Sanderson Farms (SAFM)

chicken

Key Statistics

Enterprise Value = $2.084 billion

Operating Income = $358.54 million

EV/Operating Income = 5.81x

Price/Revenue = .69x

Earnings Yield = 12%

Debt/Equity = 0%

The Company

Sanderson Farms is a classic, easy to understand, all American business.

Founded in 1947, it is the third largest poultry producer in the United States. Principal competitors include Tyson, Purdue, Pilgrim’s Pride. The company isn’t hated, but it is ignored because it is relatively small and operates in a commoditized industry that isn’t particularly glamorous.

With that said, they have a long operating history and have run the company with excellence and integrity throughout their history. They grow the company organically with cash flow, as opposed to relying on debt to fuel growth.

One factor fueling Sanderson’s recent price decline has been worries about Trump tariffs. This is bizarre because nearly all of Sanderson’s operations and customers are within the United States and tariffs will have little impact. While Sanderson sells some of their products to intermediaries who export overseas, most of their chickens are produced and sold here in the U.S. Regardless, Wall Street traders target the industry as a whole with a narrative, without regard to the underlying fundamentals of the individual companies within that group.

My Take

This isn’t the first time that I owned this stock. It was a part of the original lineup of stocks I purchased for this account in December 2016. I owned it through 8/30/17 and sold for a decent profit. The stock had an epic run up in 2017, and I got out when I thought the valuation no longer made sense.

Since then, the stock slid down to a level that I think is below its intrinsic value, bottoming at $95.97 in June. Since then, the price has hovered around $100. I picked up 16 shares on 8/15 @ $100.57.

From a relative valuation standpoint, Sanderson is cheaper than the industry as a whole. The current P/E is 8.54, while the industry average is 19.25. On a price/sales basis, it is .69x vs. an industry average of 1.49x.

Growth for Sanderson mirrors growth in the chicken industry, which ebbs and flows in the short term, but the long-term trajectory is towards growth. People aren’t going to stop eating chicken. With a growing global middle class, demand for chicken is only going to increase over time.

“People need to eat” is a familiar refrain when discussing the cyclicality of other industries vs. food essentials. Sanderson’s sales increase organically nearly every year (including during the Great Recession). Sales are up 94% over the last 10 years. Any earnings loss is usually caused by gyrations in chicken prices, which inevitably resolve themselves. With no debt, Sanderson can handle these temporary losses. With a solid product that will never go away and no debt, Sanderson should weather any recession with ease. Over the long term, it should continue to grow organically as it has since the 1940s.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Thor Industries (THO)

rv

Key Statistics

Enterprise Value = $5.048 billion

Operating Income = $684.85 million

EV/Operating Income = 7.37x

Price/Revenue = .6x

Earnings Yield = 9%

Debt/Equity = .04%

The Company

Thor Industries, Inc. makes and sells recreational vehicles. They operate two principal segments: towable recreational vehicles and motorized ones. Business has been excellent in recent years due to twin demographic trends. To sum it up: Millennials are living in RV’s and taking wake-up selfies next to the Grand Canyon, while Boomers are retiring and using them for vacations. Cheap oil has also buoyed the expansion.

While the company has been consistently growing sales and earnings at a rapid rate for every year of the expansion, it currently trades at a 66% discount from its 52-week high set back in February. 2017 was the company’s best year in its history and investors are concerned they won’t be able to keep up the pace. The stock sold off because of fears over the Trump administration’s steel and aluminum tariffs.

My Take

Thor is not the kind of company that I usually buy. It is a fast-growing, well-performing firm. It certainly looks like a “wonderful company at a bargain price.” Thor is performing significantly better than most companies trading at a P/E of 11, EV/OpIncome of 7.37x and 60% of sales. It’s average P/E for the last five years was 16.62, which seems reasonable for its quality. Multiple expansion alone to its average level would fuel a 51% rise in price from current levels.

Thor is also outperforming its competitors in the RV industry. For the last ten years, it has maintained a 16.69% rate of growth in comparison to 9.41% for the industry as a whole and 12.25% in comparison to its biggest competitor (Winnebago). It is also achieving these results with less leverage. Thor has a low debt/equity ratio of .04%. Winnebago, in comparison, has a debt/equity ratio of 50%.

Sales have organically grown with every year in this expansion, and they appear to be increasing. Sales have increased by 123% from 2013. Earnings are up 147% over the same period. With an F-score of 7 and a Z-score of 7.98, the company is financially healthy.

One risk is that we have a recession, as that would trigger a contraction in credit availability for RV purchases. Of course, a recession is a risk for everything that I own.

Another risk factor is that the RV industry might be at a cyclical peak. 2017 was the best year for the RV industry in history, with $20 billion in sales and 504,600 units sold. Despite this, I think that the industry still has a lot of room to grow in popularity. I think it will have a continued appeal for families, Millennials who want to unplug, and Boomers who are retiring.

According to the RV industry association (I know, they have a bit of a bias), RV camping trips are much cheaper than the typical family vacation. Family RV trips are probably much more pleasant, too. Everyone hates flying, but I’m sure that flying with your kids in tow is a particularly miserable experience. So, this ought to have an appeal to families. Boomers continue to retire and they should continue to drive the growth of the industry.

The recent sell-off looks like a severe overreaction to some bad macroeconomic news with little regard to the actual performance of the underlying company. While tariffs are a problem, I don’t think they can derail this exceptional business that is being buoyed by a favorable business climate in the United States and current demographic trends.

