Category Archives: Portfolio Commentary

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.

CD’s & Cash

bank

After the run-up in the market, there are no longer a lot of bargains.

I also think a recession is coming in the next couple of years, so I don’t want to take on unnecessary risk and would like to gradually unwind. I want to have plenty of cash to take advantage of the next downturn.

Additionally, looking at some of the mistakes in my portfolio, I noticed that they all happened when I bought subpar stocks just to stay 100% fully invested. Looking back on it, I would have been better off if I only purchased the bargains I felt were compelling, as I did with the stocks purchased in December 2018. I would have been better off if I held more cash and only bought when I had more conviction.

Thinking about all of this, I turned to the writings of Seth Klarman for advice. I think he nailed it with these quotes about this topic:

“Our willingness to hold cash at times when great opportunities are scarce allows us to take advantage of opportunity amidst the turmoil that could handcuff a competitor who is always fully invested.”

“It wouldn’t be overstating the case to say that investors face a crisis of low returns: less than they want or expect, and less than many of them need. Investors must choose between two alternatives. One is to hold stocks and bonds at the historically high prices that prevail in today’s markets, locking in what would traditionally have been sub-par returns. If prices never drop, causing returns to revert to more normal levels, this will have been the right decision. However, if prices decline, raising prospective returns on securities, investors will experience potentially substantial mark to market losses, thereby faring considerably worse than if they had been more patient.”

So, I moved $1,992.16 into short-term CD’s that mature in December with a 2%+ yield to maturity. The mid-December maturity coincides with my standard portfolio rebalance. Hopefully, at that point, more bargains will be available.

I considered moving towards a long-term bond ETF, but that is an outright speculative bet that a recession will happen. I think a recession is a likely outcome in the next 1-2 years, but I do not think I should make an outright speculative bet on that outcome.

For now, I will stick to the traditional value investing strategy. When I can’t find a new bargain, I will hold cash and cash instruments like CD’s and short term bonds. I will resist the impulse to stay fully invested at all times.

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 2019 Update

return

I had a good quarter. I gained 15.74%, which compares to the S&P 500’s total return of 13.5%.

For the last few years, I’ve done a major rebalance in December and then usually did absolutely nothing in the first quarter. This year, the market move and company specific events compelled me to sell some positions, and with the cash I established some new ones.

Sales

Gamestop – After two years of waiting in Gamestop for the company to be bought out,  Gamestop announced they were going to stop trying to sell to a private equity firm, dashing all of my hopes. The major source of Gamestop’s cash flow is the re-selling of old video games and system platforms. This is a dying business as more video game consumers will download games directly and purchase platforms online. With that said, I think the business will be around longer than the market thinks. This is why about 4 years of Gamestop’s business could pay for the entire company. While the business is  in decline, this cashflow has value if Gamestop plays it correctly. My hope was that an acquirer would see this value, because Gamestop itself seems to be blowing the dwindling cash on dividends.

Looking back at this debacle, I likely should have sold this after the first accounting loss a year ago and admitted defeat. I also foolishly doubled down on the position in 2017. This is usually a bad idea. I lost 52% on the stock.

Sanderson Farms – I sold Sanderson Farms after an operating loss. At the moment, this looks like a mistake. The stock is now up to $130/share from my sale price of $115/share. Sanderson is a great company, but I try to sell when my positions approach a rich valuation, even if I like the business. A higher valuation plus a top line loss compelled me to sell. I made 16.6% on the position. I will likely return if the stock becomes cheap again.

ProPetro – I made 45.33% on this position in a very short time. I purchased this in December, and I thought the uptick was absurd, so I sold. Since then, it has gone higher.

Gap – Gap announced on March 1st that they were going to split the company up into a “good company” (Old Navy) and a “bad company” (all of the mall retailers). The stock soared on the news very quickly in one day. This made no sense to me, as current shareholders still own the same thing. I thought the increase didn’t make any sense, so I sold for a 19.76% gain. This looks like it was a good trade, as I sold at the top after the surge and the stock has steadily declined since then.

