After miserably under-performing in 2017 and 2018, I had a somewhat decent year and slightly exceeded the performance of the S&P 500. For an outline of my complete strategy, you can click here.
I launched this blog and set aside this chunk of my IRA in late 2016. It has been a fun ride.
I wanted to use this account to systemically follow my own version of Ben Graham’s “Simple Way” strategy and keep a live trading journal.
I also figured I’d buy net-net’s when they were available. There haven’t been many that I could find in the last few years, with the exception of Amtech (which I took one free 50% puff from), and Pendrell (which I roughly broke even on). I’m anxiously awaiting a time in which I can buy a lot of cigar butts. For now, I’m buying Simple Way stocks: low debt/equity, low P/E’s, low enterprise multiples.
Every trade has been recorded when it happens on this blog and I’ve also posted my rationales for when I buy a new position.
I thought this blog would be something different. Most of the investing blogs I found included a lot of talk about discipline, about how to find the companies, and even had write ups for new positions.
Few of the investing blogs out there showed a real person’s portfolio. Few showed when they buy, when they sell, and show the outcome. I wanted this to be a live trading journal with all the failures and all of the successes, for all to see. I wanted to show the real, long, lonely, grind of active value investing for a normal person. I wanted this to be something different.
When I set out to do this, I wrote: “A key thing to keep in mind is that while these methods succeed over the long haul, there are periods of time when they do not work. I hope this blog will help me remain disciplined and focused on my own value investment journey.”
The last three years have certainly been a test of my discipline and that of most deep value investors. For deep value investors, this has been a particularly grueling slog.
For many, it has been tempting to stray. There are plenty of “value” investors who went out and bought a bunch of compounders with 200 P/E’s and cited See’s Candy and some Munger mental models as the reason for the style drift.
“Hey, even Buffett paid up for a good business! That’s why I’m buying Amazon and Facebook!”
“Yea dude, you’re just like Buffett in the ’70s. He really threw caution to the wind when he bought See’s at a P/E of 5 and less than sales . . . but hey, it wasn’t a net-net.”
They have been rewarded for their style drift. Over the long haul, I think they’re going to suffer the same fate as those who bought the Nifty 50 in the early ’70s and tech stocks in the late ’90s, but we shall see.
I digress. This year’s performance is an outcome that pleases me. It wasn’t much out-performance, but hey, a win is a win.
Value’s Underperformance Continues
Clubber Lang explains deep value investing
My performance this year has been especially pleasing because 2019 was another year when value under-performed the broader market.
My style is closely aligned with small cap value, and here is how this year’s small cap ETF’s performed:
VBR (Vanguard Small-Cap Value) – Up 22.77%
SLYV (SPDR S&P 600 Small-Cap ETF) – Up 24.26%
They didn’t do badly. Over 20% returns are excellent. Unfortunately, in relative terms, they didn’t do as well as the S&P.
Looking at the universe of stocks with an EV/EBIT multiple under 5 in the Russell 3,000, they are currently up a measly 12.7%.
The total return of the EV/EBIT<5 universe doesn’t even tell the whole story. In early March, this group was up over 20% after a massive rally. The rally then fell apart completely, and the group suffered a face-ripping 24% drawdown. The market gods made us feel hope, and then punched us in the gut.
Earlier this year, the under-performance was even worse than 1999. It rebounded a bit at the end of the year, but it’s still a staggering level of under-performance. Deep value is suffering its worst slog since the late ’90s, and 2019 year was quite similar to 1999.
So, while I matched the performance of the S&P 500, I outperformed most value strategies. Why was this the case?
The reason, I think, is that I had a high turnover at the right time. We’re all taught by Buffett that high turnover is wrong, but it helped me this year. When positions reached a decent value, I sold them. With the massive rally this year, that happened a lot sooner than I originally anticipated. I was usually right (Gap) but I got out of some stocks way too early (I’m looking at you, UFPI).
I also finally exited my long suffering Gamestop position once their private equity dreams were dashed. I got out at $11.45, which looks like it was a good move, as the stock is now down to $6.08.
I’m also the guy who bought Gamestop (twice!) at an average price of $24, but I take consolation that it could have been worse.
Here are all of the positions I sold this year:
Yes, that’s a lot of turnover. It’s very un-Berkshire.
I’ve long wondered if I’m adding anything to a value strategy with my stock picking and trading. This year, at least, it looks like it paid off. I avoided a significant drawdown for value and still enjoyed the Q1 and Q4 rallies.
I’ve held a significant amount of cash this year, after being all-in and 100% invested when the opportunity was rich a year ago.
I sold positions when they moved to my estimate of their intrinsic value, or when my thesis fell apart (Gamestop), or when the companies started to undergo significant operational slip-ups. My selling intensified after the yield curve inversion, as I thought the likelihood of a recession was higher. Market sell off’s then occured over developments in the trade war (not recession concerns), but I avoided some big drawdowns even though my rationale was wrong.
After being nearly 50% cash earlier this year, I gradually bought and scaled into positions that I thought were cheap.