Random

Speaking of RV’s, I can’t talk about them without thinking of this video:

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

TUR, EPOL, EIS, EWZ

I’m out. Turkey’s meltdown convinced me that I shouldn’t venture into things I don’t understand – like cigar butt international indexes.

Also dumping Poland and Israel. Israel has a close trading relationship with Turkey. I want minimal exposure to Europe, as the crisis looks likely to spread. I will probably sell Norway next month when I do the rebalance. I am also ditching Brazil. This will give me enough cash to buy at least 2 positions.

I know, I know. The US is overvalued. Home country bias. But, at least with a US company, I can wrap my head around it and hold through a tough time.

EPOL @ $23.1752

TUR @ $19.3653

EIS @ $53.5101

EWZ @ $33.7746

I’m going to replace it with actual companies that I understand.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Did Ben Graham abandon value investing?

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Did Ben Graham abandon value investing?

Benjamin Graham refined and changed many of his views at the end of his life in the 1970s.

Even though he was retired and surrounded by beautiful people and weather in California, he continued to conduct extensive research into the behavior of securities as an intellectual pursuit.

Reading some of his writings and interviews from the period, some have concluded that Graham abandoned his philosophy and embraced the efficient market hypothesis.

Here is a quote of his that led many to this conclusion:

“I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook ‘Graham and Dodd’ was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost.”

This is a quote that efficient market types will often throw in the face of value investors. To paraphrase these people: “See, even Ben Graham thought this was all a bunch of nonsense! Shut up an buy an index fund, idiot!”

Reading these quotes, many value investors are left stung in disbelief. It’s like suddenly discovering that the Pope is an atheist, Mr. Miyagi was secretly helping the Cobra Kai, Picard collaborated with the Romulans, or that Johnny eventually put Baby in a corner.

The Truth

The truth is more nuanced. Yes, Ben Graham didn’t think detailed, individual security analysis was as useful as it was when he originally wrote the book in the 1930s. That doesn’t mean he gave up on the concept of value investing.

In fact, Graham did not agree with the efficient market crowd. He had this to say about them:

“They say that the market is efficient in the sense that there is no practical point in getting more information than people already have. That might be true, but the idea of saying that the fact that the information is so widely spread that the resulting prices are logical prices – that is all wrong, I don’t see how you can say that the prices made in Wall Street are the right prices in any intelligent definition of what right prices would be.”

The behavior of markets is, indeed, crazy. You have to be slightly brainwashed by the beautiful, peer-reviewed, academic work of the Church of Beta to think that prices are logical. Look at all of the insane bubbles that have plagued securities markets in the last few decades. Look at the nonsensical valuation of stocks in early 2009.

Look at the activity in multiple asset classes. Dotcom stocks, crypto, even housing. Look at the wild ride that the S&P 500 had in the 1990s and 2000s. Was the late ’90s run up rational? Was the hammering that stocks endured in 2008 logical or emotional?

It was all irrational, it was crazy. It wasn’t a market unemotionally weighing information. It was herds of professional investors reacting emotionally to events.

Mr. Market is alive and still doing crazy shit. If you don’t believe me, just watch the cable coverage of market action every day. Cable financial news is a torrent of speculation, FOMO, greed, and fear.

If Mr. Market were a person, he would live in Florida.

Another important snippet from the quote really stands out: “the information is so widely spread.” Graham was writing in the 1970s. We tend to think of the 1970s as a time when people were using stone tablets in between bong hits and classic rock albums. The thinking is that modern markets are so much better because we have the internet, computers, financial Twitter, blogs. We are so sophisticated and technologically advanced!

This is a conceit of every generation. Everyone thinks that their era is remarkably sophisticated and eras of the past were the dark ages. The experiences of our ancestors are primitive and not useful. The reality is that history rhymes and human nature never changes, no matter our level of technological sophistication. Eventually, the innovations of every era are ultimately discarded and regarded as quaint.

In reality, the critical information people needed to know about markets was available in the 1970s. Just because there is more information and it is more convenient in today’s world, it doesn’t make modern investors any more sophisticated or less emotional than the investors of yore. Indeed, the critical information about stocks has been widely available for a long time.

There is a perception that because stock screening technology and the information is readily available, that the edge for value investors has been eliminated. I think that’s bunk. Whether it was Moody’s manuals in the 1950s, Value Line in the 1970s, or stock screeners today – it has never been hard to find cheap stocks. What’s hard is actually buying them, not discovering them.

The source of returns in value investing has never been informational, it has been behavioral. It has been revulsion towards companies that are in trouble contrasted with starry-eyed love for companies that are making all the right movies.

There is a perception that the cheap stocks of past markets were diamonds in the rough. With technology, the thinking goes, those diamonds have been scooped up. Nothing could be further from the truth. Cheap stocks were always ugly stocks. The idea that there were cheap situations without any hair on them is a myth. The reason that cheap stocks outperform in historical analysis is because they were ugly. It was because they had problems.

The only thing that has changed is the methods of gathering that information.

Quantitative Value Investing

Back to the topic at hand.

While Ben Graham thought that detailed individual security analysis was a waste of time, he also believed that the efficient market theory was bunk.

Graham supported quantitative value investing. In other words, systematically purchasing portfolios of cheap stocks. Within the portfolio, some stocks would undoubtedly be value traps. As a group, however, they would generate returns that would beat the market.

Graham sums it up in this quote:

“I recommend a highly simplified strategy that applies a single criteria or perhaps two criteria to the price [of a stock] to assure that full value is present and that relies for its results on the performance of the portfolio as a whole — i.e., on the group results–rather than on the expectations for individual issues.”

