Category Archives: Portfolio Commentary

Q2 2020 Update

Performance

Year to date, I am down 17.77% and the S&P 500 is down 3.9%.

This is actually pretty good in context of my deep value strategy. VBR, the Vanguard Small Value ETF, is currently down 22% YTD. QVAL, the deep value Alpha Architect ETF, is currently down 26% YTD.

The deep value universe of stocks with an EV/EBIT multiple under 5 is currently down 30% YTD.

17% isn’t all that bad in this context.

Due to my large cash position going into the crash, I was only down 26% at the lows, while most of this universe was in a nearly 50% drawdown.

With that said, I missed my chance to gobble up bargains at the lows because I thought the worst wasn’t over.

A Mixed Bag: Good Decisions & Bad Decisions

In the last year, I made some key decisions. Some of them turned out to be good moves and some look like mistakes.

I started accumulating cash last year when the yield curve first inverted. I thought we were going to have a run-of-the-mill recession and I thought due to the overvaluation of the market that this would be enough to cause at least a 50% crash.

I went into the March crash nearly 50% cash. This was a good decision. When I saw that the recession wasn’t going to be a run-of-the-mill affair and was turning into the worst recession since the Great Depression, I started selling my cyclical positions aggressively. By the bottom, I was nearly 80% cash.

I was also convinced that the selling wasn’t over. I saw an index at internet bubble valuations hitting the worst economic event since the Great Depression and assumed that the crash would continue. Value stocks aren’t a place to hide during a crash, so to stay market neutral, I bought a position in an S&P 500 inverse ETF to stay market neutral. This was not a good decision.

What I didn’t anticipate was the extent to which fiscal and monetary policy were going to go full-throttle in an all out effort to boost the stock market and the economy. As a result, the S&P 500 rocketed upward and my short position was beat up.

As a result, I lost about 15% on the short position. I finally got out of it when the S&P 500 went above the 200 day moving average. Fortunately, it wasn’t enough to hurt my overall YTD results.

At the lows, net-net’s started to re-appear and the number of stocks below an EV/EBIT multiple of 5 increased. I didn’t buy any of them, thinking that the economic downturn was going to continue melting down the market with no regard to valuation. I didn’t buy enough at the lows. This was not a good decision. There were many stocks I should have bought and I didn’t.

One position I bought near the lows has worked out marvelously – AOBC, which has turned into SWBI. This is a gun manufacturer. You can read my write up here. I noticed that AOBC was trading at a low multiple to book value while simultaneously background checks were surging due to COVID. Gun sales continue to be strong, and this continues to skyrocket due to the unrest currently gripping the country.

I’m currently up 189% on this position. Obviously, buying SWBI was a good decision. I sold a piece of this position when it grew to 10% of my account from 5%. I plan on doing the same thing once this happens again.

I recently purchased a net-net, Friedman Industries. You can read my write up here. It is yet to be seen if this was a good decision, but I think that the risk-reward makes sense.

Looking Ahead

Currently, the market continues to be strong and seems invincible.

I’m not short after getting my butt kicked in my short position, but I’m still not bullish. I’m currently 80% cash and still only have a handful of positions.

It’s still yet to be seen how COVID is going to shake out.

I am finding it hard to figure it out. On one hand, the lockdowns worked, we flattened the curve. On the other, now that the economy is being re-opened, cases are surging. Skeptics say that this is simply because of more testing. Those who sounded the alarm on the virus say this is concerning.

I don’t know how this shakes out. What I do know is that the the present state of the economy is not good. Unemployment looks poised to reach its highest levels since the Depression in the 1930’s. Many businesses have been completely destroyed, and the number of businesses that are being destroyed continue to mount.

On the other hand, unprecedented levels of fiscal & monetary stimulus might create a new economic boom as the economy re-opens.

I don’t know how the economy shakes out, either. My instincts tell me that the economy is screwed, but my instincts can be wrong. We went into this with unprecedented levels of leverage and the only way that a lot of businesses are surviving is by taking on even more debt, making them even more fragile. On the other hand, the fiscal & monetary stimulus might work.

I don’t know how the virus shakes out and I don’t know what’s going to happen to the economy. The way I see it, the current situation is replete with massive uncertainty.

Uncertainty is something that an investor should get paid for with a cheap valuation.

Investors aren’t getting paid for that uncertainty.

What I know for certain is that the market is not cheap by any stretch of the imagination. From a market cap to GDP perspective, the market trades at 147% of GDP. At the peak of the internet bubble, we were at 140%. That’s right – we are beyond the valuation of the most extreme bubble in American history and we’re in the midst of the worst economic calamity since the Great Depression.

If the market were to return to 100% of GDP – the S&P would crash to near 2,000. If we were to return to the lows of the last two nasty bear markets, we would fall to nearly 1,500 on the S&P.

The CAPE ratio is at 29 – higher than the peak of the real estate bubble although not as high as it was during the internet bubble.

Looking at the value universe I operate in, it is currently only an average opportunity set. There were many stocks in the EV/EBIT < 5 universe at the lows, which was a pretty decent opportunity but not as big as 2009. There are now 75, which is a pretty average opportunity set.

An average opportunity set and a market trading at internet bubble valuations is not compelling. It’s definitely not an opportunity when we face the wide range of possible outcomes that we face today.

As a result, I’ll continue to be cautious and hold a lot of cash. If I find more stocks like SWBI or FRD that look like big opportunities, I’ll buy. What I won’t do is fill up my portfolio with subpar opportunities.

The large cash balance definitely weighs on my mind. Cash is a terrible investment long term, but I want to have the dry powder if the market crashes again.

I’ve considered deploying it into my passive asset allocation that you can read about here, but haven’t made up my mind on that yet.

My goal when I started this blog was to focus on Ben Graham’s low P/E, low debt/equity strategy during the good times. When the bad times arrived, I was going to buy net-net’s. The net-net’s started appearing in March and I didn’t buy enough of them. I barely had time to research any of them before they disappeared.

My instincts tell me this isn’t over and I’ll get another chance to buy them. 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.

Portfolio Position in Troubling Times

fork

Goodbye, shorts

I dumped my short position yesterday. It looks like I screwed up with this bet. Fortunately, it wasn’t a fatal bet.

I lost 15% on the position and I’m up slightly over the last few months overall, thanks to the performance of the stocks that I still own. I owned it mainly to stay market neutral and didn’t make a big bet on it, so it’s an outcome that isn’t the end of the world.

I’m still happy that I have been cautious this year. I’m down only 22% YTD, which is a lot better than the deep value universe that I operate in. The universe of stocks with an EV/EBIT multiple under 5 is down 40% YTD. It was previously down nearly 50% and I avoided nearly the entirety of this drawdown. I also outperformed this universe last year, when I was up 32%.

I still badly lag the S&P 500 since I started this blog in December 2016 – which is very disheartening – but I’ll take the good news where I can.

My passive approach (small value, long term treasuries, gold, international small caps, and real estate) has handled the crisis excellently, down only 5% YTD after being down only 20% in the worst of the crisis. I’m often tempted to put this brokerage account into that passive approach, but I still enjoy the hunt of picking stocks and trying to figure out the macro picture.

Positioning

I bought only a couple stocks during the depths of the crisis – VLGEA (super markets) and AOBC (guns – now SWBI). VLGEA is flat, but AOBC has been an outstanding performer. I am up 80% on the position. It looks like my thesis – that COVID would drive higher gun sales – is proving to be correct. I couldn’t have anticipated nationwide riots, but that appears to be helping out the position, as well.