This quarter, I purchased five new positions. The positions and corresponding write-ups are below:
- National General Holdings
- Principal Financial Group
- RMR Group
A Tale of Two Decembers (Macro Stuff)
If you don’t care about my Macro views, you can skip this section
This December and last December are opposite images of each other.
The best way to represent this is CNN’s Fear and Greed index.
Right now, the index is at 93, indicating “extreme greed.” A year ago, we were a level of 12, or “extreme fear.”
Mr. Market is one crazy lunatic.
What changed fundamentally to cause this emotional swing? Nothing. The only difference is the price action and how everyone feels after a great year for stocks.
Last year, I was bullish. Cheap stocks were plentiful. On Christmas Eve 2018, I felt like Santa gave me an early Christmas present, as there were nearly 100 stocks in the Russell 3k with an EV/EBIT multiple under 5. It was the best opportunity set we’ve had in 5 years. Meanwhile, the yield curve was not inverted (it had only flattened, and only longer-dated maturities were inverted), so I knew that the odds of a recession in the next year were minimal. It seemed to me to be a great time to go long, and that’s what I did. At the end of last year, I was 100% invested and quite excited.
Right now, I’m quite bearish. The 3-month and 10-year yield curve have inverted this year. Meanwhile, bargains are less plentiful.
I believe that the yield curve is a proxy for how tight or loose monetary policy is, which is why the yield curve is a forward-looking indicator for the economy. The eggheads say that the yield curve doesn’t matter, and this time is different – but those are the same lines we heard after the last two inversions. I’ll take the easy rule that works every time over the expert opinions of the eggheads.
The yield curve inverted after four years of the Fed tightening monetary policy.
The eggheads assure us that this is nothing to worry about.
The Fed was raising rates for four years and finally reversed course this summer. They then started cutting the balance sheet in early 2018.
My view that the Fed was too restrictive is perplexing for many involved, especially the Fed haters who believe that the Fed was too loose with policy. After all, how can the Fed be too restrictive when interest rates are so historically low?
The yield curve tells a different story. The yield curve indicates that monetary policy was too restrictive. It seems insane, but one also needs to look at the velocity of money, an important and often ignored component of the overall monetary picture, best expressed by the classical equation, MV=PQ.
When velocity is low – as it has been since the GFC – seemingly low interest rates can still be restrictive.
Money velocity plummeted after the GFC and never recovered. This is why I think an ultra-accommodating monetary policy didn’t cause hyperinflation as everyone feared (myself included) and the fears were best expressed by this 2010 viral cartoon.
I think that four years of monetary tightening were restrictive and baked a recession into the cake.
Shortly after the Fed inverted the yield curve, the Fed started cutting rates over the summer. In September, they began to increase the size of the balance sheet again. The Fed is now in a loosening mode, which markets have interpreted as a bullish signal.
The discussion around the yield curve is quite funny. Historically, a yield curve inversion predicts a recession roughly a year or two ahead of time. The attitude of most market participants is ridiculously short term and seems to be “the yield curve inverted, and the market went up for a few months. Therefore, it’s nothing to worry about.”
I think this year’s Fed easing is too little, too late. The markets are rallying just because the Fed is loosening policy, and investors believe we will avoid a recession. The yield curve has un-inverted and is steepening, implying that monetary policy is now accommodative. Unfortunately, I think that the Fed shifted to accommodation too late in the game.
This is what usually happens. The Fed always begins loosening policy before the recession arrives, and it is always too little, too late.
In the last cycle, the Fed began cutting rates in the summer of 2007. By the end of 2007, after multiple rate cuts, the yield curve steepened. Markets hit their peak in the fall of 2007. As we now know, we were not out of the woods in late 2007. We were only at the beginning of the pain.
During the tech boom, the same thing happened. The Fed started to cut rates at the end of 2000 and un-inverted the yield curve. We still had a recession in 2001, with the stagnation that lingered into 2003.
There is always a lag between a shift in monetary policy and the impact on the real economy. The Fed began loosening policy in mid-2007. The economy didn’t start to rebound until mid-2009. The Fed started tightening its policy back in 2004, and the recession didn’t start until the end of 2007.
There is always a lag between monetary policy and its impact on the real economy.
I think the same outcome is likely this time. We haven’t seen the full impact of the tightening that occurred from 2015 through 2019. Similarly, we probably won’t know the effect of the recent loosening of policy for a couple of years.
The length of a yield curve inversion also correlates to the length of a recession. The last yield curve inversion lasted from mid-2006 to late-2007. The recession lasted from December 2007 to the summer of 2009.
This inversion lasted for five months, from May through October this year. The length of the inversion implies we’re in store for a roughly 6-month recession. I think this means we’ll have a relatively mild recession. It will be a recession that is more like the early ’90s and early 2000s recession than it is going to be like the last, big, bad, 2008 debacle.
To summarize: I think we’re going to have a recession. I also don’t think it’s going to be as bad as 2008.
The Bigger They Are, The Harder They Fall (More Macro)
Again, skip if you don’t care about my opinion on Macro stuff.