 In other words, he believed that investors should select a portfolio of cheap stocks and construct a portfolio of them to systematically take advantage of market inefficiency.

What quantitative criteria, then, did Graham recommend to select bargain stocks?

Net-Net’s

The first method, which Graham was most famous for, was purchasing stocks selling below their net current asset value. Graham referred to investing in net-net’s in the following fashion:

“I consider it a foolproof method of systematic investment—once again, not on the basis of individual results but in terms of the expectable group outcome.”

A crucial part of Graham’s quote is his point that the results of individual net-net’s are not dependable. Graham recommends buying a basket of them and allowing the portfolio to generate returns.

The problem with this approach is that they aren’t available in bulk frequently in the U.S. markets. As Graham pointed out, net-net’s should only be purchased as a portfolio. The only time that there are enough net-net’s to create a portfolio is in market meltdowns like the early 2000s or 2008-09.

I am eagerly anticipating the next decline so I can buy a portfolio of net-net’s.

Simple Graham: Low Price/Earnings & Low Debt/Equity

The next approach that Graham outlined was buying a portfolio of stocks with simultaneously low P/E ratios and low debt/equity. The great thing about this approach is that it is applicable in the United States outside of meltdowns, unlike the net-net approach.

This is the approach that I take with my own investments, albeit with other criteria (low price/sales, low EV/EBIT, high F-Scores, etc.) and qualitative analysis added to it.

Regarding price/earnings ratios, Graham recommended purchasing stocks that double the yield on a corporate bond. He suggested looking at the inverse of the P/E ratio, or earnings yield. A P/E of 10 would be a 10% earnings yield, for instance.

“Basically, I want to double the interest rate in terms of earnings return.”

“Just double the bond yield and divided the result into 100. Right now the average current yield of AAA bonds is something over 7 percent. Doubling that you get 14, and 14 goes into 100 roughly seven times. So in building a portfolio using my system, the top price you should be willing to pay for a stock today is seven times earnings. If a stock’s P/E is higher than 7, you wouldn’t include it.”

In other words, the value criterion was remarkably simple: a low P/E ratio.

Graham’s second criteria was a low debt/equity ratio.

“You should select a portfolio of stocks that not only meet the P/E requirements but also are in companies with a satisfactory financial position . . . there are various tests you could apply, but I favor this simple rule: a company should own at least twice what it owes. An easy way to check on that is to look at the ratio of stockholders’ equity to total assets; if the ratio is at least 50 percent, the company’s financial condition can be considered sound.”

Concerning portfolio management, Graham recommended holding onto the stock for either two years or a 50% gain. I think this is an important point: Graham never recommended holding shares forever. That’s Buffett’s approach. Graham, in contrast, suggested a high turnover portfolio: buy a large group of undervalued stocks, wait for them to return to a reasonable valuation, then sell and move on to the next situation.

Graham backtested this method going back to the 1920s and found that it generated a 15% rate of return over the long run.

Wesley Gray and his team at Alpha Architect also backtested Graham’s method and found that Graham was right. The technique delivered 15% rates of return over several decades.

Even with an exceptional 15% rate of return, the strategy underperformed at some key moments. In 1998, for instance, it lost 1.94%. The S&P 500 was up 28% that year. In 1999, it gained only 2.51%. The S&P 500 was up 21% that year.

There was similar underperformance in the Nifty 50 era. In 1971, the Graham strategy returned only 1.57%. The S&P 500 gained 14.31% that year.

I believe we are in a similar moment right now. Only time will tell if I am correct.

The Simple Ben Graham Screen

I run multiple screens, but I use Graham’s criteria as a cornerstone in my stock selection. Even if I am wrong in my analysis, I know that I am at least looking in the right neighborhood.

Here are ten stocks that currently meet Graham’s criteria for earnings yield and debt/equity:

graham stocks

I am not recommending that you go out and purchase any of these stocks. I am merely showing that even in a frothy market like the U.S. today, there are still opportunities which meet Ben Graham’s criteria.

Random

  • The source of Graham’s 1970s quotes featured in this blog post is The Rediscovered Benjamin Graham by Janet Lowe. The book is a collection of articles written about Graham, Congressional testimony, interviews, and articles written by Graham himself. Of particular interest are the bullish articles that he wrote in the early 1970s and early 1930s, discussing the deep undervaluation of American stocks. You can buy it here on Amazon. It’s a great read and gives you a clear perspective on how Graham’s thoughts evolved over time.
  • Captain Picard is coming back. I can’t express how much I am pumped about this. Here is Patrick Stewart explaining his enthusiasm for the role.
  • Turkey. Yes, I own the Turkey ETF. Fortunately, it is a small position. Here is an excellent article on the crisis.
  • I watched a random, weird, and goofy movie last night: The Final Girls. It’s a parody of ’80s slasher movies. If you’re familiar with all of the tropes of the genre and you’re in the mood for some lighthearted fun, I recommend it. If you’re not familiar with the genre, the jokes will probably not resonate.
  • Better Call Saul is back. If you’re not watching, you’re missing out. If you were a fan of Breaking Bad and aren’t watching this one, what the hell? As the series moves along, it is living up to its predecessor.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

PCOA (Pendrell)

I was paid out for my lone share of Pendrell @ $689.19, which I bought in December because it was trading at net cash. This isn’t a “trade” as much as it is a portfolio event. There was a reverse stock split and tiny shareholders like me were paid out in cash.

