Mean Reversion Part II

roman-orgy-vasily-alexandrovich-kotarbinsky

Roman Orgy

Last post on Part 1:http://csinvesting.org/?p=10984

Why does high growth seem to depress stock market returns and low growth seem to generate high stock market returns? It is not the growth destroys returns, but that the market already recognizes the high-growth nation’s potential, and bids the price of its equities too high. Market participants become overly optimistic during periods of high growth, driving up the prices of stocks and lowering long-term returns, and become too pessimistic during busts, selling down stocks and creating the conditions for high long-term returns.   Jay Ritter says that irrationality generates volatility “and mean reversion over multi-year horizons.” Graham would agree (p. 88, DEEP VALUE).

The implications for mean reversion in stocks are counter-intuitive. Stocks with big market price gains and historically high rates of earnings growth tend to grow earnings more slowly in the future, and underperform the market. Stocks with big market prices losses and historically declining earnings tend to see their earnings grow faster, and out perform the market. Undervalued stocks with historically declining earnings grow earnings faster than overvalued stocks with rapidly increasing earnings. This is mean reversion, and, as Ben Graham said, it’s the phenonmenon that leads value strategies to beat the market.

The update to Lakonishok’s research Contrarian Investments Extrapolation and Risk demonstrates that, aside from short periods of under-performance, value stocks generate a consistent value premium, and beat both the market and glamour stocks over the long haul. ….Researchers believe the reasons are because they are contrarian to overreaction and naive extrapolation. Efficient market academics Eugene Fama and Ken French, counter that value strategies outperform because they are riskier.  However, Lakonishok found that while value strategies do disproportionately well in good times, its performance in bad times is also impressive.  Value strategies are also outperform during “bad” states for the world such as recession and extreme down markets.

When Lakonishok compared the growth rates implied by the market price to the actual growth rates appearing after the selection date, they found a remarkable result–one that supports Graham’s intuition–value stocks grow fundamentals faster than glamour stocks.  The high prices paid for glamour stocks imply that the market expects them to generate high rates of growth. Contrary to this expectation, however, the growth rates do not persist.  Growth stocks;s growth rates mean-revert from fast growth to slow growth.

SUMMARY

If you read all the links and research papers in the past two posts for this chapter in DEEP VALUE, you know that:

  • Out-of-favor value stocks beat glamour stocks because….
  • the actual growth rates of fundamental sales and earnings of glamour stocks relative to value stocks after selection are much lower than they were in the past, or as the multiples on those stocks indicate the market expects them to be.
  • Value strategies appear to be less risky than glamour strategies.

So why do investors persist in buying glamour? For behavioral reasons like anchoring and “overreaction bias.”   We will next explore chapter 6 in Deep Value.

BAD BUSINESSES

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HAVE A GREAT WEEKEND!

Among Analysts, A Herd Mentality Prevails

Goldman

By Lance Ignon (Investors’ Business Daily, 1998)

Today’s equity analysts are better educated (CFAs, MBAs, CPAs) better informed and command more computer muscle than ever.  What they lack, critics say, is courage.

Instead of leading clients to investment ideas, many analysts follow the crowed, churning out duplicative research reports that become part of a cacophony of timid group-speak.

“Too many analysts think alike; too few are willing to risk being wrong by taking a gusty, controversial stand,” according to a widely circulated report last month from market strategist Byron Wien at Morgan Stanley & Co.

Wien’s sentiments were echoed in interviews with other market strategists, mutual fund managers, research directors and analysts themselves.

Such complaints are not new, but they come at a time when research departments are slowly rebuilding their ranks following layoffs several years ago. These new analysts will be of little use, however, if they fall in with the herd and fail to produce ground-breaking research.

Critics say both analysts themselves and the incentives that drive the brokerage business are to blame for the group-think.

In a job where performance is measured every trading day by eights of a point, many analysts find security in mimicking their peers. If they are wrong, at least they don’t stand out. Yet, analysts’ opinions are most valuable when they are not only correct but also are in the minority.

If you’re always with the consensus, you probably won’t make much money, but you won’t get fired,” Wien said in an interview with Investor’s business Daily.

Stefan D. Abrams, managing director at Trust Co. of the West, argues that brokerage firms put too much emphasis on the morning call, when analysts announce their latest recommendations to their firm‘s brokers.

The practice may generate lots of trading commissions, but it also leads to a confusing fragmentation of information.

“Analysts are basically not doing the job of helping investors develop conviction in the long-term prospects for companies.” Abrams said.

“They’re too preoccupied with the morning call so they can spout some information that may not be that important. It’s a tidbit of information. Analysts are in the tidbit business.”

The very nature of the brokerage business also stunts the effectiveness of research.

CLIENTS’ INTEREST

An analysts’ purpose, after all, is to come up with winning investment ideas that will prompt their institutional clients to trade stocks through their firm’s brokers and generate commissions. But many of these clients are interested only in larger, more liquid stocks, so analysts tend to concentrate on these types of companies.

Often, “an analysts picks up a stock simply to attract trading calls, “ said Jonathan C. Schooler, a mutual fund manager for AIM Advisors Inc. in Houston.

The result is that dozens of analysts end up covering the same behemoth company. For example American Telephone and Telegraph Co. and NationsBank, the most widely covered U.S. companies , are followed by 59 analysts each. According to Nelson Publications Inc.

The 25 most widely watched U.S. companies have an average 52 analysts each.

By virtue of their size and number of shareholders, these companies deserve wide coverage. But each additional research report adds less value if, as is often the case, it resembles the reports it succeeded.

Moreover, this kind of duplicative effort leaves analysts less time to ferret out tomorrow’s AT&T or Microsoft Corp.

Of course, there are analysts who make a point of discovering companies early in their growth cycles and who are not afraid to cut their own path.

Oppenheimer & Co.’s Cecelia Brancato started following Cisco Systems Inc. in the summer of 1990. It has since increased 2,344%.

OTHER SIDE OF THE STREET

Brancato said she knew about Cisco even before its market debut, and recognized the potential for both the company and the entire computer networking industry. This gave her the conviction to ignore the periodic negative rumours that would temporarily weaken the stock.

“Typically, I am on the other side of the Street, whether it be on my opinion or my earnings estimates,” she said. “More often than not.”

ORIGINAL RESEARCH

Wien and others suggest, however, that analysts would build more credibility by conducting original research and developing maverick opinions that help clients make money.

Meantime, many institutional investors will continue to do their own research, they say, because too much of the information from Wall Street is stale.

“I throw those things out,” Art Bonnel (PM of MIM Stock Appreciation Fund) said, referring to most research reports. By the time it gets to me, everyone knows about it.”

—-

Coal Stocks Under Stress
Bus

Coal in a battle of “survival of the fittest,” Citigroup says

May 27 2015, 14:56 ET | By: Carl Surran, SA News Editor
  • A day after Credit Suisse warned that coal miners such as Arch Coal (NYSE:ACI) and Alpha Natural Resources (NYSE:ANR) were in “dire straits,” Citigroup analysts say it will be “survival of the fittest” for the world’s coal miners.
  • While Citi believes current coal prices are below sustainable long-run levels, it does not expect a return to prices anywhere near the levels seen a few years ago; the firm cuts its long-run thermal coal price forecast to $80/ton from $90 and its met coal price forecast to $125/ton from $170.
  • The firm sees China and India as the largest sources of downside risk to its long-run forecasts, particularly for met coal, where China could re-emerge as a net exporter.

The above “research” copy-cats an amazing insight of the obvious as coal company, ACI, declines from $78 to 49 cents:

ACI

 

Ask yourself what was the purpose of stating the obvious after the fact? The analyst should produce original work such as what has the market already discounted today? What about an industry-map showing production costs and sales per ton for each type of coal and where mines are located relative to domestic and export markets?  What are the dynamics affecting the market and what can change?  How much supply needs to be reduced? Who will and won’t benefit from consolidation? Do the companies have different management than the CEO’s and Boards of Directors who took on debt to make acquisitions at the top of the market in 2011? What drove management’s actions.  Can companies work together to merge and rationalize supply and return to profitability.

Reporting the obvious to mimic a competitor seems silly. What do YOU think?

A reader suggests a sub-group (off of the Deep-Value group at Google Groups) be formed to learn and study different concepts. I certainly encourage the idea. Let me know how I can help.