While I am no longer short, I still hold a lot of cash. 78% of my portfolio is still cash. Needless to say, I am still quite bearish on the market, even though I don’t want to be short it.

The Market

If I’m bearish, why aren’t I holding onto the short position?

I know that a trend following element is absolutely essential to shorting.

I walked into the short with an eye on the market’s 200-day moving average. Recently, the S&P 500 crept above the 200 day moving average.

200dma

As a value investor, I have always talked a lot of smack about trend following, but I have been changing my mind after examining the evidence.

A great resource on trend following is Meb Faber’s paper – A Quantitative Approach to Tactical Asset Allocation. The approach advocates owning asset classes only when they are above their 200 day moving average. The approach reduces drawdowns while still delivering the market’s rate of return.

A trend following strategy like that gets out of the market when it falls below the moving average and stays invested when it is above.

Looking at the S&P 500 over the last decade, an investor would have only been out of the market a few times. They mostly turned out to be false alarms that didn’t see the market make a massive move lower. This includes the 2011 debt ceiling showdown, the oil market chaos in 2015-16, and the December 2018 meltdown.

Where a trend following strategy helps is during the big, nasty draw-downs. An investor following a trend system would have sold in February, avoiding all of the mayhem that occured in March. It would have also kept an investor out of the market during most of the 2000-03 50% drawdown. It would have also kept an investor out of the market from 2007-09 during that 50% debacle. Trend following buys in late in the game – but who cares? They avoid the cops showing up to the party, and then arrive a little late to the next one.

When a market is solidly above the 200 day moving average, it usually continues rallying higher, even when the fundamentals don’t support it.

Paul Tudor Jones is probably the most vocal advocate of using the 200 day moving average as a trend indicator. He had this to say about the approach:

My metric for everything I look at is the 200-day moving average of closing prices. I’ve seen too many things go to zero, stocks and commodities. The whole trick in investing is: “How do I keep from losing everything?” If you use the 200-day moving average rule, then you get out. You play defense, and you get out.

Historically, it is a very bad idea to be short the market when it is above this level.

While it is often maddening to value investors like me, the fact of the matter is that there is nothing to prevent something absurd from getting a lot more absurd. This is a lesson that value investors who have been short stocks like Tesla have learned the hard way.

It’s something that people who were short the Nasdaq in the ’90s also learned the hard way. An investor could have looked at the market in early 1999 and concluded that it was absurdly overvalued. They would have been correct. Even though they would have been correct, it wouldn’t have stopped the market from wiping them out by doubling before melting down from 2000-03.

Unrelated: “The Hard Way” was a pretty funny early ’90s flick.

 

There is nothing to keep an absurd market from getting more absurd.

As a value investor, I have a visceral hatred of following the herd, but I think it’s important to keep tabs on the movements of the herd to prevent me from getting trampled by it.

Absurdity

Make no mistake: I think what’s going on is completely absurd, but I’m not going to fight it.

The real economy has been eviscerated. We have Depression level unemployment – approaching 20%. America’s corporations are surviving by leveraging up, making them even more fragile than they were before the crisis. Even the tech giants that have enjoyed the biggest gains of the rebound have seen their earnings dissipate.

The Fed is providing liquidity, but that’s all that the Fed can do. Jerome Powell isn’t a sorcerer who can create a 1999 economy out of 1930s unemployment. The Fed is preventing the system from collapsing, but that’s not the same thing as fixing the damage that has been done to the actual economy. The Federal government is providing fiscal stimulus, but that isn’t enough to replace a job or re-create the actual productive economic activity that has been eliminated.

Wall Street doesn’t care. It has doubled down on its commitment to the Fed put – the idea that the Fed will have the power to prevent any further meltdown in the market. The actual earnings capacity of the market has been decimated, but the markets are completely ignoring this.

The bear thesis of the last decade – that the markets are fraudulent and being manipulated by the Fed – has now turned into the bull thesis. Buy stocks because the Fed will make it go higher. Earnings and the economy don’t matter. This is dangerous and absurd thinking.

One take is that the market believes we will swiftly return back to normal with the economy re-opening. Maybe, but I think this is a dubious bet. I’m sure activity will resume and life will go back to normal, but it’s not going to be 100% of where we were before. There will be a number of businesses (like bars & restaurants) that will not re-open, because they couldn’t survive a 100% drop in revenues. Meanwhile, furloughed employees won’t be immediately re-hired, as businesses take a wait-and-see approach to bringing them back on board.

Nor will everyone in the economy immediately leap back to normal. Everyone isn’t going to re-book their vacations, even if 70% of them do. Businesses aren’t going to resume all of their business trips and conferences. Older people will likely wait until it’s clear that the virus has either been overblown or that we have a vaccine. They also command most of the disposable income, so that’s a major hit to the economy.

There also isn’t a guarantee that there won’t be a resurgence of the virus once the lockdowns end. We flattened the curve, but who is to say this won’t start spreading all over again? This virus started with a handful of people in China and spread all over the world. Once we resume normal activities, won’t it start spreading all over again?

Most of the damage from the Spanish Flu occurred during the second wave of the virus. Will we have a second wave of this virus? Will that trigger another round of economically destructive lockdowns? I don’t know, but the probability of that happening is not zero.

Call me a pessimist, but I don’t see a lot to be optimistic about these days. The market is partying like it is 1999 while the economy is in 1932.

I’m still holding a lot of cash even though I am no longer short, simply because I think that the risks are massive and the market is behaving like they don’t exist.

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.

The value of the market, the value of value, and some soul searching

easter2020

Macro Valuations

I’ve written a lot about how the market is really expensive, no matter which way you slice it.

Meanwhile, we are facing a grim economic reality in which 6 million people are losing their jobs every week and cash flows are evaporating for American companies. Some estimate that unemployment will hit 20% (Great Depression levels) and GDP will take a massive hit, making the Great Recession look like a footnote.

Call me crazy, but I think valuations should be a lot lower in this environment.

My theory about market valuations is simple: the higher they are, the harder they fall.

Valuations don’t matter until we have a recession. When expensive markets run into a recession, they get annihilated. Because we can go for a decade without a recession, that’s a lot of time for valuations to run up to unsustainable levels. It’s also plenty of time for investors to get complacent and think valuations don’t matter. That was the prevailing attitude at the end of the ’90s and it has been the attitude recently.

The history of markets shows that markets move with earnings and cash flows over the long run and then exhibit speculative extremes in the multiples that investors are willing to pay for those earnings and cash flows.

Markets tend to extrapolate the present and assume current conditions will last forever and then get surprised when the environment shifts.

My goal (in my active account, anyway) is to take advantage of these sentiment shifts for individual stocks and the broader market. I want to buy from Mr. Market when he is depressed and sell to him when he is euphoric.

With market cap/GDP presently at 131%, macro valuations suggest that the market will deliver a negative return over the next decade. History suggests this negative return doesn’t happen in a straight line and that there will be a big bull market and a face-ripping bear somewhere in there. I think that the face-ripping bear is happening right now and we’re in the middle of it.

Right now, the markets are rallying because investors are realizing that the Fed won’t allow the system to collapse (I agree with this). They also think that the Fed they can engineer a quick and rapid recovery and pepper over rich valuations (I don’t agree agree with this).