Unfortunately, a “mild recession” doesn’t necessarily mean we’re going to have a mild bear market. The early 2000s recession (in which unemployment only peaked at 6.2%) led to a 44% drawdown in the market.
The extent of a big drawdown tends to be a combination of the severity of the recession and the extent of the overvaluation. That’s why a frothy market can drawdown severely when faced with minor economic turbulence.
In other words, the bigger they are, the harder they fall.
Before the 2000 drawdown, the market represented 146% of GDP. The massive overvaluation at the time is why such a minor recession was able to cause such a significant stock drawdown. It’s sort of like how a bubblicious stock can completely disintegrate when reality is only slightly off from the market’s lofty expectations.
Compare this to the early ’90s recession. The early ’90s recession was relatively minor, similar to the early 2000s. The increases in unemployment during the early ’90s recession were nearly identical to the early 2000s event. However, unlike the 44% drawdown in the early 2000s, in the early 1990s, the market only suffered a 16% drawdown. Why was the drawdown so minimal? Simple: valuations weren’t as high in the early ’90s. The market cap to GDP was only about 59%.
In contrast to the minor events of the early ’90s and early 2000s, the 2008 recession was the most severe recession since World War II. The market was frothy, but it wasn’t quite at 2000 bubble levels. We suffered a 50% drawdown. The 2008 drawdown happened because of the severity of what was happening in the real economy. It was not entirely a response to overvaluation in the stock market, which is what happened in the early 2000s.
I think that if we had the 2008 recession at 2000 valuations, then the early 2000s meltdown would have been much more severe. We likely would have gone into a 60% or 80% drawdown, rivaling the Great Depression. We lucked out in the early 2000s by having a relatively minor recession.
This year we crossed an important milestone. The market cap to GDP exceeded the previous bubble in 2000. In 2000, we peaked at 146% of GDP. The market currently trades at 153% of GDP.
The same is true on a price/sales basis. The market is the most expensive it has been in history. The S&P 500 currently trades at 235% of sales. At the peak of the 2000 bubble, we were at 180%.
Another great metric is the average investor allocation to equities. Currently, that’s not quite at 2000 levels, but it’s still pretty high. Keep in mind that this chart ends in Q3. It’s probably higher now, probably around 44%.
Using the equation I described in an earlier blog post, the current investor allocation to equities suggests a 2.3% real return for US Stocks over the next decade. If history is any guide, that’s a 2.3% real return that will probably have a 50% drawdown somewhere in there.
For US stocks, the 2020s is not going be anything like the 2010s.
Earnings-based metrics look a little better. The TTM P/E is about 24. The CAPE ratio is 31.
Of course, the problem with earnings-based metrics for macro valuations is that they are based on a cycle where profit margins have been exceptionally high. Margins are likely to mean revert. Margins have also been boosted by leverage. Forward P/E’s don’t look insane, but forward P/E’s are a notoriously unreliable indicator.
Profit margins have remained high over the last decade. Bulls will say that this is a new era. I think that this is likely to return to historical norms.
There are plenty of people who say, “this is a bubble, but it’s not as bad as the late ’90s.” They usually cite the fact that this bubble hasn’t included a bunch of money-losing dot com IPO’s. To which I say: so what? We’ve had similar insanity in initial coin offerings and money-losing venture capital moonshots. Last time we had Pets.com. This time, we have WeWork, Theranos, and fake electronic currency. No bubble is exactly the same, but they’re all bubbles and they all end in tears.
What Does This Mean for Value?
In the early 2000s, value stocks did well, while the broader market went down. If we’re lucky, the same will happen again.
Unfortunately, we probably are not that lucky. Once the broader market goes down, value stocks usually go down with it. The outperformance often happens in the early stages of an economic recovery. It’s also possible that value stocks will decline by less than the broader market.
I think value investors are in store for a significant drawdown, just like index investors likely are. We’ll just have to wait and see.
I’m preparing for this situation by holding onto cash when I can’t find bargains, rather than making an outright bet that we’re going to have a recession by going short or buying a massive amount of long-term treasury bond ETF’s.
Earlier this year, I purchased CDs that matured in December and yielded 2% on average. When they all matured this month, the market was even pricier than it was before that, which was disappointing.
Cash is King
Fortunately, a positive development occurred before my bank CD’s matured in December. My broker eliminated commissions.
The elimination of commissions made cash equivalent short term bond ETF’s more appealing to me. Before commissions were eliminated, it seemed foolish to buy a cash ETF for a commission, and then gradually exit the position and pay a new commission each time. That was almost certain to eat into even the paltry interest that I was receiving.
The commissions would eat into any interest I earned on the cash. With the elimination of these commissions, cash ETF’s are now a viable option for me. The removal of commissions is why I purchased NEAR, a cash ETF from iShares, with a TTM yield of 2.6%.
Currently, I am 20% cash. My approach to this environment is simple: I’ll buy cheap stocks when I find them and I’ll hold cash when I can’t. Hopefully, I’ll still get solid exposure to the value factor and limit my drawdown in the next recession.
In 2019, I wrote some blog posts that I am pleased with, including:
Here is some random ’80s:
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.