How Crazy is This?

What Chicago’s Fiscal Emergency says about the Quality of Credit Analysis in the Municipal Bond Market

Because it demands large-scale paradigm destruction and major shifts in the problems and techniques of normal science, the emergence of new theories is generally preceded by a period of pronounced professional insecurity. As one might expect, that insecurity is generated by the persistent failure of the puzzles of normal science to come out as they should. Failure of existing rules is the prelude to a search for new ones.

— Thomas Kuhn, The Structure of Scientific Revolutions

On May 12th, Moody’s Investors Service fired the shot heard around the world. The credit rating agency downgraded the City of Chicago and bonds issued by related tax districts to speculative (“junk”) status.

In a sense, Moody’s was only validating the bond market’s opinion of the city’s creditworthiness — the bonds had already been trading at junk levels for several months. This should have been a straightforward event for the chattering class to process intellectually. Rating actions tend to lag the market rather than lead it.

Oddly, however, Moody’s downgrade sparked a debate over whether Moody’s was being “fair” to Chicago. And with Chicago attempting to convert a portion of its variable rate debt to a fixed rate tomorrow, this debate has received considerable amounts of publicity. How could Moody’s cut the city to junk when the other rating agencies rate the city so much higher? (That has obviously never happened before in an era of ratings shopping and superdowngrades.) Wouldn’t having a diverse economy and large tax base cancel out the costs associated with machine politics? (It’s not like this is Chicago’s third fiscal crisis in the past century.)

This was probably the first instance in the history of the capital markets that a rating agency was accused of having too radical an attitude toward risk. How did we get here, folks?

A period of pronounced professional insecurity

Since the financial crisis, municipal bond market participants have been particularly defensive about the level of credit risk in the market as a whole. Commentary on any financially challenged issuer is reliably qualified with “the municipal market defies generalizations,” “these issuers are outliers,” or “remember that, historically, municipal defaults are small relative to corporate bonds.” But the parade of apologies for an issuer with Chicago’s level of financial dysfunction should signal that things have gone too far.

These observations began as a legitimate response to Meredith Whitney’s extremism. Whitney was never going to be correct — the amount of local defaults she predicted exceeded the amount of local government debt outstanding. It was mathematically impossible. It is still mathematically impossible. The financial media that turned her claims into clickbait have moved on to sensationalizing other sectors.

Five years later, however, many municipal market participants remain locked in an unproductive dialogue with an irrelevant personality. Consequently, they are now blind to the fact that what they are saying is no longer true. The market has more financially challenged issuers than can be counted on one hand. These governments are not outliers. They are a class, with similar characteristics and a universe of risks that differentiate them from other borrowers. And they are not small borrowers. It is a more meaningful trend that bondholders are receiving pennies on the dollar in court than it is that defaults remain rare.

There is a conversation to be had about how politics influences the perception of financial commitments and whether bond structures can further evolve to protect bondholders. If the general obligation pledge — absent a statutory lien, which few states have — lacks teeth in court, why isn’t it obsolete? Why is this bond structure still the foundation for credit analysis? Does the general obligation pledge allow governments to over-commit themselves financially in certain political contexts? I would submit to you that this is absolutely the case with Chicago.

None of these issues will be substantively explored so long as market participants remain in “move along, nothing to see here” mode. These are the first fiscal crises where pensions have been a factor at all. In previous fiscal crises, capital markets creditors had the luxury of control. That is no longer a given.

So municipal credit analysis has a lot of growing up to do. Essentially half the market was insured several years ago. As Kuhn noted regarding paradigm shifts in science, there will probably be “a period of pronounced professional insecurity” in the municipal market until new approaches emerge. Until then, there will be a lot of failures.

I will explain my own philosophy regarding financially challenged issuers at the end of this essay.

Rating divergence is actually the status quo — that’s not the story here

Shawn O’Leary at Nuveen Asset Management points out that this divergence is nothing new in Chicago’s Rating Split: Is Moody’s Out of Step?:

Before looking at rating divergence specific to Chicago, it’s helpful to look at the long-term trend of rating divergence between Moody’s Investors Service and Standard and Poor’s. In our opinion, the ratings of the two rating companies have been largely incongruous for several years …

While S&P upgraded 1.01 municipal ratings for each Moody’s upgrade from 2002 through 2007, that ratio ballooned to a whopping 6.66 S&P upgrades for each Moody’s upgrade from 2008 to 2014. And, as noted by the unemployment rate at the time, S&P’s drastic spike in the pace of upgrades occurred at the height of the Great Recession and continued through 2014. This was long after the recession’s effect on municipal finances became apparent to most market participants. While Moody’s pace of upgrades slowed in response to the recession, S&P behaved as though the recession never happened.

We believe this broader context is important to understanding how S&P could rate Chicago’s general obligation pledge at A+ (now A-) while Moody’s rates the same pledge at Ba1. Specific to Chicago, however, we find that not only has the market long treated Chicago’s debt as being at a speculative credit quality — but that it is also well-founded given the credit fundamentals.

Moreover, it is worth noting that the credit rating agencies have published rating methodologies. S&P’s US Local Government General Obligation Ratings Methodology and Assumptions (September 12, 2013 — stashed behind their paywall) includes overriding factors for liquidity and structural imbalance that the rating agency has long decided to ignore for Chicago. Those factors would have put a junk-level ceiling on Chicago’s ratings. In other words, S&P is arbitrarily holding Chicago to different standards than the other local governments the agency rates. And it is obvious why.

What financial risks does Chicago pose to investors?

Let’s examine Chicago’s credit profile and you can decide whether or not the city’s bonds are speculative investments.

Unfunded pension liabilities

The magnitude of Chicago’s unfunded pension liabilities receives considerable attention, and rightfully so. From Nuveen:

Chicago’s combined annual debt and pension costs are substantially higher than any [of the ten largest US cities] when these obligations are indexed to total governmental revenue. Chicago’s fiscal 2015 debt service and annual pension costs account for 44.8% of fiscal 2013 governmental revenue. San Jose is the next closest city at 27.8%. The nine cities other than Chicago averaged 22.4% of revenue.

Last Thursday’s Bloomberg Municipal Market Brief also provided some good comparisons (refer to the StoryChart):

The next 10 years will be the most difficult for Chicago, as current statutes require the city to increase contributions to its four pension plans by 135 percent in 2016, and 8 percent annually through 2021, according to Moody’s. Pension payments will rise 3 percent, on average, through 2026 and around 2 percent through 2032 …

The median per capita aggregate unfunded actuarial accrued pension liability for the largest US cities and Puerto Rico is $3,350. The City of Chicago’s is $7,149.

Most municipal market analysts assume that the city will address its unfunded pension liabilities and relatively high debt burden by increasing residents’ property taxes by nearly 50%.

Chicago officials have been unwilling to raise property taxes for at least a decade. Offering documents indicate that this attitude continues. The city iscurrently in negotiations with its police and fire unions to postpone transitioning from a system of arbitrary contributions to actuarial contributions (i.e., contributions that reflect the true cost of benefits).

If officials lack the political will to raise taxes when their bonds are trading at 300 basis points (3%) over the AAA benchmark, will there ever be a resolution short of insolvency? This is a material risk that should not be shrugged off.

Borrowing money in order to borrow money

Bloomberg also notes that Chicago has the second-highest general obligation debt per capita among US cities at $3,047, following New York City at $5,500.

According to offering documents (available here), the city won’t be able to afford to make debt service payments on its outstanding bonds from available funds until 2019. The city has been borrowing money on a long-term basis to make debt service payments since before the financial crisis:

Since 2007, proceeds from general obligation bonds in the range of $90 million to $170 million per year have been used to make the city’s general obligation debt service. The city expects to use approximately $220 million of proceeds of long-term general obligation bonds to fund general obligation debt service in levy year 2015 for debt service paid in 2016. The city currently plans to eliminate the use of general obligation bonds to pay general obligation debt service by 2019.

As I described at length in my earlier essay, How Chicago Has Used Financial Engineering to Paper Over its Massive Budget Gap, the city has also been using long-term debt to: (1) finance everyday expenses and maintenance; (2) finance judgments and settlements, including police brutality cases and retroactive wage increases and pension contributions for unionized employees; (3) restructure the city’s existing debt to extend the the maturities on its bonds far out into the future, in order to avoid having to pay the debt as it was coming due; and (4) provide slush funds for the city’s 50 aldermen to undertake projects in their respective areas (i.e., pork).