Everyone seems to be getting very bulled up and cocky.

I think they are making a mistake.

It’s also possible that I’m making a mistake, so I decided to take a look at some additional data to figure out if that’s the case.

Value Investing Vs. The Market

Value purists would say that I shouldn’t pay attention to all of this nonsense.

They would argue that I’m not investing in the market. I’m investing in individual businesses. I’m not investing in the stock market, I’m investing in individual value stocks.

Unfortunately, it is impossible to assemble a group of 20-30 stocks that are not correlated with the market. Whether I like it or not, my stock portfolio is correlated with the market. The market matters.

To get around this and be less correlated with the market, I could concentrate in 5-8 of my “best ideas.”

I think this is a path that can cause permanent impairments of capital. A blow up in one or two positions can endanger the entire portfolio.

I’m also skeptical that I really have any “best ideas.” The best ideas of the best investors in history often blow up.

This is why diversification is the path I’ve chosen and I think 20-30 stocks is the best way to prevent portfolio blow ups while still offering the opportunity for outperformance.

The disadvantage of diversification is that I am more correlated with the market’s returns.

The Value of Value

With all of that said, I am worried that my focus on the valuation of the overall market is blinding me to the bargains within the deep value universe.

For this reason, I decided to take a look at the absolute valuation of the cheapo segment of the market. To do this, I used Ken French’s free data available on his website.

I restricted the data to the post-1990 universe. I’m considering the post-1990 period to be the modern era in which valuation multiples have been elevated.

I’m not expecting to be able to buy stocks at 1980 single digit CAPE valuations, for instance.

Let’s start by looking at cash flow/price.

Cash Flow/Price

cashcheap

At the end of 2019, the value segment of the market was close to its mean.

Not particularly exciting.

VBR (the Vanguard small value ETF) is down about 30% year to date, so I’d estimate that this is probably close to 20% now from 15% at year end 2019. That’s really encouraging, as it implies that the value segment of the market is close to its 2009 and early 2000’s levels. Those high levels will probably set the stage for tremendous performance in the upcoming years.

Interestingly, value was very expensive for most of the 2010’s. I think this is the key factor in value’s under-performance in the last decade. Value was expensive versus its long-run mean.

cashexpensive

Meanwhile, in compounder-bro-land, the market is more expensive than it was during the internet bubble. No surprise there.

Something interesting to note: this glamorous segment of the market was cheap in 2010 and the early 1990’s, likely setting up the excellent performance for glamour in the 1990’s and the 2010’s.

Book to Market

In most environments, last year’s cash flows are a good proxy for what’s happening next year.

In Quantitative Value, Wes Grey and Toby Carlisle found that trailing-twelve-month earnings work better than normalizing them. It’s a very surprising result, but it suggests that last year’s earnings tend to be a good proxy for next year’s.

Of course, we are not in a normal environment. Many businesses are seizing up and revenues are collapsing with economic lockdowns in place. This makes this current environment unlike any recession we have experienced since World War II.

For this reason, I think book value is useful in this kind of environment. When earnings disappear, different metrics of value are useful even though earnings-based metrics work better in the backtests.

booktomarketcheap1990

From this perspective, the value segment of the market was very cheap relative to its mean in the early 1990’s, the early 2000’s, and 2009. This makes sense, as those periods coincided with tremendous performance for value.

Like cash flow to price, this was also expensive through most of the 2010’s, explaining value’s woes during the last decade.

By this metric, at the end of 2019, value stocks were expensive.

With VBR down 30%, I estimate this is probably up to 190%. That is pretty good. It’s not as cheap as it was in 2009 or the early 2000’s, but it’s getting there.

expensive

Meanwhile, in compounder-bro-land, the market was more expensive at the end of 2019 than it was during the internet bubble.

Interestingly, it’s also evident that this segment of the market was cheap at the dawn of the 2010’s. This likely drove the tremendous performance of this segment of the market for the last decade.

Considering that QQQ is flat year to date, this segment of the market likely still beyond internet bubble extremes.

Good luck, compounder bros. I think you’re going to need it.

Soul Searching

Looking at this data, it suggests to me that I might be too cautious right now.

While the broader market is overvalued, the value segment of the market is approaching levels of cheapness last experienced in 2009.

On the other hand, this can get a lot cheaper, especially if the broader market tanks. This is particularly true considering that cash flows are about to disappear for a lot of businesses.

I could be allowing my emotions to blind me, which is a classic behavioral investing mistake. I am concerned about losing my job, for instance. I have a sizable emergency fund, but the idea of losing my job still worries me and can be clouding my thinking.

Earlier this year, I was contemplating selling my house and moving in search of another opportunity.

Now, I worry if I will be able to sell my house at a decent value. What job opportunities will even exist with the economy in lockdown?

Emotional stress might be interfering with my ability to see things clearly.

When I launched my blog, my hope was that I could build a portfolio of net-net’s when the next bear market arrived. During the boom, I’d stick to low price-to-earnings stocks and then shift my focus to net-net’s and negative enterprise value stocks.

There were net-net’s two weeks ago, but many of those bargains have since disappeared.

Is it possible that the opportunity to buy net-net’s emerged and disappeared in two weeks?

Maybe.

My gut tells me this is not the case and I will have an opportunity to purchase a portfolio of 20-30 high quality net-net’s and negative enterprise value stocks, but this French data makes me second guess that.

During this meltdown, I’ve been tempted to simply throw everything into my asset allocation which is down only 7.9% year to date. This allocation doesn’t try to predict the future and has caused me no stress.

If this market truly has passed me by and I’m wrong about everything, then I need to do some serious soul searching and re-evaluate my approach.

For now, I’m not ready to give up on my active account just yet. I do think there will be an opportunity to buy net-net’s and negative enterprise value stocks at some point during this bear market.

If not, I may need to simply pursue my asset allocation strategy and stop trying to pick stocks and predict the future.

It could also make more sense to focus more on arenas of the market where I can have more of an advantage, such as dark stocks and international net-net’s.

With that said, I don’t think I’m wrong, even though I’m open to that possibility.

I think it’s a bit of a fantasy to think we’ll have a 1987-style decline and 1988-style bounceback. After all, during 1987 and 1988, it was a time in which the economy was booming and we didn’t have a recession. Mr. Market was just being crazy. We faced a similar outcome at the end of 2018 and throughout 2019, another period in which we didn’t have a recession. Mr. Market was just being crazy.

This does not strike me as a comparable situation.

We’ll have to see, I guess.

This is a hard game, indeed.

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 2020 Update

s&amp;p500

Performance

I continue to under-perform the S&P 500. I’m in year #4 of putting this blog together after setting out to out-perform the market with a value portfolio.

It’s not working so far. I believe this is because of where we have been in the market cycle.

I still believe that small value will demonstrate exceptional performance when it usually does: when we are emerging from a recession and bear market.

This is what we saw in years like 1975, 1991, 2003, and 2009. Small value delivered the following performance in those years:

1975 = +53.94%

1991 = +42.96%

2003 = +37.19%

2009 = +30.34%

Meanwhile, value always lags at the end of a bull market. It then goes down with the market during the recession.

Then, it delivers the out-performance emerging from the recession. This cycle doesn’t look any different to me.

Of course, we are not there yet. This is 2008 (small value -32%), not 2009. This is 1990 (small value -19%), not 1991. This is 1974 (small value -21%), not 1975.

