Category Archives: Portfolio Commentary

The Madness of Men

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The Madness of Men

Value investing has been enduring a tough time. This is certainly true for my own portfolio. I’m down 7.72% year to date compared to an 8.34% gain for the S&P 500. It’s times like this that it helps to look to history.

We’re currently in an era where investors are gobbling up growth companies and they don’t care what the price is. I remember the same mood back when I was in high school. People forget, but the bubble wasn’t simply concentrated in dot-com stocks. The bubble was pervasive among even the most stable of blue chip companies: Cisco, Microsoft, Coca Cola.

Going further back in history, the same euphoria characterized the Nifty Fifty era. The Nifty Fifty was a group of 50 stocks in the early 1970s that grew by leaps and bounds in the 1960s. Many of them were exceptional companies (like McDonalds and Xerox), but the euphoria pushed their valuations to extraordinary levels. Predictably, valuations came crashing down and investors were burned.

Taking things back even further, the same mood characterized the South Seas bubble. That bubble was fueled by optimism over the age of exploration and it famously burned Isaac Newton. Newton remarked of the collapse: “I can calculate the movement of the stars, but not the madness of men.”

Every bubble has something in common. There is something new and exciting in the air that promises to change our lives and this fuels speculation. It starts with a truth (i.e., real estate is an excellent investment for the middle class) and then descends into temporary madness. Of course, the market always corrects this madness. Eventually.

During the dot-com bubble, it was the promise of the internet. The internet was going to transform the way we live and everyone could see it . . . so, Cisco Systems was valued more than General Electric and Pets.com was a thing. They were right about the promise of the internet but wrong about the impact on stocks. Adding fuel to the fire was the promise of the “new economy”. Productivity was surging at the time. Productivity is the key ingredient in economic growth, so the belief was that we were entering an era of permanently higher growth. This fueled predictions of the federal budget deficit going to zero in 10-20 years. In truth, productivity was simply reverting to the mean after stagnation in the 1970s and 1980s. Keep this in mind when commentators say that the current productivity slump is permanent and means that the US economy will never grow faster than 2%.

With the Nifty Fifty, it was optimism about the power of the post-World War II American economy. The 1950s were a good time for the American economy and the 1960s were even better. The unemployment rate was only 3.9% by the end of the decade. Americans experienced abundance that was foreign to them in the past. Suburbs popped up everywhere and car ownership became ubiquitous. In the 1970s, the good times took a hit due to inflation, an oil shock, and the confidence-sapping Watergate scandal. Also, disco. Unaware of what was about to happen, investors thought that you could simply buy the fastest growing companies in the world’s fastest growing economy, and price didn’t matter.

With the South Seas bubble, it was the promise of the age of exploration. The New World opened up two continents that were rich in natural resources and abundance. Surely, investing in the company that would dominate trade in the new era was a surefire bet.

Now, the euphoria is fueled by the promise of scaled up e-commerce in the form of Amazon, cryptocurrency (personally, I only trust a currency that is secured by the full faith and credit of people with guns, aircraft carriers, stealth planes and nuclear weapons), the transformation of our lives by smartphones and the promise of whatever Elon Musk thinks is cool (electric cars, cars that drive themselves, hyper loops, USB ports in our brains, etc.)

Euclidean Technologies Q2 2017 Letter

I was reading Euclidean Technologies Q2-2017 letter and came across this historical nugget:

“Among large-cap stocks, the spread between value and growth is now larger than at any point over the past six decades, with one exception—the top of the dot-com bubble.”  Barrons, June 28, 2017

The letter is a great read and is well worth your time. The letter makes two very key points:

  1. Value stocks are going through the longest cycle since World War II of underperformance versus growth. Each period of time that growth outperforms value, value eventually stages a significant resurgence. Their chart showing this history can be accessed here.
  2. They also have a great analysis of the performance of different valuation metrics since 1970. They find that using enterprise values instead of raw market prices in a valuation ratio works best. They find that all of the major valuations work and, as is demonstrated in Deep Value, the acquirer’s multiple (in both the EBIT and EBITDA variations) exhibit the highest performance. The comparison of different valuation metrics can be accessed here.

Conclusion

I don’t know when or how the current cycle will shake out. I am confident in one thing: buying expensive stocks is dangerous and buying cheap stocks is a safe long term bet, no matter how you slice it. The current disconnect will not last forever.