State and local governments typically only issue bonds to finance the construction of capital projects — buildings and infrastructure with long useful lives that will benefit residents for generations. Chicago has incurred literally billions of dollars of debt where residents have nothing to show for it.

Excessive reliance on short-term debt

Besides a sharp loss in population (as what happened in Detroit), excessive reliance on short-term debt is a solid indicator of financial stress. Chicago has essentially used its credit lines as permanent source of funding in the sense that they are usually carrying a large balance and have frequently been utilized for non-capital expenditures. The city recently expanded its short-term borrowing program to $1 billion. For the sake of comparison, the city’s general fund operating budget is in the neighborhood of $3.3 billion.

Forbearance agreements

Apparently the irony of assigning an investment grade rating to an issuer that is already in forbearance — i.e., its lenders and counterparties have conditionally agreed to delay declaring events of default and exercising their rights and remedies —has been lost on the rating agencies, let alone an issuer that has $2.2 billion worth of forbearance agreements for variable rate debt, short-term credit facilities, and interest rate swap agreements. Chicago’s offering documents contain six pages of triggered events of default. It would be understandable if the city simply needed to replace a deal participant, but having to take it all out at (presumably) much higher interest cost in short order?

Absent these forbearance agreements, that $2.2 billion would become due immediately. The city usually has less than $1 billion of liquidity. The municipal bond market has not seen a liquidity problem of this magnitude for a local government borrower since the financial crisis. And S&P calls this situation “short-term interference.”

Although a portion of these products will be addressed by the city’s offering this week, Chicago’s lenders and counterparties have imposed some strict conditions on the remaining amount. The agreements are for a short period of time and if the city’s credit continues to deteriorate, the standstill agreements will end and the remaining amount will come due.

A large and diverse tax base, but…

Many of the analysts arguing that Chicago should still be considered investment grade cite the city’s large and diverse tax base. Chicago is a transportation hub and home to a number of major corporations.

The city’s population has been declining in recent years and only grew by 82 residents last year. That is not a typo. According to the Chicago Tribune:

Chicago’s population grew by only 82 residents last year, giving it the dubious distinction of being the slowest-growing city among the top 10 US cities with one million or more residents.

With a population of 2,722,389 residents as of July 1, 2014, Chicago still easily holds its place as the nation’s third-largest city … But cities on both sides of it are gaining.

New York maintained its ranking as the nation’s largest city, gaining 52,700 residents last year, for a gain of 0.6 percent that pushed its population to 8,491,079. Los Angeles added 30,924 residents, up 0.8 percent and bringing its population to 3,928,864.

Sun Belt cities with more than 1 million residents — places like Houston, San Antonio, Dallas and Phoenix — all continued to see dramatic gains in new residents …

“The boom of Chicago in the 1990s was due to immigration,” said Rob Paral, a Chicago-based demographer who advises nonprofits and community groups. “You take away the catalyst of immigration, and you see what we have. They’re going to different parts of the country, and there much less immigration to the US than there was decades ago.

“Texas, as an example, has been a magnet for a lot of lower-paying jobs and has the benefit of lower housing costs. If you’re making $15 an hour, the difference between making it where a house costs $100,000 and $300,000 is great.”

This last point brings us to property taxes. Some have also pointed out that Chicago has the lowest effective tax rate in Cook County, which means the city can withstand a large tax increase. This is true. According to Bloomberg, Chicago’s effective tax rate on residential property is 1.8% versus Harvey’s 8.9%. On commercial property, Chicago is not the lowest, but its 4.9% effective tax rate is much lower than Harvey’s 15.1%.

Discussing the level of property taxes in absolute terms fails to capture residents’ calculus in deciding on where to live, however. Just because Chicago has a lower tax rate does not mean residents will stay in the city if or when tax rates are increased significantly. In other areas, higher taxes will translate into more government services, better schools, and so on. In Chicago, they will be used to offset the costs associated with meaningless debt and unfunded pensions from a decade of fiscal mismanagement. That’s a huge difference and something to take into account.

The city has few assets left to sell

Chicago has already blown through the reserves it established from the Skyway and lease of its parking meters. It could try to hawk Midway Airport, but that has already failed three times.

The city’s other tax districts have their own problems

The Chicago Board of Education is also heavily indebted and its recent downgrade likewise triggered events of default. These will force the school system to pay penalty interest rates ranging from 9% to 13.5% and make swap termination payments. The board has significant unfunded pension liabilities and a $1 billion deficit.

Bonds are legally and likely politically subordinated to pension benefits

Perhaps the greatest irony of the debate over Moody’s downgrade is the other municipal bond market news it obscured. Last week, with a 6-t0–1 vote, the San Bernardino city council approved a plan of adjustment that would keep pension beneficiaries whole and basically wipe out bondholders. San Bernardino would be the third in a series of bankrupt municipalities to do so.

Some rulings in federal bankruptcy cases suggest that Chapter 9 could potentially be used to adjust pension liabilities. For that to happen, however, the municipality would have to want to adjust its pension liabilities. So far, when capital markets creditors have gone toe-to-toe with pension beneficiaries in court, they have walked away with massive haircuts.

Why is this happening? I see two (largely ignored) things driving outcomes in municipal bankruptcy cases where pensions are involved. The first is that courts neglect to situate claims in larger public policy contexts. Perhaps this is because some of the judges and law firms involved have mostly corporate restructuring experience and do not fully understand how public policy works. Perhaps it is just impossible the way Chapter 9 was drafted. Whatever the reason, the vocabulary of sacrifice in Chapter 9 cases has become quite mangled. The second is that Chapter 9 provides subtle opportunities for political rebalancing in regions where machine politics prevails. Let’s discuss these in turn.

The treatment of other post-employment benefits (i.e. health care) has been a land mine for capital markets creditors in Chapter 9 cases, whether they realize it or not. Bankruptcy judges have agreed with the municipalities that pension beneficiaries are “making sacrifices” when a plan of adjustment strips them of their health care benefits but leaves their income benefits intact.

It has become something of a farce that the courts fail to recognize and quantify the other forms of government assistance available to retirees in determining the scope of their sacrifices. In a post-Affordable Care Act world, a municipality shedding OPEBs is not an economic sacrifice — it is tantamount to transferring those commitments from local taxpayers to state and federal taxpayers. It does seem like a sacrifice from a contract perspective, however, which allows locals to say, “See what we gave up? Now it is your turn.”

This is sufficient logic for capital markets creditors to receive haircuts, which then provide the resources required for the city to honor its pension commitments. To the extent that there are future Chapter 9 cases, expect OPEBs to be the starting point for crafting a plan of adjustment going forward. It’s just too easy.

If one looks at these insolvencies from the standpoint of local politics, it is not difficult to see how capital markets creditors can end up in the crossfire between different interest groups. Market observers tend to talk about organized labor as if it were a unified whole. In reality, large city governments can have dozens of labor groups with different perspectives and connections. This can be a very big deal with respect to pension politics. Cities can have several different pension plans depending on employees’ affiliations with funded levels that vary according to influence. Pension contributions are appropriations and appropriations are political.

If a municipality can keep its income benefits whole by making a token sacrifice that “frees up” funds that would have otherwise gone to investors, then policymakers can realign the political interests of all of these groups. They are all finally back on equal footing with respect to what they are due from the government. This keeps the machine working like a machine. Considering that governments can wander down this path (and in Detroit’s case, with open contempt for its investors) and still have some borrowing options, it is not surprising that Chapter 9 cases remain tethered to local politics.

That’s a bit of a digression, but it is still instructive with respect to Chicago. Chicago bondholders could potentially be subjected to the same destructive politics, but they would be in a worse situation legally if the city’s credit continued to deteriorate. Chicago is not eligible to file for Chapter 9, which means bondholders would have seek remedies in state courts with resistance from all of the other stakeholders (who are local). The Illinois Supreme Court has elegantly subordinated their claims to pensions through its interpretation of the state constitution and has expressed indifference about the financial impact. Absent Chapter 9, there isn’t even the possibility of sharing resources.