We are only at the beginning of a recession and a bear market. Historically, this isn’t when the small value premium is delivered.

Based on the seriousness of shutting down large chunks of the global economy, this is likely to be a worse recession than the global financial crisis. The economy never grounded to an absolute halt during the GFC and that’s what is happening now.

What makes my under-performance even more incredible is that I anticipated a recession and went into the year with a significant amount of cash. Going into year end, I was roughly 30% cash and bonds. Going into March, I was nearly 50% cash.

Despite all of that cash and bonds, I still under-performed the S&P 500!

My assumption was that my cash would provide a nice cushion against the downturn I thought was coming in the market. The fact that I held so much cash and still under-performed is absolutely staggering.

Of course, this happened because most of my portfolio was in the deep value universe. Value is a universe that was annihilated this quarter.

Take a look at some of the popular value ETF’s this year:

QVAL – Down 40.23%

VBR – Down 34.98%

SLYV – Down 37.36%

Looking at the deep value EV/EBIT < 5 universe, the performance is even worse.

evebit5universe

If I bought and held all of my stocks, then I would be looking at a very similar result today. My move to cash turned out to be the right decision.

Of course, my move to cash is not what a value investor is “supposed” to do. You’re not supposed to time the market, you’re not supposed to pay attention to macro, and you’re supposed to stick to the process no matter what. That’s what all of the mental models say and that’s what all of the experts say.

I’m done with all of that. I’m going to trust my own analysis going forward rather than mental models and superinvestor quotes.

Trades

I sold off most of my portfolio over concerns about the extreme recession and bear market that is unfolding.

I opened hedging positions with TAIL and SH to stay market neutral against the stocks that I still hold. I sold the short term bond ETF when rates went negative.

I bought one new position this quarter, American Outdoor Brands, a firearms manufacturer. You can read about the stock here.

The End of the Bull

How Bull Markets End

Since I started the blog, I have been worried about the next bear market.

Equities were rich and excess was everywhere. Venture capital firms were practically setting money on fire, as rich people gambled on the next Uber and Facebook, leading to situations like WeWork.

Private equity multiples and the leverage behind those deals grew more and more extreme.

We then had an ICO and crypto bubble, which bore many similarities to the dot com bubble. It was a mania. Manias are sure to end in tears.

Of course, market manias rarely end without a catalyst. That catalyst is typically a recession. In this cycle, we simply avoided a recession for longer than normal, so the mania grew more extreme.

I knew that once a recession came along, the market would be punished in an extreme fashion. I also knew that the frothy environment wouldn’t end until the recession came, so I stayed mostly long.

Now, the recession is here. It arrived faster and with more ferocity than I could ever have imagined.

Going into this year, I assumed that a recession was coming due to the yield curve inverting earlier in 2019.

The yield curve is the most reliable indicator of a recession that we have because it is a good proxy for how tight or loose the Fed is. I was really amused at everyone trying to rationalize the inversion earlier this year.

All of the “experts” lectured us about how inversions don’t matter, despite the yield curve’s excellent track record in predicting recessions. It’s different this time!

I expect the track record of the yield curve to remain intact. It will be even more useful during the next recession, because everyone will continue to dismiss the indicator.

Next time, they’ll say the 2019 inversion didn’t matter because what took down the economy was the Coronavirus. Then, a year later, we’ll have another recession.

We were headed into a recession and bear market without the Coronavirus. The Coronavirus is making a situation that was already unfolding into something more catastrophic to the global economy.

The Coronavirus is turning this from what would have been a normal, run-of-the-mill recession into the worst one that we’ve experienced since the Great Depression.

I do not understand the logic of the bulls who assume that the economy will just snap to life when everything re-opens. Will restaurant traffic immediately return to normal once everything re-opens? Will people return to movies, restaurants, and airlines right away? Will the millions of unemployed people suddenly get their jobs back?

Firms are going bankrupt right now. Their revenues are down 90%. Are they just going to spring back to life once everyone goes back to work? What about the deeper effects on the economy? Everyone’s spending is someone else’s income. Everyone’s debts are someone else’s assets. We’re witnessing a meltdown in asset values and income.

There is no way that is just magically resolved over a couple of months because the Fed is accommodative and some people get a $1,200 check and people can return to work. The bull case strikes me more as denial of reality than a valid thesis. It looks like an unrealistic fantasy to me.

Of course, this wouldn’t be the first time I’ve been wrong. I just think it’s highly unlikely that I am.

Valuation

Valuation is destiny and the market has been overvalued since 2014.

The pundits have mocked bears since 2014.

The overarching attitude has been: “You keep talking about the CAPE ratio, but the market went up 20% last year, so you’re wrong and valuation doesn’t matter!”

The bulls were wrong in thinking valuation no longer mattered. The bears were wrong in assuming that valuations would come down without a recession. Based on the yield curve, a recession wasn’t a serious thing to worry about in the mid-2010’s. It wasn’t even a major concern at the end of 2018.

Overvalued markets don’t come down to Earth on their own. There needs to be a catalyst. In market history, the catalyst is typically a recession.

Valuation alone doesn’t push the market down. The multiple-compression comes during the recession.

The extent of a big equity drawdown is a combination of the overvaluation of the market and the severity of the recession. The bears miscalculated in the mid-2010’s because they didn’t take into account the fact that a recession was unlikely. The bulls miscalculated last year because they didn’t realize a recession was baked into the cake and a severe re-adjustment was likely going to happen based on how frothy the market was.

And yes, the market was insanely frothy. It was even worse than the internet bubble.

Last year, market cap/GDP went above its internet bubble highs.

Market cap/GDP is very good at predicting 10 years worth of returns.

What it doesn’t tell you is the sequence of those returns.

Usually, the sequence of those returns is wild and correlated with the timing of recessions and recoveries. In 2000, market cap/GDP suggested a .4% rate of return. The actual result was a .9% rate of return from that level. Market cap/GDP was a pretty damn good indicator through this lens.

Of course, the market didn’t return .9% per year for a decade in a straight line. This return happens in extreme bull and bear runs. When a very mild recession came in the early 2000’s, an overvalued market was knocked down to Earth.

From 2000-2003, the market went down 44%. Then from 2003-2007, it went up 90%. Then, from 2007-2009, it went down 50%. Then, from 2009-2010, it went up 50%. The market never moves in a straight line.

Let’s look at another decade with sky-high valuations that suggested poor returns: the 1970’s.

From 1973-1974, the market fell 45%. 1975-1980, it went up 200%. Due to inflation, all of these moves were null and the market was essentially flat over that period.

These returns were predictable based on valuations. What was less predictable is the sequence of those returns based on the timings of recessions.

An even better indicator of market valuation is Jesse Livermore’s indicator: the average investor allocation to equities.

The indicator predicted the poor returns of the 1970’s. It also predicted the poor returns of the 2000’s. It also anticipated the significant bull runs of the 1980’s, 1990’s, and 2010’s.

allocation

There is always a lag with the data for this indicator, but the latest data in Fred showed a 46% average investor allocation to equities at the end of last year. This was not as extreme as the internet bubble, when this went up to 51%.

Plugging this model into my equation based on this metric, this suggest a .7% return for equities for the 2020’s. Pretty similar to the 2000’s.

Market cap/GDP was at an all time high at the market peak this year, at 151% of GDP. This also suggests flat to negative returns to the 2020’s.

