All posts by valuestockgeek

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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.

Domtar (UFS)

paper

Key Statistics

Enterprise Value = $3.014 billion

Operating Income = $454 million

EV/Operating Income = 6.63x

Earnings Yield = 13%

Price/Revenue = .4x

Debt/Equity = 37%

The Company

Domtar is a paper company. They sell paper products, like copy paper. They also sell personal care paper-based products, like diapers and toilet paper. They are the largest manufacturer of freesheet paper in North America, operating 10 paper mills that produce 3 million tons of uncoated freesheet paper per year. 77% of their production is in the US and the rest occurs in Canada. They also produce 1.8 million tons of pulp per year, with production also divided between the US and Canada. Pulp is derived from separating fiber from wood, which is a raw material used to make a variety of paper products.

The 52-week high for Domtar is $53.89 and a return to these levels would represent a 54% increase in the stock price. The stock is under pressure for the typical small cap value reason this year: trade jitters. Domtar has most of their production operation in the United States and they sell overseas. 58% of their pulp revenue, for instance, is derived from foreign markets. This makes them sensitive to the worries about trade, tariffs, and Trump tweets. The strong US dollar has not helped the stock, either.

At current levels, it is cheap by every measure. EV/EBIT is 6.63x, price/sales is .4x, it is below book value, it is only at 108% of tangible book value, and it is trading at 3.8x cash flow.

My Take

I like boring stocks, and it doesn’t get much more boring than copy paper, tissues, and toilet paper.

This is a stable, mature, company that is not growing significantly, which is why the stock boasts a high dividend yield. For the last 10 years, revenue has floated around $5 billion to $5.8 billion. It has consistently made money for each of the last 10 years, with the exception of 2017, a year in which they lost $4.11 per share. Even though they lost money that year, it was not tied to the actual performance of the business. This loss was related to the change in the tax law that year and was a one time expense. This year, the trade war hasn’t significantly impacted the actual revenues, earnings, and cash flows of the company. The movement in the stock looks to me like an overreaction to the scary headlines.

At some point, this trade war is going to be resolved. My expectation is that once that happens, regardless of the actual outcome, stocks like Domtar will rally just because it’s over with. The market just needs a resolution. It doesn’t even have to be a good resolution. This might seem endless, but at some point, this will go away one way or another.

Domtar’s core, boring, business is not going anywhere or changing any time soon. Diaper use isn’t going to decline because of a trade war tweet. Diapers can’t be disrupted by some money losing startup backed by venture capital cash. In fact, adult diapers are likely a growth industry considering the fact that the senior population globally will continue to expand as life expectancy increases. Copy paper isn’t going anywhere, either. People have been talking about paperless offices (Captain Picard only used his iPad with the LCARS O/S) since I was a kid and paper doesn’t seem to go away. The persistence of the paper market is reflected in Domtar’s stability in earnings and cash flow.

Meanwhile, while I wait for the stock to snap back to a normal multiples, I will be paid a nice 5.22% dividend yield. Domtar’s strong free cash flow also suggests that this dividend can be sustained.

Like everyone else, I am worried about the probability of recession, so I considered Domtar’s performance during the last crisis before I purchased the stock. Domtar continued to earn money during the last recession, making a profit of $3.59 per share in 2009. The stock reacted more violently than the actual business to the recession, falling from $100 per share to $30. I don’t think this will happen again if we face another recession because Domtar is much cheaper today than it was back in 2007. Going into the last recession, Domtar traded at a much higher valuation. In 2007, it traded at 1.5x book value and today it trades at .84x book. Going into that crisis, Domtar was also much more leveraged with a debt/equity ratio that was over 100%. Today, debt/equity is only 37%.

Domtar has a high degree of financial quality. The Altman Z-Score of 2.34 implies that the company is not in distress. The Piotroski F-Score of 7 also exhibits a high degree of financial strength. The debt/equity ratio of 37% is also at a low and safe level. The Beneish M-Score of -2.68 implies that the company is not an earnings manipulator.

Domtar trades at a discount to its competitors and its history. The current P/E of 7.74 compares to a 5-year average of of 14 for the stock, which seems right for a mature company that isn’t expected to change much and pays a high dividend yield. An increase to this level would be an increase of 80% in the stock price. The average P/E for the industry is 16.45. The current EV/EBIT multiple of 6.63 compares to a 5-year average of 14.16 for the stock. On a price/sales basis, the current .40x level compares to an industry average of .63x and a 5-year average for Domtar of .50x.