Regardless of what one thinks about ratings divergence, the divergence between the rating agencies and market participants with skin in the game makes perfect sense. Bondholders have been repeatedly hosed for giving municipalities the benefit of the doubt in these circumstances.

How I regard financially challenged governments

Chicago’s fiscal emergency is the confluence of two distinct, but related, problems: (1) the city has made extraordinarily bad decisions for over a decade about how to manage its resources; and (2) the city has made extraordinarily bad decisions for over a decade about which financial products to use in borrowing money. Both the city and its school system used excessive amounts of short-term debt, variable rate debt, and interest rate swaps. They have also waited until it is too late (expensive) to transition their debt portfolio to a more sustainable structure.

Ester Fuchs points out in Mayors and Money: Fiscal Policy in New York and Chicago, a classic text on fiscal crises, that municipalities can “afford” (i.e., financially survive) decades of mismanagement as long as the municipality can service its debt. While I agree with this observation (cynical as it is), I believe financial innovation has introduced some notable twists.

A municipality can “afford” either protracted fiscal mismanagement or an unconventional debt structure. Municipalities that are dealing with both, however, tend to be screwed. As its credit deteriorates, resources that would have cushioned the municipality against mismanagement are instead diverted to resolving broken debt structures (until they aren’t).

In Chicago’s case, the city is going to have to learn how to function without most of the gimmicks that have helped it through the last decade. Many market observers underestimate how difficult that will be, even with steep tax increases. They also seem to believe city officials are capable of becoming intellectually honest overnight.

Chicago is hardly exploring new territory here. All of the recent insolvencies in the municipal bond market have combined protracted fiscal mismanagement with a reliance on innovative financial products (e.g., interest rate swaps and pension obligation bonds). This epiphany continues to elude many market participants, especially those who believe credit analysis is as simple as financial ratios.

Perhaps Chicago will successfully navigate through this storm, but it is insane to disregard the risk involved.

The Wheel of Fortune: Mean Reversion (Part 1)

graves

Last post on Chapter 4 in Quantitative Valuehttp://csinvesting.org/?p=10730 . Let’s get back to our course on Deep Value.

Let’s go back to DEEP VALUE, Chapter 5: A Clockwork Market: Mean reversion and the Wheel of Fortune.

As a value investor you are doing either:

  1. Buying a franchise, where barriers to entry allow for profitable growth, before mean reversion sets in or
  2. Buying assets where the normalized earnings’ power of those assets is below norm (Asset value = Earnings Power Value) and earnings’ power will mean revert to normal.

Therefore the concept of Regression to the Mean is powerful.  By putting the words, “Many shall be restored that now are fallend and many shall fall that now are in honor” on the facing page of Security Analysis, Graham gave the most prominent position in his seminal text to the idea that Fortuna’s wheel turns too for securities, lowering those that have risen and lifting those that have fallen.  The line, from Horace’s Ars Poetica, echoes the phrase spoken by the wise men of legend who boiled down the history of mortal affairs into the four words, “This too will pass.”  This is regression toward the mean. (p. 79).

The more extreme the initial price movement, the greater will be the subsequent adjustment in the opposite direction. There tends to be a price trend before reversal. The reasons are manifold, but the most obvious is that the trials aren’t independent—our own trading decisions are affected by the buying or selling preceding our trade.

Keynes discussed this phenomenon here:

https://www.marxists.org/reference/subject/economics/keynes/general-theory/ch12.htm or John Maynard Keynes and his life as an investor, Keynes as an investor

Two economists known for research into both market behavior and individual decision-making, Werner De Bondt and Richard Thaler, theorized that it is this overreaction to meaningless price movements that creates the conditions for mean reversion. Note page 800 in the link Does Stock Market Overreact—  the loser and winner portfolios.  Losers win out.

In a second study, Further Evidence of Inv Overreaction Thaler, Thaler and De Bondt revisited the research from a new perspective.  They hypothesized that the mean reversion they obserbed in stock prices in the first study might have been caused by investors focusing too much on the short-term. this fixation on the recent past and failure to look beyond the immediate future would cause investors to miscalculate future earnings by failing to account for mean reversion.  If earnings were also mean reversing, then extreme stock price increases and decreases might, paradoxically, be predictive of mean-reversion not just in stock prices, but in earnings too.  A stock price that has fallen a great deal becomes a good candidate for subsequent earnings growth, a vice versa for a stock price that has gone up a lot.  As you can see from the two research reports that the undervalued portfolio delivered better earnings and price performance.

The above research stand the conventional wisdom on its head and show compelling evidence for mean reversion in stocks in a variety of forms.

Buffett Discusses Mean Reversion in the Stock Market

Buffett_on_1999_Stock_Market_-_Fortune_Article & 2008 Market Call and a MUST READ: A Study of Market History through Graham Babson Buffett and Others

In the 1964 to 1981 period, Buffett wrote, U.S. GNP almost quintuples, rising 373 percent. The market, by contrast, went nowhere.

The evidence is that valuation, rather than economic growth, determines investment returns at the market and country level. Research suggests that chasing growth economies is akin to chasing overvalued stocks, and generates disappointing results. See

The growth illusion

Alas, this is not the case. Work done by Elroy Dimson, Paul Marsh and Mike Staunton at the London Business School established this back in 2005. Over the 17 countries they studied, going back to 1900, there was actually a negative correlation between investment returns and growth in GDP per capita, the best measure of how rich people are getting.  In a second test, they took the five-year growth rates of the economies and divided them into quintiles. The quintle of countries with the highest growth rate over the previous five years, produced average returns over the following year of 6%; those in the slowest-growing quintile produced returns of 12%. In a third test, they looked at the countries and found no statistical link between one year’s GDP growth rate and the next year’s investment returns.

Why might this be? One likely explanation is that growth countries are like growth stocks; their potential is recognised and the price of their equities is bid up to stratospheric levels. The second is that a stockmarket does not precisely represent a country’s economy – it excludes unquoted companies and includes the foreign subsidiaries of domestic businesses. The third factor may be that growth is siphoned off by insiders – executives and the like – at the expense of shareholders.

Paul Marson, the chief investment officer of Lombard Odier, has extended this research to emerging markets. He found no correlation between GDP growth and stockmarket returns in developing countries over the period 1976-2005. A classic example is China; average nominal GDP growth since 1993 has been 15.6%, the compound stockmarket return over the same period has been minus 3.3%. In stodgy old Britain, nominal GDP growth has averaged just 4.9%, but investment returns have been 6.1% per annum, more than nine percentage points ahead of booming China.

What does work? Over the long run (but not the short), it is valuation; the higher the starting price-earnings ratio when you buy a market, the lower the return over the next 10 years. That is why buying shares back in 1999 and 2000 has provided to be such a bad deal.

High Growth Depresses Future Stock Returns

Why does high growth seem to depress stock market returns and low growth seem to generate high stock market returns?  The market ALREADY recognizes the high growth nation’s potential, and bids the price of its equities too high. Market participants become overly optimistic during periods of high growth, driving up the prices of stocks and lowering long term returns, and become too pessimistic during busts, selling down stocks and creating e conditions for high long-term returns.  More research on that here:

  1. Jay_Ritter_paper_14_August Economic Growth and Stock Returns
  2. value-vs-glamour-a-global-phenomenon
  3. Blinded by Growth

I will finish this chapter in the next post. If you do not have DEEP VALUE or Quantitative Value, then join the deep value group found here: http://csinvesting.org/2015/01/14/deep-value-group-at-google/ and I will send.

If you only understand one concept besides Margin of Safety in investing then let it be Reversion to the Mean.

Letter to Management (SCP.TO)

scp

 As a general rule….people ask for advice only in order not to follow it; or, if they do follow it, in order to have someone to blame for giving it. –Alexandre Dumas

Sprott Resources Corp. (SCP.TO or SCPZF)

In the recent first quarter report, SCP reported $2.06 Net Asset Value (NAV) as compared to a recent $0.99 cents (Cdn) market price or a 52% discount. The details can be found here:

As a recent investor attracted to the large discount, I find this investment ugly but cheap–like me!  But I can’t own much, because I have no way to determine the intrinsic value of ALL the underlying investments held by Sprott. An investment that I own similar to Sprott is Dundee Capital Corporation. This letter/blog post will provide the suggestions of how to communicate to outside investors as partners and the lessons of great capital allocators.   I see four ways to close the discount between market price and NAV:

  1. Kill management at the holding company level.
  2. Buyback shares in the open market or make a tender offer
  3. Sell a fully-valued or poorly/unfixable investment and use the proceeds in another investment or buy-back shares.
  4. Communicate to shareholders so they can close the gap between NAV and market price.