Thor – Thor reported terrible results and I sold the stock because of the deteriorating fundamentals. I sold the stock for a loss of 38.27%.

Aaron’s – Aaron’s reached a 52-week high in March, and the valuation increased significantly, so I sold the stock for a 29% gain.

Buys

With all of the unexpected cash from my sells, I purchased some brand new positions. The new positions are listed below with links to my rationales.

  1. Louisana Pacific
  2. Hollyfrontier
  3. Winnebago
  4. Urban Outfitters
  5. Express

I also expanded my position in Nucor.

The Value Opportunity

In the fall of last year, Mr. Market’s temper tantrum created a high number of bargain stocks, which is historically an excellent sign for value stocks. More bargains typically result in higher returns.

In December, the number of cheap stocks in the Russell 3,000 peaked at 108 stocks. My definition of cheap is an EV/EBIT multiple under 5.

The below chart, which I put together back in 2017, breaks down the number of cheap stocks in the market and the subsequent return they delivered over the next calendar year.

Generally speaking, a higher quantity of cheap stocks tends to result in higher returns for this group. It means that the “cheap” stocks are unusually cheap, giving them a long runway to expand their multiples and substantially increase in price.

cheap

2000 and 2001 stand out as years of substantial outperformance for value. The indexes suffered declines as the tech bubble deflated, but value performed exceptionally well. This is because the cheapest stocks were cheap on an absolute basis after being overlooked during the mania of the late ’90s and their multiples expanded despite the carnage in the broader market.

I noticed that the situation at the end of 2018 was similar to 2000, a year which delivered epic outperformance for value investors. There were over 100 cheap stocks in the US market and, as the yield curve had not yet inverted, it didn’t seem likely that we were going to have a recession.

The market delivered on this faster than I imagined. December was a time when investors needed to strike while the iron was hot, as the opportunity came and quickly dissipated. As a group, the number of cheap stocks went from 108 on Christmas Eve to 67 today.

The record for this cohort has been mixed. In February, the group was up nearly 20% for the year. That gain has since dissipated to a 10% year to date return, now underperforming the index.  We’ll see how this shakes out as the year continues.

Macro

I think that the yield curve is the best indicator of the likelihood of a recession. I covered the use of the yield curve as a recession predictor in this post: the Dark Art of recession prediction.

Why does the yield curve “work” as a recession indicator? Simply put, the Federal Reserve is the dominant factor in the business cycle. The Federal Reserve is the cause of and cure to nearly every recession. Expansions in the US end when the Fed is too tight. A yield curve inversion is a sign that the fed is too tight.

The 3-month and 10-year treasury yield inverted a few weeks ago. The 2 year and 10 year haven’t inverted yet, but have flattened. The 10 and the 30 is another good indicator, as pointed out in this post by Scott Grannis.

There is typically a lag between a yield curve inversion and the onset of a recession of a year or two. There is a similar lag between Fed cuts and the beginning of a new economic expansion. The yield curve inverted in 2005-06 and the impact of that relatively tight monetary policy wasn’t felt until 2008-09. The Fed began aggressively cutting rates in 2007, but this didn’t start to have a positive effect on the economy until late 2009.

Ray Dalio famously says an economy is a machine. I think it’s more likely an organism, responding slowly and organically to policy changes.

The slow way that the economy responds to these changes is difficult to navigate for investors. We are like blindfolded people trying to navigate our way through a funhouse. It’s particularly confusing because the year or two after a yield curve inversion is often one of the best parts of the business cycle. The economy is red hot, and everything seems wonderful. Think about the mood in 1989, 1999, or 2006. The party was about to end, but it was also at its most roaring. All of these years were after a yield curve inversion, and it was difficult for investors to look at the robust economy and imagine how it could fall apart.

Ensemble Capital had a great tweet summarizing how strong the environment is at the end of the cycle.

ensemble

It’s almost as if the market tries to lure investors in before it slaughters them.

Another great indicator of where we are in the cycle is trending in the unemployment rate, as pointed out in this post. Right now, the unemployment rate hasn’t yet changed its trend, but it looks like it is flattening. It is already below the lows experienced in 2000. How much lower can it go?

uetrendA yield curve inversion is like a yellow light. A shift in the unemployment rate is a big red light telling you that a recession is imminent and we might already be in one.