Will the path to these returns look like a straight line for a decade, or will it be like Mr. Market’s insane mood swings . . . that has always been the case through the history of markets?

Right now, we’re facing the worst recession that we’ve experienced in 90 years at record valuations.

We should see at least a 50% drawdown from the highs. We had a 50% drawdown during less serious recessions with less overvalued markets. Why won’t it happen this time? Because markets are more efficient? Give me a break.

Does the last 30 years look like an efficient market to you?  Does it look like investors carefully calculate future economic prospects and cash flows during periods of prosperity and bear markets?

1990-2000 – Up 300%

2000-2003 – Down 45%

2003-2007 – Up 90%

2007-2009 – Down 50%

2009-2020 – Up 250%

Rather than carefully and rationally calculating future cash flows, it looks to me like markets simply extrapolate what is going on at the moment and assume that it will last forever, leading to extreme swings.

The bull case seems to be based on the idea that markets look forward and will see past this.

When has that ever been the case in markets? Looking at market history, I don’t see a group of rational actors that can see past the noise and look at the long-term picture of an economy.

At the peak of every expansion, markets get bid up to multiples that suggest it will never end. During most recessions (at high valuations, anyway), markets crash like prosperity will never come back.

Markets aren’t this efficient mechanism that we read about in finance textbooks.

This is how markets work. During prosperity, we have a wonderful bull market where multiples expand. Then, they come crashing down once we have a recession, based on how high multiples are and how bad the recession is. Fear and greed. It’s an eternal cycle of human emotion.

Why won’t this happen again, when we are facing the worst economic crisis we’ve had in a century? Have we broken the economic cycle? Are investors seeing the world more rationally than they did in the past?

This sounds absurd to me.

The Future

Of course, once all this is over, if history is any guide, we’ll have another rip-roaring bull market. We had a nice bull market from 1932-37 and we had a great bull market from 2003-07.

The good news is that the yield curve has un-inverted. Short term rates are now negative. I would expect this to continue.

Once the bond market begins anticipating a recovery, I would also expect longer term rates to start increasing again. This is happening now, but there is always a lag between the shift in monetary policy and its impact on the real economy. In the next year or two, markets will rebound. Of course, rebounds don’t happen after a mere 20% drawdown in the S&P 500 and at the opening gates of a recession.

curve

The virus isn’t going to last forever. At some point, we’ll have a vaccine. At some point, the lock-downs will end. At some point, fiscal and monetary stimulus will have an effect on the economy. That doesn’t seem like it will happen anytime soon, though.

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.

Do I trade too much?

water

Buffett: Hold Stocks Forever

One of the most common criticisms I get from other value investors is that I trade too much. This is mainly because value investing has come to mean whatever Warren Buffett says it means.

Buffett recommends that the best holding period is forever. Buy a great business at a fair price and hold onto it for decades. This has become the commonly accepted wisdom among value investors.

Buffett’s views on holding periods is best summarized by the below quotes:

Our favorite holding period is forever.

Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years

My activity is entirely inconsistent with this philosophy.

I argue that Buffett’s approach is only one method of value investing.

It is a perfectly valid approach. But it’s not the only valid approach.

Graham: Two Years or 50%

Graham had a different view. It is also one that makes more sense to me. Graham’s view was that an investor should calculate a stock’s intrinsic value, buy below that intrinsic value, and then sell when it reached that intrinsic value. In other words, Graham believed in simple, easily comprehensible, rules-based value investing.

This is different from holding onto stocks in great businesses for decades on end no matter what.

Graham explained his rules in the following interview:

Q: How long should I hold onto these stocks?

A: First, you set a profit objective for yourself. An objective of 50 percent of cost should give good results.

Q: You mean I should aim for a 50 percent profit on every stock I buy?

A: Yes. As soon as a stock goes up that much, sell it.

Q: What if it doesn’t reach that objective?

A: You have to set a limit on your holding period in advance. My research shows that two to three years works out best. So I recommend this rule: If a stock hasn’t met your objective by the end of the second calendar year from the time of purchase, sell it regardless of price. For example, if you bought a stock in September 1976, you’d sell it no later than the end of 1978.

In other words, Graham recommended that an investor should sell a stock after a 50% gain or after holding for two years, whichever comes first.

This view makes sense to me.

I estimate what I think something is worth, then I sell when it hits that value. I don’t think I’m capable of figuring out which stocks among the thousands available in the investable universe will overcome the odds and compound for decades on end. I do think I’m capable of identifying a bargain and selling when it is reasonably close to its intrinsic value.

There are drawbacks to this strategy. I will never own a stock that compounds throughout the decades. I’ll never buy and hold Nike for 40 years. I’ll never become a millionaire by investing in the Amazon IPO.

I also don’t care. I can achieve perfectly satisfactory results without trying to buy these lottery tickets.

My approach is a high turnover approach, which increases costs and taxes. This is a big deal for someone like Buffett and not so much for me. Buffett is a megaladon and I’m a gnat in the belly of minnow. My trading account that I track on this blog is in an IRA and brokers don’t charge commissions any longer. I have miniscule sums of money and I can’t influence the price of a stock.

My strategy isn’t scalable, either. At least, it’s not scalable to Warren Buffett’s level. Warren Buffett commands the one of the largest pools of investable cash (that is constantly growing!) in global markets. He can’t nimbly move in and out of stocks. It’s like an elephant trying to nimbly move in and out of a swimming pool.

Buffett’s strategy is entirely valid, but it’s not the only valid strategy.

What’s a Wonderful Business?

Buffett recommends buying wonderful businesses. Well, what’s a wonderful business?

A wonderful business is a business that can earn high returns on capital over long periods of time.

This is extremely hard to do. It’s extremely hard to do because we live in a capitalist economy with a lot of competition. If someone has a business where they can earn high returns, other businesses are going to swoop in and do the same thing, which will reduce those returns.

This is why Warren Buffett focuses so much on the concept of a moat. Those high returns on capital can only be sustained if there is something about the business that helps it resist competition.

Where do moats come from? They can emerge from a lot of places. Some businesses might have a geographical moat, like a toll bridge. Others might have a regulatory moat, where government policy helps sustain their advantage. Brands are another form of moat. Are you willing to pay a premium for a Nike swoosh? You likely already have, many times over.

Buffett has identified many moats in good brands. After successes with other wonderful businesses such as American Express and Disney in the 1960’s, Buffett recognized the power of a moat through his investment in See’s Candy in the early 1970’s.

See’s Candy can earn high margins because it has a recognizable and enduring brand. Munger explains the moat below:

“When you were a 16-year-old, you took a box of candy on your first date with a girl and gave it either to her parents or to her. In California the girls slap you when you bring Russell Stover, and kiss you when you bring See’s.”

People are willing to pay a premium for See’s because of the enduring quality of the brand. That’s not something that an upstart competitor can easily disrupt.

The same is true for Coca-Cola. Coca-Cola has a strong brand. If you face a choice between a store brand Cola and Coke, you’re going to pick Coke.

It won’t make much of a difference in your personal finances or grocery bill if you pay 40 cents a can versus 30 cents a can. Why wouldn’t you chose a marginally more expensive quality brand that you’re familiar with over one that you have no familiarity with? Meanwhile, that small difference in price creates large profit margins that are sustainable over long periods of time.

Moats Are Hard to Find

Situations like Coke and See’s sound deceptively easy to identify.