Point 1 is both illegal and immoral and thus a non-starter, but my black humor seeks to point out that the market may be wary of the prior or current management’s capital allocation skills. The market places a negative value on management at the holding company level or anticipates further declines in NAV.

Point 2: With only $2 million in cash or less than 1% of the NAV and with $1.7 million in commitments, $300,000 allows for less than 0.5% to be purchased. meaningless. Yes, debt could be taken on to buy-back shares, but where would be the margin of safety if a prolonged depression occurred?  With global debt levels at 100,000 year highs, dislocation is not a low probability event.

Point 3: This is a capital allocation decision that can only be made by management.

Point 4: Communicate with your shareholders as partners who are investing every nickel into Sprott. If YOU were in their shoes what EXACTLY would you need to know? If you were reporting to your Aunt Millie once a year about her investment in SCP.TO, what would you tell her?

Rather than give you my suggestions why not learn from the best in the world at capital allocation?

the outsiders“The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success” tells the stories of eight successful chief executives. You will meet eight indivualistic, iconoclastic CEOs whose firms’ average returns outperformed the S&P 500 by a factor of twenty (no typo).  Buy the book! Pdf here:  Outsiders_ Eight Unconventional CEOs and Their Radicl Blueprint for Success, The – Thorndike, William N_

There is a chapter in the book about the greatest capital allocator of all-time as suggested by Warren Buffett: Emultate Henry Singleton Read the case study: Dr. Singleton and Teledyne A Study of an Excellent Capital Allocator

Next, of course, study the wisdom of Warren Buffett: Complete_Buffett_partnership_letters-1957-70_in Sections and Essays of Warren Buffett _ Lessons for Corporate America_Cunningham   Note the clarity and simplicity of how he describes his investments. I broke out two of them for you: See’s_Candies_Case_Study     Sanborn_Map_Case_Study_BPLs

Besides reading the above, why not study other great CEOs like:

Finally, here is an example of an investment–simple and direct:

Can you tell your investors in a similar way the reasons for each of Sprott’s investments?

Mr. Yuzpe, this is the voice of experience calling, are you listening?

This irreverent letter is sent with good intentions, and I hope it is taken to heart.

Best,

John Chew

Today’s Distorted Production/Consumption Structure

shallow

As a general rule….people ask for advice only in order not to follow it; or, if they do follow it, in order to have someone to blame for giving it. –Alexandre Dumas

This l o n g post is critical in understanding our current investing environment.   I copied the entire post from www.acting-man.com because of its importance. Value investors seek bargains. We look at the particular shoe, car, asset, or business and seek to buy below what we estimate it to be worth. Outguessing the market or the economy is a hopeless task, nevertheless, one must be aware of distortions in order to normalize earnings–how would you have normalized earnings for housing stocks in 2005 and 2006, at the peak of a massive distortion?  Currently, we are making economic history with the current distortion of the country’s production structure.

Boom and Bust

Be aware of what that means for your investments! Read on.

Summary: Since this is a long post, let’s cut to the quick.  If interest rates are pushed below their natural free market rate (our time preference or how much do we consume today vs. save for tomorrow), then businessmen are fooled by how much real savings are in the economy to utilize or bid for. Say with a 5% loan we see in our spread sheets that building a factory would generate a nice profit, so we begin building our three-story building, but since there are not enough real savings in terms of bricks, steel, cement, as we build, the prices of those materials begin to rise. Now our building is no longer profitable because our input costs have risen or worse–there are no more bricks available to complete our factory. We abandon the project halfway through.  Look at the empty and uncompleted housing complexes outside of Las Vegas from the busting of the housing bubble in 2005/06 as a recent example.

Background: Structure_Production_Reconsidered (a full review after you have finished this post). For the fanatical student: Economic Depression Their Cause and Cure

The Goldilocks Illusion  May 11, 2015 | Author  Pater Tenebrarum

Why Market Participants Liked the Payrolls Report

Some people have wondered why the stock market reacted with such a big rally to last Friday’s payrolls data. After all, the report wasn’t much to write home about, especially if one  ponders the details. In addition, the already weak March payrolls data were revised lower to an even worse figure.

However, the report certainly did one thing: it kept the “Goldilocks illusion” alive. While jobs data are a lagging economic indicator and would likely be completely ignored in an unhampered free market (if anyone even took the trouble to collect them, that is), they are regarded as decisive for Fed policy. Few things illustrate more vividly that the central planners are driving forward with their eyes firmly fixed on the rear-view mirror.

The Fed has little choice though, since its mandate explicitly includes employment as one the things central bank policy is supposed to support (which it does mainly by fostering artificial booms and malinvestment of capital). The market’s focus on the jobs data has increased greatly in recent years as a result of this, which incidentally illustrates how utterly dependent the markets have become on a continuation of easy money policies by central banks.

The “Goldilocks” idea is that it is best for risk assets if economic data are strong enough not to signal recessionary conditions, but weak enough to keep ZIRP and monetary pumping going. Friday’s data point was presumably considered almost perfect in terms of this playbook.

SP 500

SPX, 10 minute chart: stocks bounce back to the upper end of their recent range

Normally the stock market is held to reflect the past successes or failures of listed companies, as well as expectations about their future performance. To some extent this is still the case, but as the market has come to increasingly depend on monetary pumping and the associated perceptions, this factor has diminished in importance.

We can indirectly discern this from certain data points, such as the fact that  the median stock has never been more expensive than today. This is a sign that intra-market correlations have greatly increased. However, it is actually impossible for such a large percentage of listed companies to be equally successful in terms of real wealth creation. Along similar lines, the strong rise in the Q-ratio (it is currently two standard deviations above the mean) is a strong sign that market valuations are driven by the “money illusion” rather than a rational assessment of value.

Q Ratio

A long-term chart of the Q ratio shows that loose monetary policy frequently distorts market valuations. If it tops out near its current level, it will be the second highest peak in history – click to enlarge.

What Will Shatter the Illusion?

Not everybody thinks that the “not too hot, not too cold” jobs data will keep the Fed from going through with its long-announced “policy normalization” plans. However, the conviction is growing that this will once again be pushed back to a later date. Here is an excerpt from  a Bloomberg report on the payrolls report that illustrates the current consensus on the topic:

“U.S. job growth rebounded last month and  the unemployment rate dropped to a near seven-year low of 5.4 percent, suggesting underlying strength in the economy at the start of the second quarter that could keep alive prospects for a Federal Reserve rate hike later this year.

Nonfarm payrolls increased 223,000 as gains in services sector and construction jobs offset weakness in mining, the Labor Department said on Friday. The one-tenth of a percentage point decline in the unemployment rate to its lowest level since May 2008 came even as more people piled into the labor market.

However, wage growth was tepid and March payrolls were revised downward, leading financial markets to push back rate hike bets. “We see this report as reducing concerns that weak first-quarter growth represents a loss of economic momentum,” said Michael Gapen, chief U.S. economist at Barclays in New York. Nevertheless, he said the bounce back was not strong enough to think the Fed could bump rates higher before September.

Considering that even most mainstream observers these days are usually admitting to the increasing importance of central bank policy to stock prices, it is slightly baffling that they almost never mention the money supply. The growth momentum of the money supply strikes us as the most important factor determining boom and bust conditions in the economy and the stock market.

As can be seen below, the annual growth rate of the broad US money supply measure TMS-2 (= true money supply) has slowed to approx. 7.4% in March. Historically this growth rate is still quite brisk. It also remains within the “sideways channel” within which annualized money supply growth has oscillated for more than two years. It also remains still well above the previous “bust thresholds” we have indicated on the chart. Therefore it isn’t sending a strong alarm signal just yet.

However, such thresholds are not a fixed magnitude. At what level precisely the boom-bust threshold will turn out to be depends to a large extent on contingent data and market psychology. Our hunch is that this threshold is higher than it used to be, mainly because the economy’s underlying performance continues to be quite weak compared to previous post WW2 era recoveries.