This brings my cash balance up to $1,093.81. I am not sure how I am going to deploy it. I may rebalance my country indexes around 9/30 (they were mostly purchased in October 2017) and include this cash in the new positions that I purchase with those proceeds instead of buying something right now. I’ll also have owned Foot Locker for a year on 9/25 (a position that has been very good to me) and may sell that.

This would get me on a cycle of quarterly activity with a big rebalance in December (the blog started in December 2016, when I purchased the original 20 positions). My intention is to hold positions for at least a year unless they increase significantly or the fundamentals deteriorate.

I’m itching to sell Turkey. I clearly made a mistake with that one and should probably adhere to stricter quality criteria for international indexes.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Are bonds for losers?

stocksbonds

Returns for US Stocks and US Bonds since 1900 in real and nominal terms

No Pain, No Gain. Deal With It.

My attitude about bonds has evolved over the years.

Years ago, I had a pretty simple attitude about them: paraphrasing our President, bonds are for losers. The returns tell the story. Stocks massively outperform bonds over the long run (and cheap stocks outperform everything).

(They’re for losers unless they are bearer bonds. As I learned from Die Hard, Heat, and Beverly Hills Cop, bearer bonds are insanely cool. It’s too bad that the government discontinued these relics of a more heist-friendly time.)

Bonds historically have poor returns and sometimes struggle to keep up with inflation. Stocks traditionally have fantastic performances but have horrific drawdowns. Stocks were cut in half in 2008. They fell by 80% during the Depression. My attitude has always been that if you can’t handle the volatility, then you just need a stronger stomach. No pain, no gain. Toughen up.

With that said, a gung-ho attitude about stocks is easy when you are in your 20’s or 30’s. It was a natural thing for me to get bullish in 2009 after the market crashed. I went “all in” that year in my 401(k) into stocks with the tiny $4,000 I had saved up at the time. Being reckless at the beginning of your working career with a small amount of savings is easy. Try it when you are 65 and have your entire life savings to deal with.

My callous attitude towards “pain” was ignorant. “No pain, no gain” is an attitude you can’t afford to have if you are older and are dealing with a lifetime of savings. You don’t have a lot of high earning years ahead of you, and you might need this money to survive.

Confronting reality

I first confronted this reality when my parents needed investment advice. They asked me to look at statements provided by their financial advisor.

To be frank, the financial statements pissed me off.

The advisor had them in “safe” options appropriate for their age, but it was all stuffed into an incomprehensible soup of mutual funds. All of the funds had relatively high fees. Even worse, the advisor frequently moved in and out of funds even though they were essentially the same thing. I assume this was churning and it was merely to generate commissions.

The money was my parent’s life savings, and this guy was not treating it with the appropriate respect.

While I was growing up, I watched my parents struggle and work hard to earn this money. They would forego luxury. They always shopped with coupons; they bought store brand food, they never bought new cars, they always they worked hard at their jobs. My father is a construction worker, and my mother is a dental assistant.

They worked hard for their money and made the right decisions, and this guy was treating it like it was a game.

My first advice was simple: dump this financial advisor.

Back in college, I wanted to be a financial advisor. I changed my mind after an internship where I spent all of my time cold calling. I went through a list of phone numbers, read from a script, and asked rich and not-so-rich people to invest. After talking to the financial advisors at the firm, I realized they weren’t providing any value. When I asked them how they selected investments, they showed me software that popped out whatever fund mix the computer spit out after plugging in age and risk tolerance. The computer did the work. Their real role was sales, not guiding people or helping them.

(Yes, I *KNOW* there are good financial advisors out there. There are financial advisors that genuinely care about their clients and can provide a good service. They offer behavioral coaching when the market takes a fall, they offer tax and estate advice, and they can be a good judge of character when it comes to assessing someone’s tolerance for risk. Unfortunately, I don’t know any. I certainly don’t know any who would provide such a service for a small client like me or my family.)

Then I had to ask myself, “If I’m telling them to dump the financial advisor, what should I tell them to do instead?”

My instinct with my own money is to swing for the fences and go for the high returns. No pain, no gain.

I knew that my personal attitude was inappropriate for my parent’s level of risk tolerance and age. They couldn’t afford a “lost decade” of stock returns. They couldn’t afford to lose half of their money tomorrow. They couldn’t double down and get a second job if their investments fell apart. This money needed to last. Mine had to be worth a lot in 40 years. These are completely different objectives.

After thinking about it, I decided that the best option was the “Vanguard Target Retirement Income Fund” (VTINX). It is a fund which Vanguard designed for people in my parent’s situation, who are already retired. It is 70% bonds, 30% stocks and mixed geographically. Fees are only .14%.

The fund isn’t going to provide a high rate of return, but it ought to preserve their capital if they have an emergency and need it. It’s automatically rebalanced so they don’t have to think about it.

In terms of the worst case scenario, I looked at the 2008 drawdown, and it was only 10.93%. That’s tough, but not fatal.

What about interest rates? What about the bond bubble?

Everyone you talk to in the financial world “knows” that interest rates are going up. “They’re as low as they’re ever going to be” is the popular refrain. It certainly makes sense to me. I was born in 1982, and interest rates have declined for my entire lifetime. Eventually, it has to turn around and go back to “normal”, right?

It makes sense that the final straw would be successive rounds of quantitative easing, which will cause inflation, which will ultimately spur higher interest rates.

The more I thought about it, the more it worried me when I thought about my parent’s high allocation to bonds. When interest rates rise, bond prices decline. That’s Finance 101. Did I steer them in the wrong direction? What if interest rates spike and their savings are in jeopardy?