A key problem is that moats are much harder to identify than we realize.

The concept of moats was popularized by Buffett, but it is rooted in the ideas of Michael Porter.

The ideas of Michael Porter have been widely disseminated throughout business education programs. In the 1980’s, it was first taught at the Ivy Leagues. By the 2000’s, it was disseminated and understood far and wide.

My MBA is about as far away from the Ivies that you can go. I earned my MBA at a cheap state school, but even I was taught the gospel of Michael Porter. Much like the efficient market hypothesis, which was drilled into my head during my Finance undergrad degree, Porter’s ideas were treated as gospel truth.

There’s a problem with the ideas of Michael Porter: there isn’t any proof that any of it is true. Dan Rasmussen explains much better than I ever could in this excellent article in Institutional Investor. Rasmussen explains:

Porter’s logic suggests that firms with competitive advantage would earn excess profits, so profitability margins should be a guide to which firms have the most-sustainable profit pools. Yet profit margins have no predictive power in the stock markets. In fact, academic research suggests that margins are mean-reverting and provide little information about future profitability. The implicit certainty of Porter’s view of the world — that margins are persistent, that competitive advantages result from permanent structural features of industries, that “excess profits” come only from distortions in market structure — could lead investors to overpay for current performers. The theory leads not to an investing edge, but to the most common of investing mistakes.

It’s harder than hell to distinguish between a business that is enjoying a temporary edge between one that is an economic franchise.

It’s also hard as hell to figure out if an economic franchise which has endured for decades is about the completely fall apart. One of the best examples of this is Kodak. In the 1990’s, Kodak looked like it had an impenetrable moat. Then digital cameras came along.

Morningstar has put significant resources and intellectual depth into identifying moats. As highlighted in this excellent article by Rupert Hargraves, companies christened as “wide moat” don’t outperform over the long run like they theoretically should. Are you a better analyst of a moat than the talented people at Morningstar who have devoted themselves to solving this problem?

The same phenomenon is also highlighted by Tobias Carlisle in Deep Value. Carlisle cites Michele Clayman’s analysis of Tom Peter’s book “In Search of Excellence” as an example.

In the early 1980’s, Tom Peters identified key attributes of “wonderful” companies and assembled a list of truly wonderful companies. These were companies with high growth rates and high returns on invested capital.

In 1987, Michele Clayman analyzed the stock performance of these “excellent” companies. The portfolio underperformed the S&P 500.

Adding insult to injury, Clayman also assembled a list of companies with the opposite characteristics of excellence – bad returns on capital, low growth rates. Guess what? The unexcellent portfolio outperformed both the S&P 500 and the “excellent” portfolio by a wide margin.

Of course, a modern value investor would argue that they weren’t really excellent companies because they didn’t have a moat to defend those high returns on capital.

These investors would say that the companies that they are purchasing today actually have a moat. Okay. What’s more likely? That these investors have found a moat or a business enjoying a temporarily good situation that will ultimately be eroded by competition? I would say that the evidence suggests they are unlikely to find a moat.

Coca Cola: A Case Study in Moats

The Moat

Buffett gobbled up Coca-Cola shares after the stock market crash of 1987. He knew Coca-Cola was one of the ultimate American brands and had a strong moat which allowed it to earn high returns on invested capital.

A key source of Coke’s moat was its long and successful marketing campaigns. Coke was everywhere for 100 years. Baseball games. Logos printed on every billboard. Indelible images pounded into the American psyche, like Santa Claus drinking an icy cold Coca-Cola and smiling.

The success of Coca Cola’s marketing was best demonstrated during Coca-Cola’s debacle with New Coke. In 1985, Coca-Cola tried to change their formula. They tested out their formula in taste tests and people preferred it.

Once the new flavor was released, the public hated it. Coke executives quickly realized that Coca-Cola’s success had nothing to do with the actual taste: it had to do with the public perception of the Coca Cola brand, which Coke spent decades establishing. The people associated messing with Coke’s flavor with messing with a part of Americana itself. Coke ultimately relented and brought back the old flavor in the form of “Coca-Cola Classic.”

This is a great documentary from 2003 on the debacle, the People vs. Coca-Cola.

I grew up on a steady diet of Coke marketing and Coke products. Coke’s aggressive marketing has made me associate that brand with an image of America itself.

The sugary sweetness was an immediate appeal. The sugar and caffeine high that came afterwards made me feel good. It was usually served to me at happy occasions: family events, movies, birthday parties. My mind quickly associated the taste of Coca-Cola with good times and good feelings.

Generations of children had the same experience. This made for a hell of a moat, probably the ultimate moat in the history of business.

A Wonderful Business at a Fair Price

Modern value investors are obsessed with identifying Coke-like businesses. They want to identify these wonderful businesses at fair prices and hold onto them for decades of compounding success, following Buffett’s example.

As justification for their frothy purchases, they cite Buffett’s transformation from buying stocks below working capital to buying wonderful businesses at fair prices.

Of course, the price of Buffett’s Coke purchase was hardly modern compounder territory. Buffett bought Coke at a P/E of 12.89 in 1989 and 14.47 in 1988.

Furthermore, I think that Buffett holding onto Coca-Cola for decades was a mistake. He should have sold it in the late ’90s.

Coca-Cola has treated Berkshire exceptionally well. Coca-Cola has compounded at a 13% rate since 1986 in comparison to the stock market’s rate of 10% during the same period. In other words, Coca-Cola turned a $10,000 investment into $660,653. The US stock market turned the same $10,000 into $270,528.

What is missing from the raw CAGR is the sequence of these returns. From 1986 to 1998, Coca-Cola grew at an astounding CAGR of 27.68%. However, from 1998 through 2020, Coke has only appreciated at a CAGR of 4.74%. 10 year treasuries have returned 5.31% with a lot less stress.

An investor would have been better off investing in 10-year treasuries in 1998 than investing in Coca-Cola.

Did Coca-Cola’s business change? No. Coca-Cola has continued to be a great business since 1998, growing earnings and earning high returns on invested capital. It didn’t matter for the stock.

What changed was the price. Coca-Cola got up to a P/E of 40x in 1998. The price grew faster than the fundamentals.

The valuation mean-reverted in the 2000’s despite the performance of the underlying business, causing the less than satisfactory result.

Buffett should have sold Coca-Cola in the late ’90s, but he didn’t.

Why didn’t he?

It could be for public image reasons. Berkshire had become so closely associated with the company. If Buffett sold, it would be a blow to the public image of Berkshire and Coke.

He also couldn’t nimbly move out of it, as it had grown into a massive portion of the Berkshire portfolio.

In fact, it’s quite possible that Buffett realized Coke was expensive, couldn’t sell for the public image reasons, and this may have been a major reason that Berkshire purchased General Re, which helped dilute Coke as a percentage of Berkshire’s holdings.

I’d also argue Buffett was in love with the business and couldn’t bring himself to sell.

Problems with Wonderful Businesses

Coke’s price run-up in the ’90s and Buffett’s mistake by holding on outlines a major problem with buying wonderful businesses.

If the business is indeed wonderful, how can an investor bring themselves to sell when the price gets ahead of the fundamentals?

Another major problem with moat investing is that moats are ridiculously hard to identify. I would argue that even Coca-Cola’s moat isn’t certain to persist into the future.