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.

Insight Enterprises (NSIT)

8675309

Key Statistics

Enterprise Value = $2.135 billion

Operating Income = $243 million

EV/Operating Income = 8.78x

Earnings Yield = 9%

Price/Revenue = .27x

Debt/Equity = 45%

The Company

Insight Enterprises is an Arizona-based tech company founded in 1988. They operate globally, but their focus is on North America, where 76% of their sales originate. They provide tech solutions to business clients that run the gamut: supply chain optimization, connecting workforces, cloud and data centers, and the vague “digital innovation.”

Insight provides tech solutions for businesses, so they don’t have to do all of the work themselves. A company can pay Insight Enterprises, and procure their hardware, software, set up a secure cloud, set up remote work for their employees to collaborate, etc. If you’re running a large, complex, organization – it can be extremely costly to figure out how to complete all of this from scratch. It’s far more efficient to hire an expert like Insight to do it all for you.

Supply chain optimization is a service they offer to businesses to deploy hardware and software for the client. The procure and configure hardware and software for companies. Connected workforce translates to helping companies operate on the cloud, encourage employees to work on multiple platforms. Insight also provides security for these solutions. Businesses come to Insight with tech problems, and Insight offers solutions. For their cloud solutions, they provide robust security services and infrastructure management.

Digital innovation is a custom tech consulting service. Clients can go to Insight with a unique problem and see if Insight can develop a tech solution. For example, Insight can help if you’re running a hospital and need a system to predict how many nurses you need on staff in different specializations and at different times of the day. They’ve helped railroads use drones to inspect trains faster and with less staffing. Additionally, they have developed automated drilling platforms for oil & gas companies. They’re a creative and innovative firm that can deliver real value to their clients, providing solutions that they likely wouldn’t be able to develop on their own.

To stay on the cutting edge, Insight acquires smaller firms that offer value to their clients. Insight has grown immensely through acquisitions. A few recent acquisitions include Cardinal Solutions in 2018, Datalink in 2017, Blue Metal architects in 2015. Recently, they announced their intention to buy PCM for $35 a share, or $581 million. PCM generates over $2 billion of sales, so it doesn’t look insane.

The stock suffered over the summer due to its place in the small-cap value universe and a slightly disappointing earnings report which showed some temporary rising costs related to the Cardinal acquisition.

My Take

Insight is a fast-growing company in a hot industry with a strong financial position that trades for very cheap multiples.

Their 10k is replete with buzzwords that usually make roll my eyes: Big data! Software as a Service! Internet of things! Cloud computing! Artificial intelligence!

Insight is at the cutting edge, and the company is a departure from my typically un-cool focus on dull and trashy industries. Don’t worry. I haven’t sold out: selling for 27% of sales and 9x cash flow, this is in the bargain bin of the stock market, despite Insight’s position in a fast-growing hot industry.

Insight Enterprises has a long and profitable history. The company has been consistently profitable over a long period. Insight even recorded positive earnings in 2009, in the depths of the global financial crisis.

Meanwhile, they have been able to grow sales and earnings throughout the economic expansion. EPS increased from 67 cents per share in 2009 to $4.55 in 2018. Sales growth has been similarly strong, growing from $4.1 billion in 2009 to $7.08 billion today.

Insight has a higher degree of financial quality with a Piotroski F-Score of 6, an Altman Z-Score of 3.48 (low bankruptcy risk), and a Beneish M-Score of -2.14 (not a probable earnings manipulator). The debt/equity ratio is current 45%, which is also at a safe level. The share count is down over the last year, so they are not diluting shareholders.

Insight trades at a discount to its competitors and its history. On a price/earnings basis, the current P/E of 11 compares to a 5-year average of 14.4. The average for the industry is 22. On a price/sales basis, the current level of .27x compares to an industry average of 1.45x.

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.

Bank OZK

summer

Key Statistics

Price/Book = .91x

Earnings Yield = 11%

Dividend Yield = 3.4%

Debt/Equity = 12%

The Company

Bank OZK (formerly Bank of the Ozarks) is a regional bank headquartered in Little Rock, Arkansas with a substantial presence in the southern United States. The bank has grown significantly over the last 25 years, growing from 4 locations in 1994 to 251 today. Their business is focused mostly on real estate.