Money supply TMS-2, annual rate of growth

TM2

How much monetary pumping is required to keep assorted bubble activities on life support is unknowable. However, we can be sure that the economy is becoming ever more imbalanced and structurally weaker the longer strong monetary pumping continues. This is another reason to suspect that the “bust threshold” is likely higher than it used to be. Moreover, the lagged effect on economic activity from the peak money supply growth rates recorded in late 2009 and late 2011 has to be diminishing by now. As newly created money continues to ripple outward from its points of entry into the economy, the likelihood that “bad effects” become visible increases.

Currently there are two firmly established consensus opinions that are based on the irrational faith that  this time, central bankers somehow know what they are doing. One is the idea that strong economic growth is “just around the corner”, where it has been suspected to be lying in wait for the past six years. A corollary to this is the belief that the economy cannot possibly weaken to the point of entering an official recession.

A second, related conviction is that no “inflation problem” can possibly appear on the scene. Inflation problem in this case means: a noticeable increase in CPI. There are many good reasons for this consensus opinion. A number of contingent trends are helping to keep consumer prices in check. They comprise large consumer debt overhangs in nearly all developed countries, negative demographic trends, subdued wage growth (due to global labor arbitrage and tepid economic activity) and ongoing productivity growth in manufacturing (which seem to be waning lately). Moreover, in the post 2008 era, newly created money hasn’t primarily been borrowed into existence due to growing credit demand in the real economy. Instead it has entered financial markets more or less directly, as central bank debt monetization leaves major market participants with first dibs on new money.

All these trends affect demand for consumer goods, and even though we cannot truly measure their impact, some empirical confirmation is provided by related data points such as weak growth rate in retail sales. However, the demand side is only one part of the equation. Years of monetary pumping have left their mark on the economy’s production structure (KEY POINT!), and we want to briefly look at the problem from this angle.

The Balance between Production and Consumption

The chart below shows the industrial production index for capital goods (business equipment) compared to the production indexes of consumer goods and non-durable consumer goods. Given extensive global trade, domestic US consumer goods production has been partly replaced by imports, but the history of these indexes still conveys useful information.

capital goods vs consumer goods

Industrial production: capital goods vs. consumer goods and consumer non-durables

When interest rates decline, long-term projects that yield a consumable output only after a long period of time appear to become increasingly profitable. The decisive factors are firstly that the profitability hurdle declines as interest rates fall (for instance, it makes no sense to borrow capital at 4% for an investment yielding only 3%, but the situation obviously changes if borrowing costs decline to 2%), and secondly, that the net present value of long-lived capital goods increases sharply when they are discounted at a lower interest rate. The longer the time period involved, the bigger the effect will be.

As a result, factors of production will increasingly be bid away from the lower stages of the production structure (those closer to the consumer) to the higher stages (capital goods production) and the economy will become more capital intensive. In an unhampered free market economy, this is generally a positive development indicating a progressing economy. A decline in interest rates will signal that people are increasing their savings. Additional savings are a  sine qua non for a  sensible lengthening of the capital structure, as new long term investments need to be funded. If people are postponing consumption in favor of saving, this funding will in fact be available.

By increasing their savings, people are signaling that they prefer to be able to consume more or better goods in the future in exchange for lowering their present consumption. The creation of a more capital-intensive production structure will make this possible, as it will lead to greater output of consumer goods in the future (the quantity, and/or the quality of output my increase, and future output may also include goods that could otherwise not be produced at all). Interest rates and prices are the  signals indicating to entrepreneurs which types of investments make the most sense and to what extent the time structure of production can be lengthened.

Things become problematic though if interest rates are artificially suppressed by administrative fiat instead of declining due to an increase in savings. Economic calculation is falsified: relative prices are distorted, and the resources required to fund a lengthening of the production structure are in reality not available to the extent indicated by the interest rate signal. The investment activities of entrepreneurs will be misdirected – too much will be invested in the wrong lines, based on an incorrect assessment of consumer wants and the amount of real funding available for long term investment projects. Initially an economic boom is set into motion. Large accounting profits accrue and will be partly paid out in the form of dividends, stock buybacks and higher wages. However, at a later stage it will become obvious that many of these profits were actually illusory and that in reality, capital was consumed.

The people engaged in the production of capital goods need to be able to consume long before their own labor yields goods ready for consumption. They must eat, they need a place to stay, etc. The more factors of production are shifted toward capital goods production and away from consumer goods production, the more likely it becomes that not enough “free capital” in the form of consumer goods is available to support these long-term activities. Obviously, this problem can only be made worse by printing more money. KEY POINT!

The boom eventually expires because it turns out that many new investments can actually not be funded. Once this is recognized, a scramble to obtain the required capital commences, putting upward pressure on market interest rates. The distortions in relative prices that originally fired up the boom begin to reverse and malinvestments are unmasked as unprofitable – the bust begins. By looking at the ratio between capital and consumer goods production indexes, one can clearly discern boom and bust periods:

Boom and Bust

Not every bust necessarily results in an “official recession”. Sometimes the bust can be concentrated in just a few industries (like e.g. oil production and S&Ls in 1986-1988) – click to enlarge.

Let us reconsider the “CPI inflation” question in light of the above. If too many resources are devoted to capital goods production, the economy will over time tie up too many consumer goods relative to the amount it releases. The economy’s pool of real funding consists of two components: savings and consumer goods that become continually available from ongoing production activities. Although it is well known that many companies these days prefer to engage in financial engineering (mainly in the form of stock buybacks and m&a activities) rather than investing in capital, what counts are  relative proportions. If bottlenecks in the supply of consumer goods develop at some point, consumer prices may unexpectedly rise even if the currently tepid level of consumer demand remains unchanged.

The Growing Amplitude of Business Cycles

David Stockman recently  posted a chart from a BIS report that shows the amplitude of financial market cycles and business cycles in the real economy:

amplitude

Financial market cycles vs. real economic cycles

This chart illustrates the fact that the increasing activism of central banks in recent years has led to a commensurate increase in the amplitude of business cycles, with boom and busts in asset prices becoming especially pronounced. Since stocks are titles to capital and real estate can be grouped with long-lived capital goods from an analytical perspective, this is in keeping with the distortions in the production structure discussed above.

We have mentioned that the current cycle differs slightly from previous cycles due to the fact that “QE” injects newly created money directly into financial markets. The firms selling securities to the Fed (i.e., the primary dealers) will use the funds they receive to purchase securities again. The sellers of securities in this second round of purchases will largely tend to do the same, and so forth. However, this doesn’t mean that new money will forever stay within the confines of the financial markets in a kind of closed loop. More and more of it will “leak out” over time.

For example, the purchase of expensive trophy properties by the rich generates commissions for real estate agents and profits for real estate developers. Rising stock prices may lead individual investors to sell a part of their investments to increase their consumption. Companies are issuing lots of bonds to take advantage of low rates and seemingly insatiable investor demand. Some of the proceeds are flowing back into the financial markets in the form of stock buybacks, but a large part is used to purchase capital goods, pay wages, invest in R&D, etc. In short, the enlarged money supply eventually ripples through the economy in a variety of ways.

Someone will always have to hold the additional cash balances, and while strong demand for money since the 2008 crisis has so far contributed to keeping consumer price inflation in check, this state of affairs cannot be taken for granted (the demand for money may actually have been egged on a bit by ZIRP as well, as savers of modest means likely feel they have to set aside more money in light of the lack of interest income). We can already see though that those with the largest amounts of cash at their disposal are treating it as a hot potato (hence the frantic bidding for expensive properties,  high end art works, etc.).

Conclusion

We can be certain that the vast expansion of the money supply in recent years has once again led to the erection of an unsustainable capital structure. Should money supply growth rates continue to falter, a bust is likely to arrive sooner rather than later, as investment projects that depend on monetary pumping to keep up the appearance of profitability will quickly turn out to have been misguided.

Moreover, the large amount of new money that has been created in recent years continues to move through the economy and the possibility that people will reassess their demand for cash balances cannot be dismissed, in spite of the contingent trends that are currently keeping a lid on consumer demand. This may become especially pertinent if the Fed reacts to the next bust by immediately kicking money supply inflation into high gear again. After all, the strong demand for money is  inter alia predicated on the belief that the inflationary policy of recent years isn’t going to continue indefinitely.

