing one of their primary sources of demand, thus driving the strongest economies into the ground with the bad. Once the strongest economies experience this pain, they realize precisely what is at stake, and are induced towards action. Inaction thus will be broken.

Looping into Earnings

This negative feedback loop rippling through the Eurozone has made its way to the US through two global channels. First is the obvious: Europeans do buy plenty of goods and services from the U.S. and there is a notable drag on earnings here both from the lack of demand, and from the falling value of the Euro. As the Euro moves lower, the value of U.S. exports declines apace, and this was one of the more cited reasons amongst U.S. companies for lackluster revenue growth.
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.

Meanwhile, earnings out of the domestic markets for US based companies remain fairly good. As we have been hammering home lately, the housing market has registered notable improvements in recent months, and this has a serious multiplier through the economy. Indicators ranging from home prices, to rail traffic paint a far more optimistic view of the U.S., and were it not for the global woes, earnings would look quite good hear. While the global woes are inescapable right now, such a drastic fall-off in economic activity leads to growing pent up demand for when activity reaches the right side of a trough. In the meantime, multinational firms have lagged the market immensely, but when pent up demand inevitably returns, there will be a slingshot effect that drives global earnings for U.S. multinational back upward.

Early in the recovery, U.S. manufacturing roared ahead, actually surpassing the pre-Great Recession peak, and emerging markets grew at a rapid pace, while housing continued to drag. Today that scenario is reversed, with housing starting to recover, while manufacturing and emerging markets cool off. Perhaps for once in this recovery from the Great Recession we can get all economic engines pointing in the same direction.

Warm personal regards,

Jason Gilbert, CPA/PFS, CFF
Managing Director

Elliot Turner, Esq.
Managing Director