Growth has been both organic and through the acquisitions of smaller banks. Some of the banks acquired in the last five years include: First National Bank of Shelby (North Carolina), Bancshares Inc. (Houston), Arkadelphia (Arkansas), Intervest Bancshares Group (Florida). The bank is growing aggressively through acquisitions, but is largely maintaining their southern presence. I think this is a smart move, as this includes some of the fastest growing states in the country.

My Take

I discovered Bank OZK when I was looking for regional banks below book value that were well capitalized with easy to understand businesses (as opposed to the massive, global, banks – which I don’t even think the CEO’s completely comprehend).

Right now, the major macro worry about banks is that we might be on the brink of another recession. Everyone remembers how banks fared in the last recession, so investors are proceeding with massive amounts of caution. OZK has a concentration in real estate loans, and memories are also fresh of that debacle. OZK suffered a peak to trough decline of over 50% during the last crisis.

While Bank OZK suffered a significant stock decline during the financial crisis, the actual business weathered it well. In 2009 during the depths of the recession, OZK earned a profit of 55 cents per share. This was during a time when most banks were suffering massive losses. Meanwhile, the company is much better capitalized than it was going into the last recession. Debt/equity was over 250% going into the last recession and it is only 12% today.

Meanwhile, the stock is priced like a recession has already taken place. In 2009, in the depths of the financial crisis, Bank OZK traded at book value. Prior to the crisis, it peaked at nearly 4x book value. Now, the stock is below book value trading at 91%. We aren’t in a recession and this bank is profitable, but the market is treating this stock like we’re already in one.

This is also a company that is undergoing significant growth. Revenues are up 462% since 2009. Dividends are up 515%. Earnings are up 489%. Return on equity is also at a respectable level of 10.89%. Meanwhile, the bank doesn’t appear to be obtaining these results with higher amounts of risk taking, with a very low debt/equity ratio. I don’t see why they won’t be able to continue growing into the future and maintain their current returns on equity. The bank also sports a nice dividend yield of 3.4%.

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 2019 Performance

q2

Performance

It wasn’t a bad quarter. I slightly underperformed the S&P 500, and I have a very slight edge YTD.

This doesn’t sound like much of an accomplishment, but I’m pleased with it considering the way that small-cap value was absolutely crushed in Q2.

VBR, Vanguard’s small-cap value ETF, was up 17.83% on May 3rd for the year. It is now up only 13.96%.

VBR is the scaled-back softcore version of a small-cap value fund. It delivers the small cap value premium and outperforms, but it’s watered down so it is easier to stomach than the real thing. The median P/E for VBR is 14.4 across 847 stocks at an average market cap of $3.4 billion.

The more hardcore, concentrated, deep value funds were absolutely crushed in the 2nd quarter. QVAL, for instance, was up at the peak of 19.31% YTD in April. It is now up only 10.31% YTD.

Looking at the universe of stocks that trade at an EV/EBIT multiple less than 5, they were up over 20% in February. The rally then completely fell apart once the yield curve inverted and the trade war heated up. This universe of stocks is now up only 2.91%.

I’m happy I avoided the same fate.

Trading

I would have suffered the same fate, but I sold a significant number of stocks at the high. I sell for five reasons:

(1) The stocks are back up to their typical valuation ratios. If I bought a stock at a P/E of 10, hoping it would get up to 15, I’ll sell when it gets close to 15. I’m not buying stocks to hold onto them for decades of earnings growth. I am buying undervalued stocks and selling once they hit intrinsic value.

(2) The positions are over a year old, the story has changed, and I can find more appealing buys.

(3) The stocks have rallied back to their 52-week high.

(4) The fundamental results of the company are deteriorating and signaling that it is a value trap.

(5) A change in the news around the stock affects the entire reason I bought it.

Here are all of the stocks I sold this quarter:

Q2sells

It felt wrong to trade so much, but the market move was nothing normal, just like the move in December was not normal. The inversion of the yield curve also spooked me. I am a bit more trigger happy to sell, as I think we’re on the brink of a recession soon.