I think indexing makes sense over the long run and I don’t think we’re on the brink of a 1929 or 2008 scenario. With that said, I do think that this current environment is fueled by performance chasing, just as it was in the 1990s. Just like the 1990s, money is pouring into large cap index funds. As index funds concentrate their bets on the biggest components of the index, those companies see their valuations increase. This isn’t due to any change in their actual business performance but is due to their weighting in the index. The money pouring into index funds is not permanent capital and I suspect many will head for the hills once the current cycle turns on them, as usually happens.

Most investment strategies work and make no mistake: indexing is simply a strategy. It’s a smart, tax efficient and cheap strategy. It will only work for investors if they stick to it, which they typically don’t, as demonstrated by this chart.

Value is having a tough time, but it’s times like this that are the reason value investing works over the long run. If value investing delivered double digit returns every year consistently, then everybody would do it.

The strategy I am pursuing is consistent with Ben Graham’s recommended strategy from the 1970s: buying low P/E stocks that have safe balance sheets. I look at other factors (such as the enterprise multiple), but that’s the gist of what I’m doing. When looking at my own performance, I compare it to this backtest of the strategy done over at Alpha Architect. In 1998, the 20-stock variation of the strategy lost 9.01%, compared to a 26% gain in the S&P 500. In 1999, the strategy gained 4.55% against a gain of 19.53% in the S&P.

The worst year for the strategy was 1969, in which it lost 28%. The S&P lost only 8% that year.

Over the long run, however, Ben’s simple (but not easy) strategy delivered a 15% rate of return. That’s the long run return I’m striving for with this IRA over the next few decades.

I don’t know how long the doldrums will last, but I do know they will end. It may take years, but I’m not going to abandon it. The only thing I may change if the market takes a hit is to shift my focus to asset-based investing (i.e., net nets and stocks below tangible book). The only reason I’m not doing that now is that they are not available in sufficient quantities.

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 2017 Performance Update

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The trends that were in place in Q1 are still raging on into Q2. Large cap tech stocks continue their ascendancy and value lags. In comparison, I am not doing well at all.

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Inside My Portfolio

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The laggards in the portfolio are the same from the first quarter. My retail stocks (CATO, AEO, GME, DDS) continue to get hammered. Dillard’s seems to be holding up as the best of the bunch. This makes sense because it is the least scary looking and highest quality of the retail names that I own.

Dillard’s is usually a mall anchor and focuses on higher end clothes. There are also stand-alone stores. American Eagle is actually in the mall (where fewer people are going these days) and targets teenagers. Teenagers, in sharp contrast to the teenage world I grew up in, don’t care about what clothes they wear. This is good for civilization but not for my portfolio! Cato is one of the few names I own that actually produced a quarterly loss in Q1, making that one a bit terrifying. It will be interesting to see how this plays out. I suspect the scarier looking names (AEO, CATO) will actually outperform the less scary DDS, but we’ll see.

Topbuild (BLD) continues its momentum. If it tops 50% in gains, I may pare back the position. Sanderson Farms (SAFM) is benefitting from rising chicken prices.

IDT is a very volatile stock. After their terrible quarter in March, it fell from $20.29 to $12.38. It then rebounded up to $17.58, falling again after another bad quarterly result down to $13.75. The loss occurred because of a $10 MM legal settlement with the FCC. The good news is that there was hardly any drop off in the core operating business of IDT and the settlement appears to be temporary (I hope!). IDT is also paying a healthy dividend.

The Market

The overall market continues its momentum, with most of the performance soaked up by big cap glamor companies. Amazon is up 29% year to date, Telsa is up 69%, Facebook is up 31%, Netflix is up 21%. This occurs against the backdrop of a strong economy with serious headwinds. There is significant political uncertainty around the Trump administration, and the Fed continues raising rates.

I don’t think the current environment will last. The present frenzy over sexy stocks like Facebook, Amazon, and Tesla has ‘late ’90s’ and ‘nifty 50’ written all over it. There is no telling when the momentum will stop, but I think it will end eventually. The question is when it will stop, which is a question that no one can answer. Is this 1997 or 2000? Is this 1967 or 1972? No one knows, but I’m not going to jump on the bandwagon and embrace the current mood.

Value strategies continue to lag. This has been going on for a decade. A strategy I like to compare myself to is Validea’s Benjamin Graham Portfolio. Year to date their 20-stock Ben Graham portfolio (based on their own interpretation of a Ben Graham stock screen) is down 9.2%. This gives me some comfort, as I know that I’m in good company. Since 2003, Validea’s version of the Ben Graham strategy delivered an annualized return of 8.6%, compared to the S&P 500’s average of 6.5%.