I decided to look at the historical data concerning bond returns, particularly in rising interest rate environments. The period I chose to focus in on was the Great Inflation of the 1960s and 1970s.

The Great Inflation (1960 – 1982)

prime rate

The prime rate from 1950 to today

There was no period for rising interest rates like the Great Inflation of the 1960s and 1970s. Having learned their lessons from the deflationary 1930s a little too well (the Fed didn’t act enough in the 1930s, which turned a panic into a prolonged hellish period of declining prices and high unemployment), the Fed played it fast and loose with monetary policy in the ’60s and ’70s.

The US government also began to play it fast and loose with fiscal policy, which was difficult to manage with the dollar tied to gold.

The “Nixon Shock”: The end of the gold standard

Paying for the Vietnam War and the Great Society was an expensive endeavor with the dollar tied to gold. Nixon’s solution was to abandon the Bretton Woods gold standard and end the dollar’s link to gold so we would have full autonomy to spend what we wanted.

The “Nixon Shock” kicked an escalating inflation situation into overdrive, with inflation reaching the double digits by the end of the 1970s. The OPEC embargo didn’t help. Economic stagnation combined with high inflation was “stagflation,” and it contributed to widespread fears that the United States had lost its mojo.

By 1979, 84% of the American people polled said they were “very dissatisfied” with the direction of the country. The malaise, as they called it, ran deep.

Paul Volcker, the Fed chairman at the time, knew that this had to stop. He took extraordinary measures to stop inflation, pushing interest rates to historic highs. By 1981, he had driven the prime rate to 20%. The high-interest rates caused a genuinely horrific recession. The recession of the early 1980s was slightly worse than the Great Recession of recent memory. Unemployment peaked at 10.8% in 1982. In comparison, it peaked at 10% in 2009.

Ronald Reagan, to his credit, stuck by Volcker’s tough medicine even though it was not in his political interest. Reagan’s poll numbers dropped into the 30s. A lesser President would have fired Volcker or publicly criticized his actions. Reagan did no such thing. He knew that inflation had to be contained and knew it was in the long-term interests of the country to beat it.

The tough medicine worked. Inflation was defeated. As inflation eased, we were able to reduce interest rates for nearly 40 years. The bond bull market has benefitted almost every U.S. asset class for the last few decades. We have been reaping the benefits of Paul Volcker and Ronald Reagan’s tough medicine for decades.

So how did bonds do during the Great Inflation?

I digress. The question I wanted to answer was how bonds held up during the Great Inflation of the 1960s and 1970s, which is the worst case scenario for interest rates rising. From 1960 to 1981, the prime rate rose from 4.5% to 20%. My instincts told me that bonds must have been completely crushed during this time period.

They weren’t crushed. However, in inflation-adjusted returns, they barely kept up. In nominal terms, they performed surprisingly well. There was only one down year (1969) in which the bond market experienced a 1.35% decline.

bond returns

While the real returns were terrible, they certainly fared better than cash or a savings account during the highest period of inflation in US history (inflation was advancing at a 10% pace, if you can imagine that).

With all of that said, in a diversified portfolio for a risk-averse investor like my parents, they served their purpose. They provided nominal returns and controlled for the drawdowns of the stock market.

Taking it back a little further, I looked at the returns of my parent’s 70/30 Vanguard portfolio and broke it out by decade. This asset allocation provided a suitable buffer for the volatility in the stock market. The decades where it performed poorly were solely due to inflation. Even though they struggled to keep up with inflation, the portfolio still held up better in those decades (the 1910s, 1940s, and 1970s) than cash in a savings account would have. The next decades (the 1920s, 1950s, and 1980s), as interest rates eased, the portfolio performed extraordinarily well.

conservative portfolio

Additionally, the portfolio also protected investors during extreme market events, which is the key purpose of a bond allocation. During the Depression and the drawdown of 1929-33 (when the market declined by nearly 80%), this allocation held up well, losing only 15.88%. During the crash of 2008, the drawdown was only 7.57%. It’s also worth noting that the portfolio delivered positive returns in the 2000s, which was a “lost decade” for American stocks.

That’s what bonds are all about: in a balanced portfolio, they are for an investor who can’t take a lot of pain. They are a pain buffer. They limit the drawdowns when stocks periodically fall apart and they deliver a low return that exceeds cash in a mattress or the bank.

Bonds aren’t for losers. Bonds are for people who can’t afford short-term massive, painful, losses. They can’t look at a stock market crash and just take a philosophical approach and say “well, 10 years from now I’ll be okay.”

Yes, bonds aren’t nearly as good as stocks over the long run. Yes, they won’t do well during an inflationary period when interest rates are rising.

They’re not supposed to do those things. Bonds help risk-averse people stay the course with the equity piece of their portfolio, which will provide the real capital appreciation and long-term returns. I was wrong for scoffing at bonds as a piece of a balanced portfolio and delving into the issue made me more confident with the advice I gave my parents.

Interest rates & inflation: no one knows

Looking at the history of inflation & interest rates and taking a historical perspective towards it also gave me the sense that no one really knows where either is headed.

The confident predictions that interest rates will rise are based on the perception that interest rates aren’t “normal”, simply because they look low in the context of the last 30 years.

From a broader perspective, the last 30 years have been an unwinding of the historically unprecedented interest rates of the 1970s. Interest rates might just be around normal levels now.

You constantly hear confident forecasts from “experts”. None of them really know any more about the future than we do. They are making educated guesses, just like you and me. Just because they have an impressive title and credentials doesn’t mean they know the future.

