Q3 2019 Update

Performance

q3

My performance has essentially matched that of the S&P 500 year to date.

In Q2, I moved to nearly 50% cash after many of my stocks hit my estimate of their intrinsic value and a few of them exhibited some operational declines (bottom line earnings losses, major declines at the top of the income statement).

I was also spooked by the yield curve inversion. I’m still spooked by the yield curve inversion. I believe a recession is coming and I suspect a lot of my highly cyclical stocks will suffer in this event, hence the fact that I’m trigger happy to sell.

At the same time, I feel compelled to go where the bargains are, so I continue to own these cyclical names. I realize that P/E can be misleading at the peak of an economic cycle, as the E reflects peak earnings. With that said, even when I look at some of these stocks on a price-to-book or price-to-sales basis, some of them trade at levels they last experienced in 2009. It’s like the recession is already priced into them. The prices don’t make sense, therefore, I feel the need to own them.

Here is a breakdown of the current valuation metrics on some of my cyclical names. They seem absurdly cheap to me, which is why I own them even though I have a fairly grim assessment of the macro picture right now.

psales

The compromise I’ve settled on in this environment is to sell aggressively when the companies reach my conservative estimate of their value or when they experience an operational decline, all while holding cash instead of remaining fully invested.

Be Fearful When Others are Greedy

Warren Buffett likes to say “be greedy when others are fearful, and fearful when others are greedy.” That’s a great saying, but it’s one that is hard to implement in practice. Buffett also advises against timing the market, but this quote is implicitly a market timing suggestion. To be greedy when others are fearful, you need to actually have cash on hand to buy from the fearful. To be fearful when others are greedy, you actually need to sell to the greedy people. If your investment philosophy is buy-and-hold no matter what, then I don’t see how you could implement Buffett’s advice.

Buffett’s advice to not time the market also flies in the face of his own actions. Berkshire currently has $122 billion in cash. This is market timing. Buffett will say that it’s not timing and there aren’t any large deals or bargains that he can buy. The truth is that there aren’t any large deals or bargains because we’re at the peak of an economic cycle and people are overpaying for good businesses.

Buffett knows this. A good example of his knowledge on this subject is his speech at Sun Valley in 1999, which you can read here. He gave this speech during a time of buoyant optimism about the stock market. I was only in high school, but I remember clearly that every restaurant always had a TV tuned to CNBC, as a parade of “analysts” hyped up their latest bubble pick of the day. It’s the reason I became interested in the market in the first place at an early age. Buffett challenged the euphoria and boiled down his analysis to cold, hard facts: the direction of the stock market depended on how much corporate America could scoop up in profits from the US economy, how the market valued these companies relative to the size of the economy, and the direction of interest rates.

As a valuation metric, Buffett discussed US stock market capitalization to GDP, which was at all time highs back then. Right now, we’ve exceeded the previous late 1990s high. It certainly seems to me to be a good time to be fearful when others are greedy and keep some cash on hand to take advantage of a downturn.

I think Buffett is reluctant to directly criticize present valuations because of his stature in the markets. His words could cause a stock market crash. He’s a lot more famous now than he was in 1999, after all.

market cap to gdp

Value’s Wild Ride

The move to cash turned out to be an opportune one. Shortly after this occured, value was crushed in Q2. Vanguard’s small cap value ETF (VBR) suffered a 8.13% drawdown. SPDR’s S&P 600 small cap value ETF (SLYV) suffered a 9.92% drawdown. Finally, QVAL, one of the most concentrated value ETF’s suffered a 13.99% drawdown.

I avoided much of this drawdown, which is why I’m doing better than the value ETF’s year to date. This is why matching the performance of the S&P is a decent outcome this year.

With that said, I probably got lucky. The market sold off over worries of the trade war, not an imminent recession. Whatever the reason, I’ll take the outperformance over other value strategies.

Year to date, VBR is up 14.55%, SLYV is up 15.23%, and QVAL is up 12.70%.

Of course, this year to date performance obscures some of the tremendous volatility that occurred this year.

Below is the performance of these three value ETF’s for the past year:

value

As you can see on the chart, in early September there was a major move that benefited cheap investors.

I am currently 80% invested, but I also took part in this swing. My portfolio had a 9.5% swing in value from the August lows to the September peak.

I have no idea what caused the move. This could be turn out to be a head fake. A similar move occurred in late 2016 after Trump won the election, as investors anticipated a big infrastructure bill and tax cuts (Oh, we were so young), which was supposed to benefit more cyclical cheap stocks.