I still think the yield curve is a valuable tool for forecasting recessions. One of the reasons it is such a useful tool is because so many people doubt it every time it happens. I remember being a teenager watching CNBC in the late ’90s and listening to pundits say that the yield curve didn’t matter. A popular narrative at the time was that the US budget surplus was distorting rates. There was similar talk in 2006. A popular narrative at that time was that the “global savings glut” (emerging markets had high savings rates and they were pouring money into treasuries) was distorting the bond market, and the yield curve didn’t mean anything.

No one wants a recession except for maybe the perma-bear crowd. Listening to a recession prediction is like telling someone that they’re going to get into a car accident tomorrow or that their significant other is going to cheat on them. It’s a horrible prediction, and our minds will try very hard to find reasons not to believe it.

The narrative this time is that rates are too low for the yield curve to matter. The Fed can’t trigger a recession when the Fed funds rate is only 2.5%. I don’t accept this explanation, either. I think rates are only “low” in the context of our experiences in the ’80s and ’90s, when rates were abnormally high.

I like to boil things down to their essential components, and I don’t think anything explains the relationship between the quantity of money and inflation better than the classical equation, MV = PQ, the equation of exchange that Milton Friedman had on his license plate. The equation simply states that the quantity of money and the velocity of money are the key determinants of inflation.

The instinct of most people was that the Fed’s dramatic expansion of the money supply would result in a massive inflation problem. This never happened. Inflation hasn’t even gone above 3% throughout this entire expansion.

It seemed logical that an explosion of the Fed’s balance sheet and the quantity of money would result in massive inflation. The reason this didn’t happen is that the velocity of money remained stuck at an absurdly low level after the carnage of the financial crisis.

This decline in the velocity of money could have happened for a few reasons. It could be demographic reasons, such as declining birth rates and an expanding elderly population. This is a popular explanation for what happened in Japan, who didn’t experience inflation after an explosion in their own monetary base and ultra-low interest rates. The US has more favorable demographics than Japan, so I’m not sure if this holds up. Another possibility is that the crisis was so severe that it psychologically scarred households and firms and depressed the overall velocity of money.

Whatever the explanation, it looks like monetary velocity is stuck at a low level, meaning that rates can stay “low” with little impact on inflation.

m2

Money velocity: extraordinarily low

inflation

Inflation: can barely crack 3% even with unemployment near all-time lows

Rates look low when we compare them to recent experiences in the ’80s and ’90s, when we were working off the Great Inflation of the 1970s and when money velocity was high. I believe that with an inflation rate below 3% and money velocity stuck at a low level, a 2.5% fed funds rate can be high enough to push the economy into a recession even though it appears to be absurdly low based on our experiences in recent decades.

What do I do about it?

The phrase “late cycle” has become a punchline. People have been saying “late cycle” for the last 7 years. With that said, the yield curve seems to indicate that at this point we really are in the late cycle. This is 1998, 1989, 2005. Trouble is probably on the horizon.

In my little world, I am merely trying to determine what I should do about it.

Option #1 – Do nothing and stay fully invested. This is what Peter Lynch and Warren Buffett would recommend. They ignore the macro environment and focus on the businesses in the portfolio. This would also be the advice of many quants, who all advise that timing the market is nearly impossible. I’m sympathetic to this point of view, but I find it hard to accept. I analyze individual businesses, but none of them exist in a vacuum. Their fates are wholly determined by the macro environment, so I find it hard to accept the idea that I should just ignore it completely. It also doesn’t jive with what Munger and Buffett actually do. Berkshire carries massive cash balances. Munger kept Daily Journal mostly out of the market in the mid-2000s, moving aggressively once the global financial crisis dished out a tremendous opportunity set.

Option #2 – Get out of stocks completely. Should I get out of stocks completely? It is extremely difficult to time an economic cycle correctly and it is even harder to time a factor like value. There are unusual moments such as the early 2000s when value investing performed well even though the economy was in a recession. Missing a time like that would be terrible for my returns.