I think that the market is going to get crushed once we have a recession, and small-cap value won’t be a place to hide. After that, I think small-cap value is going to have a strong run of out-performance. I don’t feel that we’re in a place where I can buy value stocks and stop looking at it. This isn’t an environment where I can set and forget a portfolio, as I believe we’re on the brink of a big move to the downside. I might be wrong, but I think we’re at a dangerous juncture.

At one point this quarter, I was 50% cash. Regardless of how wrong it felt to sell a bunch of stocks after only holding them for a few months, it turned out to be the right move and helped me hang onto the gains I had accrued YTD.

With the cash, I slowly deployed it into many new cheap positions. Most of these stocks have been hammered over trade war anxiety. New positions and links to the write-ups are below:

1. Hooker Furniture

2. Flanigan’s

3. Hurco

4. Miller Industries

5. Schnitzer Steel

6. Twin Disc

7. ArcBest

8. Preformed Line Products

9. Werner Enterprises

10. Weyco Group

Trade War

Nearly all of the stocks that I bought this quarter are cheap because of two main concerns: (1) They’re in economically sensitive industries, and the markets are concerned about a recession, (2) They’re vulnerable to the trade war.

I actually agree with the market’s concerns about a recession, which has me concerned. Whenever I agree with the consensus, I second guess my opinion.

As for the trade war, I think it has been a ridiculous overreaction. According to the US Census Bureau, the US exported $120 billion worth of goods and services to China in 2018. We imported $539 billion. Those are big numbers, but they aren’t really a big deal in the grand scheme of things. US GDP is $19.39 trillion. Imports from China represent about 3% of our GDP. How much will that decline as a result of the trade war? Let’s say it’s 20%, which seems extreme. That amounts to .6% of our GDP. And we’re not going to lose .6% of our GDP. The slack will likely be picked up elsewhere.

I’m a free trader and think trade is good for our country and the world. It saddens me that the Republican party, which used to the champion of free trade, is now abandoning that position. At the same time, I like the fact that a bunch of people who hated free trade now comprehend that tariffs are a tax just because Trump articulated a protectionist position. In terms of my own views on trade, I agree with every word of this.

While the rhetoric is bad and I disagree with it, I think the retreat from free trade will wind up being more rhetorical than anything that translates into actual policy. It’s all a bunch of posturing and bravado, like everything else in our political system.

This creates an opportunity for value investors who are willing to buy into this uncertainty. One way or another, this trade war is going to be resolved. It’s either going to result in the worst case scenario, or we’re going to reach some kind of deal. Either way, once the uncertainty is lifted, I think these stocks will do okay.

The ultimate worry for the market is something like the Hawley-Smoot tariff. Years ago, I read in Jude Wanniski’s The Way the World Works, that nearly all of the market moves during the 1929 stock market crash were tied to headlines about the trade war. The specter of this tariff hangs over the market, but I don’t think we’re facing anything of that severity today.

(Ben Stein covered the Hawley Smoot tarriff better than anyone in Ferris Bueller’s Day Off.)

Regardless of how much the Trump administration tries to put the genie of globalization back in the bottle, it’s a fool errand. We’re too dependent on trade, and the long-term trajectory of the human race is to trade with each other. Think about it. It’s a natural evolution. The entire trajectory of human civilization has been towards more integration, more trade, more specialization.

We all started off as a bunch of naked hunter-gatherers in little clans struggling to survive to 30. We had to do everything on our own. We would hunt our own meals. The outside world was dangerous. We went from these small clans to villages. People start to form specializations. With agriculture, this intensifies. Some people work in the fields, others hunt. Eventually, we raise our own livestock. We start to form larger communities of villages, then nations. With the advent of industrialization and mass communication, we become more integrated. With Moore’s law barrelling along and making communication nearly instantaneous throughout the world, we become more interconnected. People like Trump and Bernie Sanders can try hard to put this genie back in the bottle and try to embrace economic isolationism, but they’re fighting a losing battle against the long term trajectory of human civilization.

To put it in perspective, the Hawley Smoot tariff took the average tariff from around 5% to 20%. This, without a doubt, intensified the effects of the Great Depression. From that peak, it has plummeted ever since. That’s not going to stop. I don’t care how hard they try.

I’ve gone a little off track. To put it simply: I think the trade war is overblown and is an opportunity for investors.