I see similar comparisons with AAII’s value stock screens. AAII’s best performing stock screens over the long run are their value screens. Most of these stock screens are also having a tough time year to date. Again, this gives me comfort. I know I’m in good company!

As they say: misery loves company!

The big question is how all of this plays out. Back in 2008, value stocks declined before the broader market. It was a canary in the coal mine, predicting the broad-based decline in stocks that year. In contrast, value stocks registered similar poor performance in 1998 and 1999. When the broader market was decimated in 2000-2003, value stocks actually had a bull market! Hopefully, the current situation is more like 1999 than 2008, but we’ll just have to wait and 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.

Q1 2017 Performance Update

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My Q1 2017 Performance: Down .11%

S&P 500 Q1 2017 Performance: Up 5.53%

My portfolio is regularly tracked here.

The S&P 500 had an amazing quarter and I had a lackluster one in relative terms. Overall I’m down 2% since I started tracking the portfolio in mid December 2016. At one point I was down 5% earlier this quarter.

Anti-Amazon Trade (GME, CATO, DDS, AEO)

Much of my under-performance is attributable to my anti-Amazon trade. As mentioned in the earlier post, the conventional wisdom is that Amazon is going to destroy conventional retail. I remain unconvinced that retail is going to die. People will always shop in physical stores. While retail may be in decline, it will not go away. For clothing in particular, people will always want to see the item and try it on. There is also the instant gratification aspect of conventional retail that will allow it to endure. Moreover, no matter how technologically sophisticated we become, people will always want to leave the house and occasionally go shopping. They are not going to hang out at home all day and never shop in a physical location again. Even Amazon realizes this truth, which is why I find it amusing that they are thinking about expanding into physical retail!

My unsophisticated thesis is simple: the retail stocks are all priced like retail is going to die soon and I don’t think it is going to happen. Simultaneously, the price of Amazon has been bid up to an extreme P/E ratio (180.98) and the momentum continues.

While I may be early to the anti-Amazon trade, I don’t think I am wrong. Predicting when the market will accurately value a stock is not possible. You can only buy when there is a mismatch between price and intrinsic value and wait.

IDT

IDT is my worst performer. During the week of March 6th after reporting disappointing earnings, the stock collapsed from $19.50 to $13.11, a decline of 33%. The stock plummeted further to $12.03. I was certainly wrong on this one, but I do not want to sell. $5.66 of that $12 price is cash. IDT has no debt. They also aren’t cutting their dividend and while the core business is struggling, it’s not dying. I’m sticking with it.

MN

Manning and Napier is also not doing well. Active management continues to be punished after the amazing track record of the indexes since 2009. Investors don’t want to pay high fees to asset managers when they can buy a low-cost index fund that will outperform them. Assets under management are declining, which is hurting the business. I don’t think this trend will last forever and in the meantime I am at least being paid a nice dividend yield to own Manning and Napier. The company currently has a negative enterprise value, with the current price less than the cash on hand, which currently stands at $9.19 per share. It’s a ridiculously cheap stock and the slightest glimmer of hope should allow me to take at least one free puff from this cigar butt.

Bubble Basket

David Einhorn refers to a “bubble basket” that he’s short on, which includes Amazon and Netflix. Q1 2017 was a good time for bubble basket. Tesla, a company with no earnings trading at 6.48 times revenue, is up 30% year to date. Amazon is up 18.23% and trades at 180 times earnings. Netflix, trading at 347 times earnings, is up 19.39%. Facebook, trading at 40 times earnings, is up 23.47% year to date. These are simply crazy valuations and I suspect they eventually they will go down in history with the Nifty Fifty.

Snapchat also debuted on the markets this quarter, as a symbolic representation of the frothy mood. The IPO felt like a flashback to the late ’90s, when an IPO and a dot com at the end of a name was a key to instant riches. SNAP has no earnings, $404 million in revenue. $27.11 billion market cap. This isn’t Pets.com crazy, but it’s still pretty crazy.

Einhorn is losing money shorting these stocks, but I still think he’s right. Therein lies the problem with shorting: there is no way to predict how long the market will be crazy and ignore reality. It will eventually happen, but there is no telling how long it will take.