While it was socially acceptable to give children sugar water when I was a kid, that dynamic is different today. Coke has tried to get away from this problem by diversifying into other products. Still, I find it hard to believe that Dasani will have the same marketing grip over future generations that Classic Coca-Cola had over previous generations.

If Coke’s moat is uncertain, then what moats are certain?

If it’s possible that Buffett – the greatest business analyst of the last hundred years – is making a mistake by holding Coke, then what are the odds that you going to make a mistake by buying the business that you think has a wide moat? I am certainly not a business analyst that’s as good as Buffett.

It is also increasingly difficult to acquire these businesses at “fair” prices. Investors fall in love with wide-moat businesses and bid them up to prices which are likely going to create disappointing future results.

For example, modern value investors are buying things like Visa and Costco because they are wonderful businesses with moats.

I certainly agree that, on the surface, Visa and Costco have incredible moats. Visa controls a significant portion of the global payment system and it’s unlikely that a competitor can disrupt that. Costco controls an ever increasing portion of America’s retail spending habits and maintains that by maintaining low prices and locking in consumers with memberships.

Neither of these businesses can be acquired at the kind of “fair” prices that Buffett acquired companies like See’s and Coca-Cola.

Look at the current EV/EBIT multiples of these wonderful businesses:

Coca-Cola – 24.14

Costco – 19.91

Visa – 23.42

Additionally, Buffett didn’t buy Coke and See’s at crazy, or even slightly high, prices. They were incredible bargains!

As mentioned earlier, for Coke, Buffett bought it at a P/E of 14 and 12. The enterprise multiple was likely much lower than that raw P/E suggests. See’s was purchased for $25 million. Sales were $30 million the year that he bought it. Profits were $4.2 million.

Buying a company for less than its annual sales and at a P/E of 5.95 is nothing like buying today’s compounders at EV/EBIT multiples over 20.

Yes, See’s wasn’t a net-net, but it was hardly a situation where Buffett and Munger threw caution to the wind and paid a sky high valuation for a great business that compounded over time.

Do I Trade Too Much?

Let’s return full circle to the question I asked at the beginning. Do I trade too much?

I don’t buy wonderful businesses and hold them for all the reasons described above. I buy cheap stocks and then get out when the fundamentals deteriorate or they get close to intrinsic value. I certainly trade more than the Buffett-style compounding value investors, who would waive a ruler at me like a nun in Catholic school for betraying the faith.

I went to Catholic school and this was a frequent occurrence.

I trade even more frequently than Graham’s rules recommend.

Not only do I sell at intrinsic value, I often sell at mere 52-week highs. I’ll also sell if I notice a deterioration in the performance of the business, often relatively quickly after I buy them.

A major reason I sell so quickly is because I know I’m not necessarily buying wonderful businesses. I’m buying businesses at what looks like a bargain price regardless of its underlying quality. I get out when I see signs of a deterioration in the business, which helps me avoid value traps.

I’d argue that the approach works, even though I’ve lagged the S&P 500.

As with all things, I like to look at the evidence and not the dogma.

Here is a comparison of stocks I’ve sold, comparing my sale price to the current market price.

price1

2

sells

selling

I’m not following the Buffett scriptures, but it seems to me like I’ve made some pretty decent sell decisions.

I think I will continue to follow my own path instead of sticking to an investing religion dogmatically.

Summary

  • Buffett believes in long term holding periods. Graham recommending shorter periods. I agree with Graham.
  • Wonderful businesses with moats are extraordinarily hard to find. It’s also hard to find in any quantitative sense.
  • There isn’t any empirical evidence that proves that wonderful businesses outperform over long periods of time. In fact, the opposite is true.
  • I get criticism for trading too much, but it seems to be working out for me. I’m going to chart my own path and not stick to an investing dogma like it’s a religion.
  • You do you. There isn’t any one true faith in investing.

Random

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.

Quick Note

TAIL

I bought TAIL yesterday. I basically bought this as a hedge against the stocks that I still own that I can’t bring myself to sell. This helps me stay somewhat market neutral during this bear market.

I’m not taking an outright short position on the market. Yet, anyway. Still struggling with whether I want to actually do that.

Deep Value

The good news is that the deep value universe of stocks in the Russell 3K with an EV/EBIT multiple under 5 is now over 200 stocks, which is the best environment we have seen since the financial crisis.

Under normal circumstances, I would be a buyer. I just don’t think markets bottom when a recession is only just beginning.

deepvalue

Market Valuations

Other good news, after yesterday’s decline, market cap/GDP is now down to 110%. This isn’t cheap, but better than where we were. There are a range of outcomes from here depending on where valuations are 10 years from now:

Market cap/GDP = 40% = -6.3% CAGR

80% = 1.7%

120% = 6.7%

The outcome is largely unknowable. Future valuations strongly depend on what interest rates are 10 years from now.

I think you could make a strong case for both outcomes: interest rates will be lower as we emulate the Japan example, which suggests valuations can be higher.

It’s also possible interest rates will be higher. I think that’s the likely outcome, as our demographic situation is different than Japan and I think money velocity will likely pick up as Millennials enter their peak earnings years. It’s also quite possible that, thanks to quarantines, we’ll have a baby boom in 9 months which is also bullish for the long term prospects of the economy.

In any case, we have to look at the range of outcomes. The base case is 1.7%, which isn’t really too exciting compared to the risk of owning equities.

Recession

Markets don’t bottom at the beginning of a recession when unemployment is low.

Of course, there isn’t anything normal about what’s going on right now. This was a violent move down, and for all I know the market could make an equally violent move up when this is all resolved.

I turn to valuations and history for guidance. In the last two recessionary drawdowns, market cap/GDP got down to 75% in 2003 and 57% in 2009. That means this likely really isn’t over until we get down to at least 80%.

The yield curve is currently un-inverted. That’s good news. I’m unusual among cranky market bears in that I want the Fed to ease and try to stop this recession aggressively and think they’re doing the right thing by throwing the kitchen sink at this. I also think that the federal government needs to pursue hardcore fiscal stimulus to end this.

yield

Markets don’t bottom when the yield curve just starts to un-invert. They bottom when we have a large spread between the 3-month and 10-year. That’s a pretty good indicator that an economic boom and turnaround is in our future. We aren’t there yet.

Buuuut . . . at least we’re starting to get there and are headed in the right direction.

More good news is that the vaccine is being tested. Let’s make sure this works and roll it out and defeat this thing.

Stay safe and healthy. Hug your people. Well, those you’re safely quarantined with. 🙂

Random

Electric Youth is great.

 

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

I’m out

dark

Selling

I sold a lot of stocks this week. I sold most of my stocks this week. I’m now up to 79.5% cash and bonds in this portfolio. This is obviously a wildly bearish perspective for markets and the economy.

One perspective on this: I’m panic selling and I’m not taking a long term perspective.

People of this persuasion would probably say: value investors should buy when there is blood in the streets! Isn’t there blood in the streets right now?

I don’t think so. I think we are only at the beginning of a truly horrific period for the markets and the economy and I am accumulating cash to take advantage of the bottom, which we are nowhere near.

I don’t think we’re anywhere close to the end of this. This is not capitulation. My Twitter feed is still full of people talking about buying the dip. The BTFD mantra isn’t slowing down.

That is not the mentality you see at the bottom of the market.

With all of this said, yes, I’m timing the market. Yes, I know you’re not supposed to time the market. Yes, I know you’re not supposed to pay attention to macro.