Trading

I sold two positions this quarter.

  • Twin Disc (TWIN) – I exited this position with a 34.29% loss after they reported a loss and it looked to me like the business was deteriorating. I exited the stock at a price of $10.0608.
  • Winnebago (WGO) – I am trigger happy to sell cyclicals once they hit a reasonable price. I sold Winnebago at a price of $39.8777 for a gain of 21.31%. This was around the price that Winnebago traded at last summer before the declines in Q4 2018. Once the market began worrying about a recession in Q4 2018, the stock dropped down to $24. Now that the stock is back to where it was when there was a “healthy” economic outlook, I got out of it.

I bought a few positions this quarter. Below are the companies and links to my reasoning for why I bought them.

  • Bank OZK. A regional bank trading below book value.
  • Insight Enterprises. A fast growing tech company at a cheap valuation.
  • Domtar. A stable, boring, mature, company with a single digit P/E and a 5.2% dividend yield.

Macro

I still have nearly 20% of my portfolio in cash and CDs that mature in December, when I conduct my annual re-balancing of the portfolio.

Despite the recent stock rally, the yield curve remains inverted. This is a signal that predicts every single recession. Each time, we’re told it doesn’t matter. All of the talk about why the yield curve doesn’t matter strikes me as wishful thinking. I’m guessing that the rule works better than the analysis of the talking heads who tell us it doesn’t.

My thinking about the yield curve is quite simple: it’s a measure of how accommodative or loose monetary policy is. Monetary policy is the key determinant of the direction of the economy.

A steep yield curve tells you that the Fed is pouring stimulus into the economy and the markets. It is a poor idea to fight this and take a short position in the markets when that is going on. Meanwhile, an inverted yield curve tells you that the Fed is too tight with monetary policy and the economy is likely to contract.

What complicates the yield curve as a forecasting tool is that there is a significant lag between the direction of monetary policy and the direction of the economy. After a yield curve inversion, it can take 2 years before the recession begins. The same is true for expansions and a very steep yield curve. The Fed begins accommodating at the first signs of a slowdown. Usually, by the time that they begin loosening, it is already too late. It takes a year or two for their stimulus to begin affecting the actual economy. The Fed was already ultra accomodative in 2008, for instance, but it was too late and the recovery didn’t begin until the second half of 2009, about a year and a half after they started cutting interest rates.

Adding further confusion to this is the fact that the market anticipates moves in the economy before they actually occur. This is why the market began rallying in March of 2009 while the economy was still mired in a recession. It’s also why the market began declining in late 2007 when most observers thought the economy was strong.

3month.PNG

The Fed recently cut by another quarter of a point. Some criticize this move as the Fed trying to prop up the markets. Well, of course they are. There isn’t anything wrong with the Fed trying to use market signals to get ahead of a recession. I think that the Fed is also responding to very real data and economic weakness.

I also think that the Fed is likely not cutting enough, which is why the yield curve is screaming at them to be more aggressive.

In fact, while the Fed was talking about loosening policy since December, they were in fact still cutting the size of the balance sheet. They only recently began increasing the size of the balance sheet in September of this year.

fed balance sheet

I listened to a great podcast recently with Cam Harvey and Meb Faber, which you can listen to here. Cam discovered the yield curve tool as a recession forecasting mechanism in the 1980s and discusses why it is a robust indicator.

The market remains fixated on Trump tweets and the trade war, but I think the real story is an emerging US recession. A US recession seems perplexing to everyone involved in the US economy because the US economy looks so strong. Well, it always looks strong at the top.

Meanwhile, declines in the unemployment have flattened. Once the unemployment rate shifts and begins increasing, a recession is imminent. That hasn’t happened yet, but it appears to be flattening. This is typically not a good sign.

unemployment

This might sound crazy when interest rates are this low, but my belief is that the Fed is currently too tight. A nice, simple, way to look at monetary policy is the equation of exchange, MV=PQ. Everyone has scratched their head for the last decade as quantitative easing and ultra low interest rates haven’t fueled a rise in consumer inflation. The explanation is revealed in the equation of exchange. For money creation to result in high inflation, the velocity of money needs to be in a healthy condition. The fact is that money velocity has plummeted since the Great Recession and has not picked up. Low velocity means that monetary policy can be very accomodative without creating inflation.

velocity

It’s really hard for money creation to stoke inflation when people aren’t actively spending the cash at the same levels that they have in the past. This is why I think that even though interest rates look like they are absurdly low, the Fed is actually too tight and they are going to push the economy into a recession.