Addendum

This article is actually a continuation of the “Echo Boom” articles we have published previously (see here for  part 1 and  part 2). In the next installment we will look at the relationship between “price inflation” and the stock market. This relationship is not as straightforward as is generally believed.

All in all we can conclude Goldilocks is treading on increasingly thin ice.

Charts by: BIS, St. Louis Federal Reserve Research, StockCharts, Doug Short / Advisorperspectives

Lesson on Franchises in Cyclical Markets

Gold-Miners-vs-200-MA

 

Mining-Stocks-Sentiment

Money Managers Are Price Chasers

Markets can do ANYTHING in the short-term, so the following is not a prediction that miners will rise in price. However, what comes first–the price rising or the buying? :) Miners chop around in a trading range as money managers flee the sector and now sit with record low allocations to this sector. * How good are money managers (on the whole) picking the right sector to invest in?  I leave it to you to find that out.

Wedgewood Partners: Franchises in Cyclical Market and a Lesson on Diversification

wedgewood partners fourth quarter 2014 client letter Look at pages 12-20 where David Rolfe, the manager, discusses NOV, SLB and CLB–high-quality companies in the cyclical oil sector.

  1. clb_vl
  2. slb_vl
  3. nov_vl

He points out diversification may mean the sources of profitability can be different among companies within a particular sector.  (Refer to Competition Demystified by Bruce Greenwald for a course on this distinction). Note the high revenue conversion to free cash flow (page-14) for those companies compared to other companies in the oil services sector.

Now move on to wedgewood partners first quarter 2015 client letter crude realities.  Note on page 13 how he looks at the oil services market–the structural attribute to focus on is drilling intensity.  Interesting…. Look at pages 18 and 19 for a further discussion on NOV and CLB.

To learn, you might download those company’s recent annual reports and try to figure out their revenue to free cash flow conversion.  Look at what the companies use for maintenance capex.  Note how Core Labs is a free cash flow gusher (Charlie Munger would smile on this).  Core Labs is a different business than SLB and NOV, but is grouped in the same industry/index.  When sellers of ETF sell, they don’t distinguish among companies and therein lies opportunity for us. Yeah!

I do the opposite of this:

**Merrill Lynch Fund Managers Survey May 4, 2015

Today’s chart of the day focuses on sentiment in the basic materials sector. Regular readers of the blog already know that I have been closely following Merrill Lynch’s Fund Manager Survey for years now. This months survey was conducted in a period between 2nd to 9th April 2015 with a total of 177 panellists, with $494 billion of assets under management. The survey should be used as a very good contrarian indicator.

According to the recent survey, global fund manager allocation towards global materials declined sharply in the month of April to net 27% underweight from net 16% underweight the previous month. As we can clearly see from todays chart of the day, sentiment is very depressed right now. Merrill Lynch states that the current allocation is 1.8 standard deviation below its long term average.

Furthermore, the overall commodity and natural resources theme is very much disliked by global money managers. Commodity allocation is unchanged for the third straight month and remains at net 20% underweight. That is 1.2 standard deviations below its long term average and even more interestingly, fund managers remain underweight commodities for the 28th month in the row.

(Source: www.shortsideoflong.com)

Great Annual Reports/Shareholder Letters; Catch-22

the outsiders

How-the-outsiders-became-one-of-the-most-important-business-books-in-america/

I recommend the above book!

When we read annual reports and shareholder letters we are searching for good businesses, cheap assets and excellent operators and capital allocators.

From the Preface of  The Outsiders: In assessing performance, what matters isn’t the absolute rate of return but the return relative to peers and the market. You really only need to know three things to evaluate a CEO’s greatness: The compound annual return to shareholders during his or her tenure and the return over the same period for peer companies and for the broader market (S&P 500)

Context matters greatly–beginning and ending points can have an enormous impact, and Welch’s tenure coincided almost exacly with the epic bull market that began in late 1982 and contiued largely uninterrupped until early 2000. During this remarkable period, the S&P 500 averaged a 14 annual return, roughly double its long-term average. It is one thing to deliver a 20 percent return over a period like that and quite another to deliver it during a period that includes several severe bear markets.

A baseball analogy helps to make this point. In the steroid saturated era of the mid-to-late 1990s, twenty-nine nome runs was a pretty medicore level  of offensive output (the leaders consistently hit over sixty). When Babe Ruth hidid it in 1919, however, he shattered the prior record set in 1884 and changed baseball forever, ushering in the mdoern power-oriented game. Again, context matters.

The other important element in evaluating a CEO’s track record is performance relative to peers, and the best way to assess this is by comparing a CEO with a broad universe of peers. As in the game of duplicate bridege, companies competing within a  industry are usually dealt similar hands, and the long term difference between them, therefore, are more a factor of managerial ability than expernal forces.

When a CEO generages signifiantly better returns than both his peers and the market, he deserves to be called “great,” abnd by this definition, Welch, who outperformed the S&P 500 by 3.3 times over his tenure at GE, was an undeniably great CEO.

He wasn’t even in the same zip code as Henry Singleton:

From a Deep-Value Member: Hi guys and girls:

Seeing as though we have such a passionate investors in John’s group, and we’re in annual report season, I wondered if everyone could nominate their top 5-10 “must read” shareholder letters. I will collate the results and re-post the top 10 back to you all when done (hopefully by the coming weekend). I think the idea here is for us all to hear about a few undiscovered names, rather than the obvious ones… so there is nothing too small or obscure as long as you think it conveys something meaningful and insightful.

Please reply with “shareholder letter” in the title as it will make this a little easier for me. Also… we can all assume Berkshire is an annual must read, so lets leave this on one off the list. I’m curious to hear what people have to say. Let me start off seeing as though I have put forward the idea.

  1. Fairfax Financial Letter 20015
    Markel Corporation Annual Report 2014
  2. Burgundy AM (Canada) Stoicism-and-the-Art-of-Portfolio-Intervention       2014-Confessions_of_a_Buffetteer (from Canada)
  3.  http://www.leithner.com.au/links.php (Australian Grahamite-FABULOUS) http://www.chrisleithner.ca/newsletter/index.php#.VUzyCvlVhBc    Great links to investing material/lessons.

Cut and past the above–excellent web-site with a trove of Graham an Dodd links, materials and letters!

JP Morgan
Amphenol
Overstock.Com
Serco Plc
Amerco

……………………………………………

After two weeks of sifting and sorting, I can reveal our top 10 favorite shareholder letters.  It’s an eclectic mix.

Thank you to all you who contributed.

  1. Complete_Buffett_partnership_letters-1957-70
  2. Aristotle Capital Annual Letters Managers-and-Baseball-Aristotle-Borowski-7.22.13     Aristotle-The-Essence-2015Q1-ACML-15-197-Kosher-Meat   Aristotle-Commentary-2015Q1-Value-Equity-ACML-15-220
  3. Ned Goodman Annual Letters Dundee 2013-Annual-Report and Dundee Annual-Report-2012
  4. Ennismore Asset Management Letters OEIC – Most Recent NL  and  Globo – Jan 2014 (Good to see the international managers mentioned)
  5. Oaktree Capital ManagementHoward Marks Liquidity
  6. Packaging Corp of America Shareholder Letters PCA_2014AnnualReport  (??)
  7. Skagen Fund 2015 04 01_Market-report  (looks interesting!)
  8. Expeditors EXPD_2014_Full
  9. Seacor Holdings  SEACOR 2014_Annual_Report (A brilliant man in a mundane group of businesses)
  10. Grantham Mayo van Otterloo – Quarterly Letters  breaking-out-of-bondage-and-are-we-the-stranded-asset- and gmo-7-year-asset-class-forecast-(1q-2015)

Here are my (from another reader/contributor) favorite letters:

Skagen from Norway – Just finished reading it today – good stuff!
http://ipaper.skagenfondene.no/Skagenfondene/English/SKAGENFundsAnnualReport2014/
Go straignt for the PDF (icon in the middle)

About Skagen: We search for companies that are priced significantly lower than our estimation of the value of the underlying operations. Our ideal investment is a company which is Undervalued, Under-researched and Unpopular, and that has potential triggers which could make hidden values visible and therefore create excess returns for our clients.