No one really knows what the future will bring and it is wrong to steer investors away from bonds simply because we “know” interest rates are going up. At the end of the day, no one really knows anything when it comes to predicting the future.

I don’t know if the next decades will be anything like the 1960s or 1970s, but even if that’s the case, the money that my parents invested in VTINX ought to hold up, which is what I and they care about. The bond allocation ought to perform better than cash and it ought to protect them if the stock market crashes.

Again, no one knows what the future will bring. You just have to make decisions that are appropriate for your risk tolerance, not anyone else’s.

Random

  • I’ve been reading “Brat Pack America: A Love Letter to ’80s Teen Movies“. It’s a fun book delving into the history of 1980’s teen movies, which are some of my favorite guilty pleasures. It’s making me appreciate them on an even deeper level. John Hughes was the first director to make movies in which teenagers were treated like actual human beings instead of a vehicle for the nostalgia of older people. When you see them through this context, they’re pretty amazing. I don’t think modern movies treat teenagers with the same level of respect that John Hughes did. They’re unique in this sense, which is probably why they have stood the test of time and are still popular.
  • Speaking of John Hughes . . . “Oh, you know him?”

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Q2 2018 Performance

quarterlyperformance

My streak of underperformance continues. I have no idea when it will end. All I know is: you can’t time this stuff. You just have to stick to it. Over time, markets reward disciplined rules-based value-oriented approaches. I think Cliff Assness put it best when he said in a recent interview that you should “find something you believe in and stick to it like grim death”. I believe in this stuff. It’s logical, time-tested, battle-tested. I’m not going to abandon it because of underperformance.

Value tends to do best coming out of a recession. If I had to guess, I won’t really see any outperformance until we see another recession and the recovery from it. That’s going to take anywhere from 5 to 10 years. Of course, that’s not how things worked out in 2000. The outperformance of value actually started before the recession. There simply isn’t any way to know or time it. I just have to stick to it.

This is my key advantage as a small investor. A professional enduring my underperformance would be in serious trouble with their investors. In an effort to keep their job, they would start to buy more popular positions. They would start to hug the indexes. They wouldn’t be able to ride something like this out and be cool with it. This is why most professionals underperform.

What’s my edge? I don’t have an informational edge. The only edge that I have is behavioral, which is something most professional investors can’t afford to have. I can handle the stench and dive into the dumpster. I can ride out the underperformance. If I can’t, then I might as well put this IRA into an index fund.

In short, I have to stick to it like grim death.

Sells

After staying put for the first quarter, I did much more trading this quarter. You can read a list of all of the trades here. I’m trying to stick to some concrete, easily identified sell rules. Those rules are:

  1. I can sell on an operational slip. For me, that is an operational loss. When I’m buying a stock on the basis of EV/EBIT, what is the position worth if EBIT begins to fall apart?
  2. I can sell if I held the stock for at least a year.
  3. I can sell as part of an annual rebalancing or a price increase of more than 50%.

For the operational slip rule, this was a result of the lessons I learned from my positions in IDT, Manning & Napier, and Cato Corp in 2017. All gave me early warning signs of a problem in the form of a decline in operating income and I ignored it.

Selling is one of the hardest elements of deep value investing. You can go with a very simplistic system such as Greenblatt’s magic formula, in which he recommended holding a stock for a year and then selling it unless it was still undervalued. Graham recommended selling after a 50% gain or after holding for two years.

My method is a combination of the two along with an element of downside protection by getting out of positions in businesses that post operating losses.

A deep value portfolio is going to be a high turnover portfolio. I am not buying stocks of companies with deep moats and high returns on invested capital. These are companies with problems that are causing an undervaluation. My goal is to buy when sentiment is poor and sell when sentiment has improved. I also sell when the fundamentals deteriorate. This is a major reason that the account I decided to track on this blog was the IRA, so I wouldn’t have to worry about tax considerations.

My sell rules aren’t perfect. My sale of Francesca’s, for instance, is looking like a mistake. Even though it will result in mistakes, I think sticking to it will help to cut off the bleeding in the worst positions. I will probably add to the rules over time as my experience grows.

Many investors hate rules. I love them. Rules keep me honest. Rules keep me out of trouble. There are thousands of investment ideas. It’s important to have strict guidelines or it will be easier to do dumb stuff. Guidelines and rules keep me honest. They keep me from straying from a tried and true path.

Buys

After selling for various reasons (price pops, operational slips, etc.), I bought a number of positions in the past quarter. They are all listed below. I also included links to my brief write-ups on each position, explaining why I found the idea attractive.

They check all of my boxes: (1) statistically cheap, (2) clean balance sheet, (3) poor sentiment, (4) potential for improvement.

  1. Ultra Clean Holdings
  2. Big Lots
  3. Jet Blue
  4. Aaron’s 
  5. Unum Group
  6. Argan

Macro

I’m fully invested, which makes me nervous when U.S. stocks are as expensive as they are. I’m trying as hard as possible to ignore macro stuff and stick to buying undervalued stocks.

Now I’ll proceed to look at it anyway.

allocation

For US stocks, the average investor allocation to equities stood at 42.82% at the end of Q1 based on the latest data. That’s a slight improvement from 43.63% at the end of Q4 2017. This suggests a 3.2% rate of return from US stocks over the next 10 years. This is the same as than the 10-year treasury yield (3.2%) but much less than the current yield on AAA corporate bonds (4%).

Bottom line, the market is expensive. That should be news to no one. That doesn’t mean it’s going to crash. That doesn’t mean we’re going into another Depression. It means they’re expensive and returns are going to be fairly low over the next ten years. The road to those returns is unknowable.