As far as stocks that have been hammered over recession anxiety, I own them because they trade like the recession is already priced in. Forgetting about single digit P/E’s (P/E can be misleading at a cyclical peak), even on the basis of Price/Sales and Price/Book, they’re at some of their lowest levels in a decade. This suggests to me that a recession is already priced in, which is why I’m willing to take the risk and buy them.

Recession Watch

As stated before, I think we’re due for a recession, which is why I have been trigger happy to sell once stocks hit my target price. If the market enters a bear market, it’s going to occur because of real recessionary weakness in the economy, not Trump’s trade rhetoric.

It’s also a significant reason I’m holding a little cash ready to go. Right now, my cash balance is $10,898, which represents 20% of my portfolio. Some of this is CD’s, which mature throughout the year. A bunch of them also mature in December when I typically do a big rebalance, but I can get out of them if the market crashes and serves up a nice opportunity.

The Fed is signaling that they are cutting, but they are effectively tightening. They still haven’t cut rates, and the balance sheet is still shrinking. I don’t think it’s a coincidence that much of the volatility and trouble in the markets began in early 2018 when they started really reducing the balance sheet in earnest.

tight

Meanwhile, the 3-month and 10-year bond yields have inverted, which is always an indication that a recession is occurring in the near term. Everyone is making excuses for why “this time is different,” but those are the most dangerous words in finance. There is always an explanation for why the yield curve doesn’t matter every time it inverts. In the late ’90s, for instance, the explanation was that the US budget surplus caused the inversion. In 2006, it was the “global savings glut.” There’s always an excuse, and it’s always wrong. We’ll just have to wait and see, as no one has a crystal ball, but my thinking is that we’re getting a recession.

average

I think this recession will create a significant opportunity for investors. Right now, the average investor allocation to equities is at 43%. This suggests a return over the next 10 years of 4-5% in US equities. That’s better than we can get in bonds, but it’s nothing particularly exciting. If stocks have another big rollover, I’m hoping for an opportunity to buy at much more attractive valuation.

Writing & Research

I was busy this quarter tinkering with some fun research of my own.

1. Is Diversification for idiots?

One of the biggest questions for value investors has been the correct number of stocks to own in a portfolio. Concentration is in vogue among value investors, but from a quantitative point of view, 20-30 stocks is ideal.

Each additional stock in the portfolio helps reduce volatility and cushion maximum drawdowns, but each additional stock in the portfolio has a declining marginal benefit in reducing volatility.

The volatility & drawdown reduction is maximized around 20-30 positions. Beyond that, adding more stocks is a waste of time and doesn’t do much to reduce risk. The ideal portfolio seems to fall somewhere in the 20-30 range. Ultra concentrated portfolios, while they offer the opportunity for substantial out-performance, run an equally high risk of a major blow up.

It sounds nice to say: “I concentrate in my best ideas.” How did that work out for Bill Ackman when he piled into Valeant or his Herbalife short? Are you smarter than Bill Ackman? I think Bill Ackman is a genius. I’m certainly not smarter than him.

Because I have strong doubts about the ability of anyone to predict the future, I think concentration is really dangerous, no matter how much homework you do or how much you think you know. Even the most stable, sure-thing investments can fall apart with a law, a new technology, an upstart competitor, a scandal. Concentration is Russian roulette for a portfolio.

At the same time, you don’t want to dilute the potential for outperformance too much. The difference in terms of volatility doesn’t change much between 30 stocks and 100 stocks in a portfolio. 20-30 seems to be the sweet spot.

I think survival is more important than outperformance, which is why I prefer a portfolio of 20-30 stocks. A portfolio of this size still offers an opportunity for outperformance, but greatly reduces the possibility of a blow up.

2. The Value Stock Geek Asset Allocation

The portfolio I track on the blog doesn’t represent all of my money. The rest of my money is held in more diversified asset allocations.

I’ve been on the hunt for an ideal asset allocation for a long time. Of the existing menu of choices, the one I like best is David Swensen’s, which I wrote about here.

As much as I like Swensen’s approach, I didn’t agree with it completely, so I set out to design my own strategy. My asset allocation strategy isn’t for everyone, but it works for me. It almost delivers an equity return, avoids lost decades, cushions against panics, and protects in inflationary environments.

Random

Here is some ’80s ear candy.

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.