Troy Asset Management in the UK
http://www.taml.co.uk/archive-reports/investment-reports

Orbis Fund management in Bermuda
https://www.orbisfunds.com/Home   (Free registration required)

Ennismore Small European Value
http://www.ennismorefunds.com/

GMO
www.gmo.com (free registration required but worth it)
Their Quarterly letter is a real gem.
http://www.gmo.com/websitecontent/GMO_Quarterly_Letter_4Q14.pdf

RECM in South Africa
https://www.recm.co.za/

California based Aristotle Capital
http://www.aristotlecap.com/news-events-2/publications/

John Chew: Fantastic to have the international contributions!

Great Value Investing Blogs as chosen by another blogger:

Just wanted to drop a quick note to let you know that we featured csinvesting in a recent roundup of the best dividend / value investing columns:  http://dividendreference.com/articles/2015/170/10-brilliant-value-investing-experts-worth-reading/    (Nice words, but all I need to do to stay humble is ask the opinion of my Ex.

 

Catch-22 

HAVE A GREAT WEEKEND!

 

 

Tim McElvaine: Kissing a lot of frogs to find a prince or Portrait of a Deep Value Investor

“Value investing is about praying on the emotions of the seller,” McElvaine said, noting that he loves to be a buyer of un-loved securities when their owners need out at any cost.

McElvaine pointed to a Globe and Mail headline about beat-up mining stocks being great tax-loss sale candidates this past December. He bought up shares in Sprott Resource Corp and Anglo American recently for trading at considerable discounts to NAV (more info at chat.ceo.ca/mcelvaine).

Six years into the global bull-market and McElvaine’s funds are about 25% in cash to provide an opportunity to buy assets if prices return to Tim’s liking.

Is the US bull-market over? McElvaine talked about what could go right in the United States, and suggested that a great way to stimulate the US Economy would be to wipe out student loan debt, which is $1 trillion of $1.3 trillion owned by the US Government, according to McElvaine. That move could put $1 trillion back in the hands of the most aggressive consumers.

There was a brief moment before Tim’s speech that my dad and I got to share a word with him, and I asked how do they know if a cheaply priced security represents a value gap, meaning it’s undervalued and going higher, or is it a value-trap, as so often cheap stocks get cheaper.

“You don’t know,” Dad and McElvaine agreed, which reminded me of something Tim taught me 6-7 years ago:

“You’ve got to kiss a lot of toads in this business to find your prince.”

Take the time to read his annual reports and transcripts, then go the extra mile and look at the annual reports of the companies he mentions–do you see what he sees?  For example, in the chat of his presentation for 2014 (see bold index and then the link) he mentions that Sprott Resource Corp is trading for about $1.00 Cdn while its NAV is above $3.00 or “It’s not pretty, but it’s cheap.”  Can you learn from his approach and analysis? What would you do differently? You have to be a contrarian with a calculator to buy what is hated.

Some reports below:

Buying dollar bills for fifty cents Recent talk on his investments.
2014-Transcript-of-May14-Annual-meeting

2013-Annual-Report and 2013-Partners-Confererence-Transcript

2012-Annual-Report and 2012-Transcript-Partners-Conference-website-version

Go deeper: http://mcelvaine.com/reports/

Tomorrow: I will post a reader’s list of great annual reports.

I love reading Warren Buffett’s letters and I love contrasting his words with his actions…I love how he criticizes hedge funds, yet he had the first hedge fund,” Mr. Loeb said. “He criticizes activists, he was the first activist. He criticizes financial services companies, yet he loves to invest in them. He thinks that we should all pay taxes, yet he avoids them himself.  – Business Insider LINK

http://investmentresearchdynamics.com/warren-buffet-is-the-definition-of-scumbag/     (A bit over the top but I like to present the contrasting view whether I agree or not).

Mark Twain Falls for Silver Fever (A Study in Bubbles)

SilverStock_Certificate_1863

Silver FeverEvidence of bubbles has accelerated since the [2007-2009 financial] crisis.
~ Robert Shiller (“Irrational Exuberance,” 2015).The celebrated author and humorist Samuel Clemens (pen name Mark Twain) documented his experiences in the Nevada mining stock bubble, and his writings are one of the earliest (and certainly the most humorous) firsthand accounts of involvement in a speculative mania.

After a brief stint as a Confederate militiaman during the beginning of the U.S. Civil War, Clemens purchased stagecoach passage west, to Nevada, where his brother had been appointed Secretary of the Territory. In Nevada, Clemens began working as a reporter in Virginia City, in one of Nevada’s most productive silver- and gold-mining regions. He enviously watched prospecting parties departing into the wilderness, and he quickly became “smitten with the silver fever.”

Clemens and two friends soon went out in search of silver veins in the mountains. As Clemens tells it, they rapidly discovered and laid claim to a rich vein of silver called the Wide West mine. The night after they established their ownership, they were restless and unable to sleep, visited by fantasies of extravagant wealth: “No one can be so thoughtless as to suppose that we slept, that night. Higbie and I went to bed at midnight, but it was only to lie broad awake and think, dream, scheme.”

Clemens reported that in the excitement and confusion of the days following their discovery, he and his two partners failed to begin mining their claim. Under Nevada state law, a claim could be usurped if not worked within 10 days. As they scrambled, they didn’t start working, and they lost their claim to the mine.  His dreams of sudden wealth were momentarily set back.

But Clemens had a keen ear for rumors and new opportunities. Some prospectors who found rich ore veins were selling stock in New York City to raise capital for mining operations. In 1863, Clemens accumulated stocks in several such silver mines, sometimes as payment for working as a journalist. In order to lock in his anticipated gains from the stocks, he made a plan to sell his silver shares either when they reached $100,000 in total value or when Nevada voters approved a state constitution (which he thought would erode their long-term value).

In 1863, funded by his substantial (paper) stock wealth, Clemens retired from journalism. He traveled west to San Francisco to live the high life. He watched his silver mine stock price quotes in the newspaper, and he felt rich: “I lived at the best hotel, exhibited my clothes in the most conspicuous places, infested the opera. . . . I had longed to be a butterfly, and I was one at last.”

Yet after Nevada became a state, Clemens continued to hold on to his stocks, contrary to his plan. Suddenly, the gambling mania on silver stocks ended, and without warning, Clemens found himself virtually broke.

“I, the cheerful idiot that had been squandering money like water, and thought myself beyond the reach of misfortune, had not now as much as fifty dollars when I gathered together my various debts and paid them.”

Clemens was forced to return to journalism to pay his expenses. He lived on meager pay over the next several years. Even after his great literary and lecture-circuit success in the late nineteenth century, he continued to have difficulty investing wisely. In later life he had very public and large debts, and he was forced to work, often much harder than he wanted, to make ends meet for his family.

Clemens had made a plan to sell his silver stock shares when Nevada became a state. His rapid and large gains stoked a sense of invincibility. Soon he deviated from his stock sales plan, stopped paying attention to the market fundamentals, and found himself virtually broke.

Clemens was by no means the first or last person to succumb to mining stock excitement. The World’s Work, an investment periodical published decades later, in the early 1900s, was beset by letters from investors asking for advice on mining stocks. The magazine’s response to these letters was straightforward:  “Emotion plays too large a part in the business of mining stocks. Enthusiasm, lust for gain, gullibility are the real bases of this trading. The sober common sense of the intelligent businessman has no part in such investment.” (from Meir Statman)

While the focus of market manias changes – mining, biotech, Chinese stocks, housing, etc… – the outline of a speculative bubbles remains remarkably similar over the centuries.  Today’s newsletter examines the latest research into speculative bubbles and looks at how we can apply that knowledge, with examples of the recent booms (bubbles?) in Chinese stocks and Biotech.  This newsletter is much longer than usual letter, in part because the topic is both complex and important.  Skip ahead to the end for the Chinese and Biotech conclusions.  Speculative bubbles_2

nasdaq bubble

Hate Math

Poor future returns

 

Source: http://hussmanfunds.com/wmc/wmc150504.htm

Prof. Greenwald on Value Investing

OVERVIEW Value_Investing_Slides

Greenwald_2005_Inv_Process_Pres_Gabelli in London

Greenwald Overview of VI

A Value Investing Class in Three Minutes

sentiment_cycles
Buying High

Next Week

I have been too busy to do another lesson but be ready next week! For those attending the Berkshire Hathaway Meeting in Omaha enjoy the experience. Flash your Deep-Value Group card for up to 95% discounts.

HAVE A GREAT WEEKEND!