Expensive markets don’t crash just because they’re expensive. Usually, there is an event that triggers the sell-off. Usually, the event is a recession. I think about rich valuations in the sense of “the bigger they are, the harder they fall”. To fall, you still need something to push you.

The most common cause of a recession is the Fed tightening too much, which is why the yield curve is a useful indicator. The 2 year vs 10-year yield curve still hasn’t inverted, implying that a recession is not imminent. We’re likely entering a very juicy stage of the business cycle (think 1969, 1989, 1999, 2006).

yield

There also hasn’t been an uptick in unemployment, another indicator that a recession is about to begin. Unemployment continues to drop. With a tight labor market, some employers are experiencing inflationary pressures (Eric Cinnamond mentioned others on “the investor’s podcast”). This suggests to me that the Fed won’t stop tightening and at some point, they’re going to push the yield curve into an inversion and trigger a recession.

unemployment

Nonetheless, the fact that I don’t expect a recession in the next year makes me comfortable with the fact that I’m fully invested and have positions in some deeply cyclical industries. The market could easily crash 20%, but I don’t think we’re going to see a really nasty recession that would trigger a 50% drawdown in the next year.

Random

1. I saw “Solo” and didn’t understand the criticism of it. It was fun and it checked off on all the fan boxes: we saw how Han met Chewie, how Han obtained the Millennium Falcon, etc. We even saw the Kessel Run! It was certainly better than “The Last Jedi”. My suggestion is to not listen to the haters and see it.

2. I hope Gamestop gets bought out. This has been one of my long-suffering positions and there are signs on the horizon that the situation is improving.

3. Argan is the position I am most excited about. It certainly seems like a “no-brainer” at this valuation and considering the quality of the company. Still, I’m trying to keep an equally weighted 20 stock portfolio and I am not taking a position that is too concentrated. We’ll see if I come to regret that.

5. My day job has been pretty hectic this quarter but it seems to all be working out. I work in operations for a bank. I was promoted last December to a section manager role and faced an internal audit and headcount exodus right after getting the job. I was able to hire new people who are working out well and I received news this week that I passed our internal audit, which was a relief. I hope the rest of the year is a smoother ride now that those hurdles are gone.

6. My personal highlight of the last quarter was taking a week off of work, going to the beach, and spending my time reading “Margin of Safety” by Seth Klarman. Good times.

7. I also caught a couple of really good under-the-radar movies. Thoroughbreds was a really twisted tale that you should check out. It was unlike anything I’ve ever seen before (American Psycho for rich entitled high schoolers?) Just don’t expect to feel good about human nature when it’s all over. I also really dug Lady Bird, a funny movie about a high school senior in 2002 plotting to get out of Sacramento and go to college. That was actually a feel-good movie. I recommend it!

8. Deutsche Bank really worries me. The bank looks like it is in a slow-motion collapse. It’s one of the biggest banks in the world and I don’t know how the global economy would handle it if the bank fell apart.

9. I’ve really been enjoying the Focused Compounding podcast with Geoff Gannon and Andrew Kuhn. They avoid a lot of the trendy topics that are geared towards big investors that seem to dominate the podcast landscape these days (sorry guys, I don’t care about venture capital or angel investing because I’ll never be able to do it and I think most of them are lucky gamblers anyway). They focus on individual stocks and situations that small investors can take advantage of. This one and “The Investor’s Podcast” are my go-to’s. I look forward to listening to them whenever they pop up in my feed.

10. Politics is nauseating and it is getting worse. When I was in my 20s, I loved politics. I was a news and political junkie. That hasn’t been the case for most of the last decade. It’s becoming increasingly impossible for people to empathize with the opinions of others. This is very apparent on Twitter and I follow people on both sides of the aisle. Everyone thinks the other side isn’t just wrong, they’re evil and need to be destroyed. All of this anger and vitriol isn’t good for people’s state of mind. Both sides have a mob mentality. I don’t know how we’re going to snap out of it. To paraphrase Charlie Munger, ideology is turning our brains into mush.

11. Last, but not least, Captain Kirk’s finest hour.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Ultra Clean Holdings Inc. (UCTT)

chip

Key Statistics

Enterprise Value = $556.88 million

Operating Income = $97.56 million

EV/Operating Income = 5.71x

Price/Revenue = .62x

Earnings Yield = 14%

Debt/Equity = 13%

The Company

Ultra Clean Holdings, Inc. is a small but global player in the semiconductor industry. They sell equipment used to manufacture semiconductors. This includes things like precision robotics, gas delivery systems, wafer cleaning, chemical delivery, and a variety of other tech that I have a limited understanding of. What I do understand is that the semiconductor industry is booming, Ultra Clean is at a dirt cheap valuation, and they’re a key player in creating the technology used in the manufacture of semiconductors.

Sentiment

The stock is down 9.2% over the last year. While the decline was only 9.2% over the last year, this ignores the wild ride. From June 2017 through the October 2017 peak, the stock rallied from $18.75 to a peak of $33.60, at which point the stock declined 49% to its present levels.

Why did the stock endure such a decline? Mainly, a series of earnings reports created doubts that Ultra could maintain its high level of recent growth. A 2 cent earnings miss in October 2017 triggered a 27% selloff. A 1 cent earnings miss in January caused another 34% drop. While earnings missed slightly, revenues increased by 42% year over year in the January earnings report.

My Take

I typically avoid stocks in rapidly growing industries. Growth tends to fall apart as a rule of nature. Contrary to popular sentiment, capitalism and the price system actually work. Growth is also usually rewarded by rich valuations because investors extrapolate the present into the future. For that reason, growth is rarely worth paying a premium for unless you have unique insight into why the growth will persist.