If you’re short and the stock goes up 100%: you lost all of your money. This is why shorting technology stocks in the ’90s was a risky move even though there was a bubble and the shorts were vindicated. If you were early to the short (in, say, 1998), then you would have lost a tremendous amount of money even though the thesis was vindicated in the early 2000s. Take a look at the percentage returns for the NASDAQ 100 from 1998 through 2002:

1998: Up 85.30%

1999: Up 101.95%

2000: Down 36.84%

2001: Down 32.65%

2002: Down 37.58%

“The market can stay irrational longer than you can stay solvent.” – John Maynard Keynes

That is why I don’t short stocks or use leverage. Timing is hard, even if you’re a pro like Einhorn. If Einhorn can’t do it, then I certainly can’t do it!

Portfolio Value

On an EBITDA/Enterprise Value basis, many of the worst performing stocks in my portfolio are some of the most attractively valued. Why sell now?

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The frequent under-performance of value strategies is a key reason that they outperform over the long run.

If a fund manager delivered the kind of relative under performance that I delivered this quarter, they would probably be yelled at by their boss or at the very least forced to endure a healthy dose of corporate passive aggressiveness.

It’s moments like this (which can last years) during which there is a strong incentive to simply buy stocks that look like the S&P 500 or had some recent momentum. This strategy is a recipe for long term under-performance.

Behaviorally, it is easier to go with the crowd. If you’re right and the crowd is right, then you’re doing great! If you’re wrong and the crowd is wrong, then at least everybody else was wrong too!

If, however, you take a contrarian opinion and the crowd is right and you’re wrong (as I am with the anti-Amazon trade for now) then you lose your job. Contrarian opinions are eminently risky. Things are even more behaviorally difficult when you look at the companies in a value portfolio. Why am I even investing in this garbage? Everybody knows that retail is dead, Gamestop will be replaced by streaming video games, etc. This makes it all the easier to click that tempting “sell” button and end the pain.

This is why having one investor (me!) and no boss is advantageous and makes for better investing.

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.

Greenbrier (GBX)

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Greenbrier, one of my holdings, is poised to benefit from a recovery in oil prices.  Greenbrier manufactures, leases and repairs rail cars.

Greenbrier was a beneficiary of the fracking boom and was negatively impacted by the bust in the last two years.  Much of the oil that is being drilled throughout the US must to be transported via rail.  Greenbrier’s stock peaked at $75 a share in mid 2014 around the same time that oil prices peaked above $100 and then began its decline to $50.

GBX’s Performance

Meanwhile, amid the decline in oil prices, Greenbrier has been humming along and generating profits while the stock has been disconnected from the actual performance of the company and slid to the current $41.85 price level.  Take a look at the operating income for the last few fiscal years:

2016: $408 million

2015: $386 million

2014: $239 million

They have also been paying down debt.  Long term debt has been reduced from $445 million to $303 million.

Saudi Arabia & Oil Prices

With that said, it appears that oil prices are bottoming.  Saudi Arabia engineered the decline in oil prices to kill their competition.  Their mission is now accomplished and they want to see oil prices go back up.  They are now organizing OPEC to cut production and raise oil prices again.

I suspect Saudi engineered higher oil prices will simply mean that US production will increase in response, which will benefit the train industry and companies like Greenbrier.  The only way that it wouldn’t benefit would be if the US invests in oil pipelines.  It appears unlikely that any pipelines will be built.  In addition to the environmentalists, there is a strong resistance from NIMBY citizens.  Any struggle to get these pipelines built will probably be akin to the Bush administration’s efforts to drill in ANWR, efforts that were abandoned because they were deemed to be too much of a political pain.

Personally, I don’t see how transporting all of this oil via train and truck is any better for the environment than putting it in a pipeline, but I don’t think it is good investing to think in terms of what should happen.  Even if the new administration fights the political pressure and gets a pipeline built, it will be years before it actually happens.  In the meantime, we will need a way to transport all of this oil and rail will benefit.

Margin of Safety

Greenbrier presents an excellent margin of safety at the current price.  Even without higher oil prices, Greenbrier has been performing well while the stock price has fallen amid speculation that ignores the fundamentals of the business.  My guess is that betting against rail while oil goes down has been fashionable on Wall Street, thereby creating attractive prices.  It is a great value even if my prediction about oil prices doesn’t come true.  I feel the same way about Valero, another stock I own as a play for an oil resurgence.

That’s the idea behind the margin of safety — even if I am wrong, the stock was purchased at a wide enough margin of safety that I should still do ok.  I can bet on higher oil prices in a safe way, as opposed to buying a leveraged ETF or oil futures.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.