Much of the evidence indicates that the cycles are so difficult to time and the performances are so lumpy that it’s best to just stay fully invested.

My sense is that this cycle is more like the late ’60s and early ’70s than it is like anything like the ’90s or 2000s. The ’70s was a period of time where value was crushed with the overall market in the ’73-’74 drawdown. The darlings of that era, the Nifty Fifty, weren’t anything like the late ’90s absurdity. They were quality companies at crazy valuations.

How did value hold up during this period? Below is a comparison of S&P 500 returns to those of Walter Schloss along with the low P/E low debt/equity strategy that Ben Graham pursued and was backtested by Wes Gray’s Alpha Architect team.

70s1

Schloss was known for holding a lot of cash when he couldn’t find bargains, which is likely why he avoided a lot of the horror in the ’73-’74 drawdown. The fully invested Ben Graham quant strategy fared worse.

I would like to avoid the next drawdown and have a lot of cash to take advantage of the opportunities that will emerge in the aftermath of the decline.

The classical value investing approach is to not time the market but only invest in the bargains, like Schloss did. At the end of the expansion, there will be fewer bargains, and you’ll end up accurately timing the market without really trying.

This approach is easier said than done. If you took a classical asset value approach, Schloss would have had to wind up the partnership in the late ’60s when the net-net’s disappeared in the United States. Instead, he shifted his focus to stocks selling below book value. If he waited for the net-net’s to return, he would have missed out on some of his best years for returns. Not only could you wait for a few years, but you could also end up waiting for an investing lifetime.  For this reason, I think it would be foolish to “get out” of the market entirely.

At the same time, I don’t want to suffer horrific drawdowns and have no cash to take advantage of the opportunities that will inevitably result from a significant drawdown.

Option #3 – Short the market. I don’t short anything. I am proud to say that I have never shorted a stock in my life. After following markets for the last twenty years, I have developed a deep appreciation for how insane markets can be. Tech stocks were overvalued in 1998. They still doubled in 1999. Enron was engaged in fraudulent behavior going all the way back to the 1980s. It didn’t melt down until 2001.

Shorting is speculation and can result in a permanent loss of capital. I don’t do it. Shorting is for masochists.

This isn’t to knock the shorts. They’re the smartest people in the market and often do the most in-depth diligence. This doesn’t make it a wise investing strategy. I feel the same way about marathon runners. They are hard working, dedicated, impressive people. They’re also masochists who pursue pain for the sake of pain. Just because they are awesome individuals doesn’t mean that it’s a good idea to go out and run a bunch of marathons.

I’m also not interested in hedging. The best hedge is to merely own less of whatever it is that you’re hedging.

I’m also averse to complicated investing strategies. Perhaps I read “When Genius Failed” too many times. Whenever I hear a complex investing approach touted by an investing egghead, it’s hard for me not to roll my eyes. My instincts scream at me to steer clear.

Option #4 – Gradually adjust my positioning.

This is what I will probably do.

Right now, the cheapest stocks in the market are cyclicals. I own a lot of them. These stocks will likely be annihilated in a drawdown. Winnebago is a glaring one. There aren’t a lot of people with enough confidence and disposable income to go out and buy a big, expensive, RV during a recession. Winnebago suffered an 80% drawdown during the financial crisis.

Additionally, the fact that a yield curve inversion usually takes a year or two to impact the “real” economy gives me time to adjust my positioning. As I sell positions (as they age, run up in price, or the fundamentals change), I will likely reduce my positioning in cyclicals.

I will probably hold onto my cheap insurance and more defensive picks. Oshkosh is a good example. With a significant chunk of their business originating from the federal government, it should hold up well in a large equity drawdown.