The Great Question

The great question for value investors is whether this will shake out like the early 2000s or every other recession.

The fact of the matter is that value stocks have under-performed the market throughout this expansion, just as it did in the 1990s. In the 1990s, money poured into hotter, more promising areas of the market and these boring stocks were left for dead.

Eventually, everyone collectively realized that the tech bubble was insane and capital shifted into cheap value stocks. This created a unique moment where cyclically sensitive value stocks increased while the broader market declined, because the broader market was dominated by large cap tech names that were deflating to more normal valuations.

declines.jpg

Value’s wonderful early 2000s run was aided by the fact that the early 2000s recession was so mild. The actual businesses of value stocks continued to generate earnings and profits, so it was easy for these stocks to mean revert. In more serious recessions, like 2008 or the 1973-74, many of these cyclical businesses were undergoing serious problems, which is why the stocks were crushed during those recessions.

A good way to measure the severity of a recession is to look at the maximum unemployment rate. Unemployment peaked at only 6.3% in 2003. In contrast, during the expansion of 2010s, unemployment reached 6.3% in 2014, when we were far along into an expansion.

Right now, we have one ingredient for a value resurgence: value is ridiculously cheap relative to growth. Growth proponents will argue that this is nothing like the ’90s expansion. They cite trashy firms like Pets.com and the money that poured into money losing IPOs. Surely, you can’t say that Netflix is anything like those trashy dot com stocks.

I disagree. I think this moment is a lot like the 1990s. First of all, the 1990s bubble wasn’t restricted to trashy IPOs. It affected large cap names of all stripes, including quality companies like Coca Cola and Microsoft. Earlier, this quarter, I tweeted this out to demonstrate:

spy

It wasn’t all trash. There were bubbles in industrial conglomerates, quality big box retailers, computer hardware manufacturers. The bubble was in large cap quality stocks. Coca Cola even reached bubbly levels back in 1998, around 40x earnings.

You couldn’t get higher quality than General Electric back in 2000, and yet it was ridiculously overvalued and this fueled its decline. It fell from a peak of $50 a share down to $25. In the current era, there isn’t any disagreement that companies like Amazon and Facebook are incredible. That doesn’t mean that they’re not overvalued.

In the 1990s and the 2010s, investors who ignored valuation and simply bought up the best companies have been rewarded. Compounder bro’s are the darlings of the moment. They paid a price in the early 2000s bear market and I don’t see why history won’t repeat itself.

Meanwhile, just because there aren’t a lot of insane IPO’s flooding the market, it doesn’t mean that this market is without insanity. I think the crypto craze is a good example of a classical bubble invaded by charlatans of many different stripes. The venture capital world also appears to be in an insane state. After some early successes in this cycle, they have been gambling on anything that promises to “disrupt” something. At this point, you could probably score capital if you promised to disrupt the soap market. Ali G could probably secure financing for his ice cream glove. It appears that the glow around angels and venture capital is starting to fade, as demonstrated by the recent difficulty with the WeWork IPO. On Twitter, VC’s are fuming that public markets actually care about things like earnings and cash flow. It’s funny to watch. I also can’t roll my eyes any further into my head.

Bears are treated like they are absolute morons, which is how they were treated during the 1990s bubble. Back in 1999, bears all universally looked stupid after being wrong for a such a long and fruitful economic expansion. When the bear market was actually imminent, they were the boy who cried wolf and everyone ignored them.

I think the mistake that bears made is that they thought this market would pop on its own from the weight of valuation. The fact is that a bubble needs a needle to pop, a catalyst. There hasn’t been a catalyst to end the insanity for a long time. I think one is coming, and it’s in the form of a recession.

I think it’s inevitable that this bubble will pop, and value will likely outperform growth over the next decade and valuations mean revert to more normal levels. While growth stocks will return to a normal valuation, multiples will continue changing in the value universe, which is what fuels the idiosyncratic return of value strategies. My thinking for a long time is that this will be more like the 1970s than the 2000s. Value will get crushed, but not as badly as the bubble names, and will then do nicely once the economy begins expanding again.

In the 1973-74 debacle, value was crushed because the economy was crushed. Meanwhile, the Nifty Fifty (the bubble names of that era) were crushed even more because the were so ridiculously overvalued. I think this is likely to happen again.

If the next recession is mild, like the early 2000s, then value will likely have a similar experience. If this recession is severe, like 1973-74 or 2008, then value is going to suffer a decline with everything else. I don’t know which outcome is going to happen, but I think that the 1970s experience is more likely.

We’ll see.

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.