Yes, this is speculation. But you know what? Picking individual stocks is speculation. I created this account for active bets. I have other accounts for my balanced asset allocations. This account is for active bets. Right now, I’m making an active bet that this is only the beginning of a massive drawdown and value stocks are not going to be a place to hide.

I’m also nearly certain I’m right about this and I’m acting accordingly. This is only the beginning of the horror show that is about to unfold. I even sold my “cash equivalent” ETF because I’m concerned about the corporate debt market, which that ETF has exposure to.

I might look like a fool for doing this by the time all is said and done, but I think this is a prudent course of action based on where we are.

Recession

Back in December 2018, I was bullish. The reason was pretty simple: I knew we were not going to have a recession and there were a lot of cheap stocks.

Going into this year, I was bearish. The yield curve had already inverted, which reliably predicts recessions 1-2 years out. The world economy was already showing signs of slowing down, and manufacturing was already in a recession.

In the recession, my expectation was that stocks would fall 50%. I thought that my 30% cash allocation would give me a decent cushion when that happened. I also assumed that throughout 2020, I would have the opportunity to gradually exit positions and build up that cash position. There was nothing gradual about this decline.

While everyone loves the buy-and-hold mantra and Warren Buffett also extols it, I think it’s a common mantra at the end of a bull market that is typically bad advice.

Buffett has a quote which people like to repeat: “Be fearful when others are greedy, and greedy when others are fearful.”

Well, to be fearful when others are greedy, you actually need to sell. To be greedy when others are fearful, you actually need to have cash on hand to take advantage of the bargains. This advice is incompatible with buy-and-hold.

The reaction to the Coronavirus is going to make a recession that was already underway even worse. This isn’t going to be a standard recession. This is going to be much worse than recent experiences. This is unlike anything we’ve experienced since the Depression.

Around me, closures are being announced all over. Malls are closed. Sports are cancelled. Airports are dead. Even among the places that aren’t closed, people are avoiding them.

Think about what is going on right now. Global trade and global supply chains are slowing. People are beginning to quarantine themselves. That means they’re not going to restaurants and bars. What happens to the people who depend on tip income at restaurants and bars, for instance? What happens to the businesses where they spend money? How about people who work at airports? Movie theaters? Daycares?

Right now, we are suspending large chunks of the economic machine.

Now, think about all of the leveraged firms that are out there. How are they going to handle the slightest hiccup in their cash flows? Will they be able to keep making payments on their debt? Or will this force them over the edge? Now, what happens to all of the people who worked for those leveraged firms? Where do those people spend money? How about the partners that these firms had? Everyone’s spending is someone else’s income.

In 2008, the peak to trough decline in GDP was only 2.24%. Think about the impact that a 2.24% reduction in GDP had on markets and the economy. With the situation that’s currently unfolding, I’m betting the decline in GDP is going to be a hell of a lot worse than 2.24%.

Valuation

The thing about valuation: it doesn’t matter until something goes wrong.

Think about your typical highly valued stock. It has an absurd expectations embedded into it. As long as it continues to meet those expectations, then valuation doesn’t matter.

Of course, as a rule of nature, s*** happens. Eventually, there will be a hiccup or whiff of bad news. The stock craters. It is a phenomenon that repeats over and over again. It surprises market participants again and again.

The entire US stock market is the equivalent of a richly valued stock right now.

We’ve been lucky for the last 10 years. No s*** has happened. No recession. We had a near default in 2011, but it didn’t happen and we didn’t have a recession. We had an oil decline in 2015, which was bad for the oil industry, but good for everyone else. No recession. This is why valuations haven’t mattered and bears have become a punchline among the investing commentary class.

Now, we’re going into a storm. The s*** is hitting the fan. And we’re going into this at absolutely absurd valuations.

Recently, on a market cap/GDP perspective, we exceeded the highs of the tech bubble. The stock market was valued at 150% of GDP.  We were at 140% in 2000. We’re at 125% now.

To put this into perspective, at the lows in the early 2000’s bear market, we got down to 75% of GDP. That is 40% down from here.

And what happened during the recession of the early 2000s? Unemployment peaked at only 6%. To put this into perspective: unemployment was 6% in 2014 when we felt like the economy was booming. In the early 2000’s, we barely had a decline in GDP. The overvaluation in the market meant that an extremely mild recession was enough to send markets into a 45% peak-to-trough decline.

In 2008, the market was not as expensive. We were at 110% of GDP. The valuation fell to 57% of GDP. If we fell to this level from here, it means markets fall by another 54%. Hello, S&P 1,250.

2008 was an intense recession. However, as I mentioned earlier, that was only a 2.24% decline in GDP. Unemployment peaked at 10%. The fact that the market wasn’t as expensive as it was in 2000 probably cushioned that drawdown.

The extent of a serious drawdown is a combination of the overvaluation of the market and the severity of the recession. We were lucky that the early 2000’s recession was a mild one. I’ll bet that if we went into the 2008 recession at 2000 valuations, we would have seen a 60-80% decline in the market.

This time, we went into this drawdown already ahead of the 2000 era valuations. Meanwhile, we are likely going to get a recession that is even worse than 2008. This is a recipe for a horrific decline in the markets.

Value’s Place in This

I own a bunch of stocks with a margin of safety, right? If I already own stocks with margin of safety, then why should I care about the broader market? Why sell when I know the stock is worth more than that?

Well, the fact of the matter is that value almost always goes down with the broader market, sometimes by more. When markets drawdown, they bring everything else down with it. Serious drawdowns happen during recessions.

red

In every big drawdown, the US stock market has managed to drag small value down with it. This even happened in the early 2000’s. Value did well over this period, but in the middle of it, it still experienced a 31.28% drawdown.

Margins of safety don’t offer protection in recession. The margins of safety get bigger as the bear markets grind on.

Another part of the problem is that my margin of safety is based on EBIT and earnings. One of the drawbacks of this approach is that EBIT evaporates into a poof of smoke during a serious recession. Goodbye, margin of safety.

Looking Forward

Eventually, of course, I think this market will bottom. There will be fiscal stimulus. There will be monetary stimulus. There will be pent up demand from months of quarantines.

This will eventually be a stock picking bonanza, just like 1974 or 2009.

I just don’t think we’re there yet.

What if I’m wrong?

Well, that’s why I own a passive account that’s balanced between asset classes that should do well in multiple economic environments (this portfolio has 40% in treasuries and gold) and it is where I don’t try to predict the future.

If I’m wrong, I’ll have too much cash and I’ll continue lagging the S&P 500. No news there.

If I’m wrong, you can all laugh at how stupid I was to sell good businesses at bargain prices.

Frankly, I hope that happens, because I don’t want a recession or decline of this magnitude to happen. It’s going to be bad news for a lot of people who don’t deserve this. I’ll take absolutely zero pleasure in seeing this happen.

But . . . every fiber of my being tells me that I’m not wrong. I haven’t decided if I want to make an outright bearish bet on something like SH, but don’t be surprised if you see that trade soon.

I am positioning myself accordingly and trusting my instincts and my analysis.

Random

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.

2019: A Year In Review

returns

Performance

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

pain

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.

cheapobucket

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:

closedyearend

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:

  1. Movado
  2. National General Holdings
  3. Prudential
  4. Principal Financial Group
  5. 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.

feargreed

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.

bigtrouble

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.

yieldcurve

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.

velocity

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.

average

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.

margins

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.

Random

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.

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.

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.