Fortunately, I own zero leveraged companies. I specifically stick to stocks with low debt/equity ratios at all times because I know they will hold up well in a drawdown and I have a healthy enough respect for the market to know that a bloodbath can happen at any time, regardless of what the yield curve and unemployment are doing. It’s also what Ben Graham recommended. I covered my logic for this approach in this post about the debt/equity ratio and how a lack of leverage provides protection during drawdowns. To summarize, sticking to companies with healthy balance sheets enhances long-term returns by reducing the extent of a drawdown during a market meltdown.

debtequity

As I reduce my exposure to cyclicals, I will need to find a home for the cash. I don’t want this money sitting around earning nothing. I am considering buying more defensive stock picks and accumulating a position in long-term government bonds. As the Fed reduces interest rates to combat a recession, long-term bonds should perform well. Long-term bonds increased by over 20% in 2008, for instance. I will likely do this through an ETF vehicle like TLT.

At the same time, if I’m wrong, long-term bonds will go down but will still pay interest and won’t suffer huge drawdowns. I think this is a much safer choice than outright shorting the market.

Conclusions

I’m curious about your thoughts and input into how you are navigating the rapidly changing environment. What do you think the best approach is?

Random

I love the latest season of Documentary Now. The below is an excellent parody of “Wild, Wild, Country.”

 

 

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.

 

2018: A Year In Review

myperformance

My Portfolio

This has not been a good year for my portfolio. I am below where I started, and I am down 16.4% for the year.

This is the second year in a row in which I have underperformed the S&P 500. This is certainly disheartening. The last two years for me have made a strong case for shutting up and putting money in an index fund, but I’m not ready to give up just yet. More on this later.

Buys

This quarter, I purchased a number of new positions. You can read the write-ups below.

Most of these companies are statistically cheap on the basis of earnings, cash flows, enterprise multiples, and sales. All have a strong financial position with low debt/equity ratios, good Z-scores, good Piotroski F-Scores. From a quantitative perspective, they’re all in the right neighborhood.

One position, Amtech, was purchased for the asset value. Amtech is selling below net current asset value and near cash. This is high quality for a net-net, considering that the company actually has earnings and positive cash flow. Most net-net’s tend to be terrifying perpetual money losers.

For the stocks I purchased for earnings, a common concern for them is that their underlying businesses are at a “cyclical peak”. I don’t believe we are going to have a recession in the next year, which is why I am comfortable purchasing them. I’ll explain more on my views of the macro landscape later in this post.

Sells

Below is a list of all of my sells this year:

2018sells

Previously, I tried to hold stocks for at least a year before selling them unless the stock was up significantly.

I loosened that rule up this year to give myself an escape hatch if the fundamentals deteriorate. For me, the biggest red flag is an actual loss at the top of the income statement. This helped me get out of two value traps early: Big Five Sporting Goods and Francesca’s Holding. I managed to exit Big Five with an 8.27% gain, which is incredible considering that the stock is down 62% for the year. Getting out of Francesca’s early was another great move, as it is down 87% for the year.

I try not to get married to positions. I think it’s important to keep an eye on the fundamentals of the companies I own. If the fundamental change, I should revisit my opinion.

International Indexing

This year, I also abandoned my “international indexing” strategy, which I pursued because of the poor opportunity set in the US combined with my poor skills in researching individual foreign companies.

The debacle in Turkey exposed this as a bad idea for me.

In order to stick with a position, I need to understand it. I don’t know anything about the situation in Turkey other than the market was cheap. That’s not a good thesis that will give me enough confidence to hold through a horrific drawdown.

I decided in the fall that this account should focus on my original mission when I set aside this money and started this blog. I set out originally when I launched this blog to hold individual positions in companies that I’ve researched. That’s what I am sticking with.

Misery Loves Company

This has been a difficult year for systematic value investing. As they say, misery loves company. Value investing has had a terrible year and my portfolio is not an outlier. Here are some examples:

  • The Russell 2000 value index is down 15.3%.
  • The Vanguard small-cap value ETF (VBR) is down 14.8%.
  • QVAL, the quantitative value ETF from Alpha Architect, is down 19.69%.
  • Validea’s 20-stock Ben Graham screen is down 15%. The 10-stock various is down 23%.
  • AAII hasn’t updated it yet, but as of November 30th the value screens did not have a good year. I suspect that when they update for December, the results will be a lot worse. As of 11/30, the Ben Graham “enterprising investor” screen (probably the closest proxy to what I’m doing) was down 15.5%. Their low price-to-free cash flow screen was down 12.5%. The high F-score screen was down 17%. Notably, the magic formula held up nicely this year. They show that screen with a gain of 7%.