With that said, the EV/OpIncome 5.7x valuation of Ultra is simply too cheap to ignore. I’m not paying anything for the growth rate. Ultra is priced like one of my failing retail stocks that are getting crushed by competition with Amazon. In contrast, this is a company that grew revenues by 64% in FY 2017 compared to FY 2016. The growth is continuing, with the recent year over year quarters showing a 42% gain in revenue. The minor earnings slips look to me like they are simply a result of expenses that are necessary to keep up with the torrid pace of business growth. Cap-Ex increased from $7 MM in 2016 to $16 MM in 2017. Research & development increased from $9 MM to $11.6 MM. COGS went from $475 MM to $756 MM. While the growth in expenses is high and is leading to some minor earnings volatility, they seem to be growing organically with the growth of the business. Managing expenses in a business that is growing by 40% is a hard task. Of course, Wall Street is demanding and unforgiving boss.

This is a situation where minor earnings volatility is leading to roller-coaster stock price volatility and an opportunity for value investors.

The risk here is that the demand for semiconductors falls apart. I have zero insight into whether the demand will continue to grow at its torrid pace, but I do notice that semiconductor demand is tied closely to global economic growth, which doesn’t show any signs of letting up at the moment. With that said, at a debt to equity ratio of 13%, $162 MM in cash compared to $55 MM of debt, Ultra doesn’t look like a company that will fall apart once the demand cycle for semiconductors inevitably falls.

If semiconductor demand continues to be strong, slightly better expense management should cause an EPS beat, which could send the stock back to a reasonable valuation and its 52-week high. The 52-week high was $33, which would be a 100% increase from present levels. The 5-year average P/E is a very high 37x. Currently, the stock trades at 7x. Even if the stock increased to a multiple of only 20x, this would be an increase of 185%.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

Big Lots (BIG)

biglotselkton

Big Lots in Elkton, MD

Key Statistics

Enterprise Value = $1.859 billion

Operating Income = $274.5 million

EV/Operating Income = 6.77x

Price/Revenue = .32x

Earnings Yield = 10%

Debt/Equity = 25%

The Company

Big Lots is a large discount retailer. They operate 1,400 stores throughout the continental United States along with a smaller operation (89 stores) in Canada. Big Lots sells everything from candy to furniture, all at a steep discount. Traditionally, Big Lots acquired their inventory by taking advantage of closeout situations. A closeout is a situation where a major vendor wants to bulk dump the last of their inventory on a firm like Big Lots. Big Lots buys the inventory in bulk (it can be completely random – like Keurig machines or inflatable pools) at a steep discount, and they sell the items to their customer at a low price.

This isn’t the only way that Big Lots acquires inventory, but closeouts have traditionally been the core of their business. Their big sales on closeout items are typically what attract customers to the store, who also make impulse purchases on goods that aren’t as attractively priced. Quickly perusing deals on their website, you’ll see that they frequently sell goods at a discount to both Wal Mart and Amazon.

Inventory management and ability to secure merchandise deals are a major part of their business. They have a long track record of successfully navigating this difficult industry, with the business dating back to 1967.

Sentiment

The stock is down 12.8% in the last year and is 35.9% off its 52-week high which was reached in January of this year. The stock is afflicted by the “retailpocalypse” sentiment. At the first sign of trouble, retail stocks are absolutely crushed in this environment.

The past two earnings reports were greeted with horror by Wall Street, hence the steep discount from the 52-week high and ultra cheap valuation. In the most recent earnings report, earnings were down 39% from the same quarter a year ago. Revenue was also slightly off.

My Take

Big Lots is priced like a business that is in severe distress even though it isn’t. Wall Street overreacted to the recent earnings reports just because they are on high alert about any minor hiccup in the retail sector. It’s a good company in a hated industry.

At the current P/E of 10.41, if the stock returned to its average valuation over the last 5 years (16.41), it would be a 57% increase from current levels. For what it’s worth, management expects to earn $4.50 per share this year, which is pretty close to what it made last year. They are not warning of significant deterioration. If the business situation improved just a little bit, I don’t see why the stock couldn’t return to its average valuation multiple.

One of the major risks facing Big Lots is a trade war. They are heavily dependent on cheap goods from overseas markets to support their pricing model. If a trade war truly did happen, Big Lots would be harmed. At the moment, the threats going back and forth between the United States and China seem small and are likely posturing.

Interestingly, Big Lots actually delivers higher returns on capital than its biggest competitor, Wal Mart. Big Lots earned a 10% return on assets, compared to Wal Mart’s 4.43%. Wal Mart’s operating margin is presently 4.3% compared to Big Lot’s margin of 5.24%. Indeed, Big Lots is hanging in there and doing well even though it is competing with brutal competitors: Wal Mart, Amazon, and dollar stores.

There are also no signs of financial distress: they have a 25% debt-to-equity ratio, an F-Score of 5 and Altman Z-Score of 6.88. The decline in the stock seems driven solely by a minor drift down in performance, nothing major.

Like Aaron’s, I think Big Lots is a company that should benefit at this point in the economic expansion. Discount retailing is an industry that should thrive as the lower and middle class begin to feel more confident about their jobs and spend more money on discretionary items.

PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings.  Read the full disclaimer.

I am a value investor. My outlook is inspired by the ideas of Benjamin Graham. This site is a real time chronicle of my portfolio and an outlet to share my ideas. I hope you enjoy.