Is Retail Dead?

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Value investing requires one to defy conventional thinking.  It requires independent thought.

Right now, the conventional wisdom is: brick and mortar retail is going to be dead soon.  Most physical retailers are going the way of Blockbuster Video and Borders books.  People are going to buy everything online.

You can see this conventional wisdom in the valuations that the market assigns to the following stocks:

Wal-Mart: 14.98 times earnings

Dillard’s: 11.38 times earnings (a stock I own)

Gamestop: 6.79 times earnings (a stock I own)

Amazon: 171.87 times earnings (!)

Clearly, investors are wildly optimistic on the prospects of Amazon and downbeat on the future of more conventional retail operations.  Like most things, I think that the market is getting ahead of itself.  They have taken a trend (the rise of online retail) and are getting carried away with it.  The amazing innovations that Amazon churns out definitely fuel the optimistic forecast.

For Gamestop, the logic is a bit more easy to understand.  Consumers are going to buy more of their video games online directly to their console rather than shop in the store.  Maybe.  When I look at Gamestop’s actual operating income for the last four fiscal years, I see a much different story:

FY ending 2016: $648 million

2015: $618.30 million

2014: $573.50 million

2013: -44.90 million

In other words, Gamestop has been delivering consistently better results while the market has been losing faith in its prospects as a result of speculation.  I do not see a business that is dying.

The point of value investing is to ignore the speculation and focus on what is actually happening and what the company is actually earning.  At 6.78 times earnings, Gamestop presents a tremendous margin of safety regardless of its future.  In other words, 6.78 years of earnings can pay for the entire company’s market capitalization.

Amazon is the sexiest of growth stocks with amazing prospects for the future.  But the stock offers no margin of safety.  Gamestop does.  That’s why I am taking the unconventional route and owning brick and mortar stores like Dillard’s and Gamestop that the market hates (or is ambivalent to) and passing on incredible story stocks that the market loves.

Keep in mind that Amazon is up 332% in the last five years.  Those are tantalizing returns that attract attention and investors.  However, following the crowd and chasing returns is not investing.  It is speculation.  Investing is considering what you, as the owner of the company, are paying for what the company is earning.  The logic is that Amazon will continue to grow and continue to be an amazing company.  Perhaps it will.

“Perhaps” and “maybe” have no place in an investment operation.  Those words are for the track, not for investing.  When it comes to my investments, I demand a margin of safety.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.

Portfolio Stats

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Above are the characteristics of the portfolio.  As there are no companies trading below liquidation value, this year’s portfolio sticks to Graham’s recommended mix of safe balance sheets and earnings yields that double the current AAA bond yield, which is 3.71%.

Graham recommended a minimum earnings yield of 10% regardless of how low interest rates are.  After the most recent run-up in the markets, there were not many bargain stocks to choose from and I had to loosen the standards and try to simply double the current AAA corporate bond yield.  I certainly stretched both rules with Valero.  However, when you factor in Valero’s current 3.48% dividend yield, the logic makes a bit more sense, particularly when it appears that oil prices are bottoming.  Regardless, the average still remains 10.95%, which is above Graham’s recommendation.

The average debt/equity ratio of the portfolio is currently 14.845%, which is safe.  This average rate does not include MSGN, which has negative equity, a phenomenon common among spin offs because parent companies normally like to unload debt on these entities.  I am comfortable with this debt because 19 out of the 20 securities in the portfolio have safe balance sheets and I can afford to have 1 security representing 5% of my portfolio with a risky capital structure.  Additionally, I am comfortable with this debt because the risk of recession is low based on the current household debt service ratio explained in an earlier blog post.

For each of the stocks in my portfolio, there is a reason to either yawn or be repulsed, which is the point.  All of these companies have problems but they are all earning money and have safe capital structures, implying that their problems will not be fatal.  If the company were perfect, everyone would own it and the bargain would disappear.  Beautiful companies aren’t cheap.  The beautiful cheap company is about as common as a unicorn and takes a genius like Warren Buffett to spot.

I’m not anywhere near Warren Buffett’s level of intelligence, so I’ll settle the diversified portfolio of deep bargains.  Besides, with the small sums that I am investing, I can indulge in deeply discounted small cap companies that larger investors cannot invest large sums in.  Over long stretches of time I believe that I can beat the indexes with this approach.

PLEASE NOTE: The information provided on this site is not financial advice and I am not a financial professional. I am an amateur and the purpose of this site is to simply monitor my successes and failures.