The current situation could go many different ways, as is always the case in markets.

Traditionally, value stocks sell off before the rest of the market before a major calamity. They tend to be canaries in the coal mine. This was certainly the case in 2007. This is because value stocks are cyclically sensitive and, at the end of the expansion, they are the most vulnerable to a decline. This is also why they tend to rip in the early years of expansion, like 2003 and 2009. Everyone thought they were utterly doomed, but the world doesn’t end the way everyone was expecting. Stocks that had the biggest clouds hanging over them tend to perform exceptionally well once the weather improves.

The critical question, then, is: are we at the end of the economic expansion? Are we at the end of this cycle of economic development, or is the recent market sell-off one of Mr. Market’s typical bouts of insanity?

For possible answers, I turn to history.

Mr. Market’s meaningless temper tantrums

The market is replete with the corrections of the 10-30% magnitude that don’t reflect any reality in the real economy.

The most famous example of this is the crash of 1987, which had hardly any impact on the real economy. Mr. Market went into euphoric overdrive in the first half of 1987 (probably cocaine-fueled), with the market rising 22% from January 1st through the August peak. It then suffered a 33.7% peak to trough decline from August 1987 through December.

People are obsessed with another 1987 style crash happening again. Whenever the market has a nice run, Twitter is replete with comparisons of the chart to a stock chart of 1987.

I find this amusing. We should be so lucky. The 1987 crash had zero impact on the real economy and turned out to be an incredible buying opportunity. During the crash, Buffett’s friends (people like Bill Ruane and Walter Schloss) were at their annual conclave in Williamsburg, Virginia. They saw the panic for what it was and went to the phones to buy stocks.

Buffett used the crash to buy one of his most famous investments: his large allocation to Coca-Cola, which would set Berkshire’s returns into overdrive in the 1990s.

The people who are trying to predict the next crash of 1987 are missing the point. You can’t predict things like the crash of 1987. The trick is to identify the opportunities created by these events by buying new opportunities with a prudently calculated margin of safety.

Even indexers were fine in the crash of 1987 as long as they didn’t succumb to panic selling. Amid all of the “carnage” of 1987, the S&P 500 returned 5.25% that year. In 1988, the index returned 16.61%. In 1989, it returned 31.69%. It was a non-event, but market commentators are still obsessed with it.

Who suffered from the 1987 decline? Speculators. People who were leveraged. People who bought financial derivatives and exotic financial products. People who bought concentrated positions in speculative names. People who bought concentrated positions on margin. In other words: they’re the same people that always lose money over the long run and people who deserve to lose money over the long run.

Investors, in contrast to speculators, made out just fine in 1987. In modern parlance, these are the kind of people who thought they could predict volatility and went long in XIV. Alternatively, these are the kind of people who thought they could predict the price movement of cryptocurrency – i.e., a financial product best suited for anonymously buying heroin. Because blockchain is going to alter Western Civilization or something. Speculators always lose, and they’re always surprised when they lose. It’s so strange to me how people keep flocking to speculation like blood-sucking mosquitoes to a bug zapper.

What are some other instances of market downturns that didn’t reflect or predict anything in the real economy? In 1961-62 the market suffered a 28% drawdown. In the summer of 1998, the S&P suffered a 19% drawdown. ’83-’84 – 14% drawdown. 2011 – 19.4%. 1967 – 22%. 1975 – 14%. You get the idea. These things happen all the time.

Here is a young Warren Buffett talking about the 1962 hiccup. It sounds pretty familiar.

 

 

 

What particularly amuses me is how people are always trying to develop explanations for why these things happened. The 1987 crash is the most studied crash of all time with extensive media coverage. There still isn’t any consensus on what caused it. Some blame “portfolio insurance”. Others blame the Plaza Accords. Others still contend that the 1980s stock boom was a speculative bubble and the bubble never ended. They think the Fed has just been bailing out markets for 30 years and all of the gains since 1987 have been illusory.

Trying to predict and explain these things is a fool’s errand, unless you think you’re the next Taleb or Paul Tudor Jones (you’re not). I usually laugh at the commentators with impressive credentials and expensive suits who go on cable and explain why this stuff happened. Well, sir, if you look at the 200-day moving average, put this over the 50 day moving average, and if you look at the uptick in volume, and compare this to steel prices, and then take a look at these Bollinger Bands, and then look at the M2 supply’s impact on bond outflows, and compare this to the put/call ratio . . . blah, blah, blah

They might as well be astrologers. They might as well be ripping apart chicken guts and trying to predict tomorrow’s lottery numbers. Of course, this really shouldn’t be a surprise coming from the Wall Street elite. This stuff isn’t above them. They’re not all rational. These are people who buy healing crystals, after all.

The people who try to predict Mr. Market’s moods are like dutiful scientists following around someone at a bar after 15 tequila shots and trying to explain all of their behavior, trying to develop some rhyme or reason to it. “Hmmmm, very interesting, she is projectile vomiting after singing Sweet Caroline. Perhaps there is a correlation between vomit and Neil Diamond.”

I suppose much of it has to do with the rise of the efficient markets theory. If markets are efficient and they reflect all available information, then Mr. Market’s temper tantrums must actually mean something.

From their perspective, it can’t be my simple explanation: people are crazy and stuff happens. It can’t be that Ben Graham got it right in the 1930s and that much of financial theory since then has been a big waste of time.

Mr. Market gets it right (sort of)

Occasionally, Mr. Market gets it right and the carnage is tied to real turmoil in the real economy that will cause a real impact on the fundamentals.

Sort of, anyway. Even when Mr. Market gets it right, he overreacts. Mr. Market usually believes every bad recession is the end of Western civilization and the market suffers a 50% drawdown that would not be justified if markets were truly efficient. This is evidenced by the fact that the market normally snaps back by 50-100% in a year or two after the bloodbath.

The ’73-’74 drawdown is one example of an authentic event. The S&P 500 suffered a peak-to-trough decline of 48%. Oil drove the economic funk. With US oil production peaking in the 1970s, the US economy became more reliant on oil imported from OPEC nations. When OPEC colluded to restrict supply in response to US support for Israel, oil skyrocketed. This caused a severe and brutal recession in the United States.

The 2008 event was tied to real economic activity, as we’re all aware of and I don’t need to repeat. Banks were failing and it felt like the system was falling apart.

How about 2000? Many cite the 2000-02 market as one long bear market. I divide it up into stages. The initial fall in 2000 was simply Mr. Market throwing a temper tantrum. There was no catalyst. In 2000, people suddenly realized that it was crazy to pay 100x earnings for Cisco, even though it was a great company. They realized it was insane to pay 10x sales for IPOs of dot com companies that didn’t make any money. It was simply a mood wearing off.

Side note: Cisco was the first stock I ever bought. I sold it after I read “The Intelligent Investor” and realized it was crazy to own it.

In 2001, however, the deflation in the stock market along with 9/11 began to have a real impact on the economy, which triggered the more serious sell off of 2002 and early 2003.

What is this thing – a meaningless temper tantrum or something real?

The key question is whether or not the recent decline is merely Mr. Market panicking or if he is predicting real damage in the US economy.

To answer that, we should ask what distinguishes speculative panics from real events.

The most significant difference between a real event and speculative BS is that there is no consensus explanation for speculative panics. There are plenty of scapegoats for the crash of 1987, the “flash crash” of 2011, but no consistent broadly accepted explanation. In contrast, there is no doubt what caused the market declines of 1981-82, 1973-74, 1990, 2008.

Is there any consensus on what caused the recent collapse? Not really. Speculation abounds: the market is concerned about trade wars, the Fed hiking interest rates, hedge funds are “de-risking.” There isn’t any consensus. There isn’t a clear bogeyman. That leads me to believe that the market is not accurately predicting any carnage in the real economy within the upcoming year.

I also doubt we’re entering a recession for the following reasons:

1) The yield curve hasn’t inverted. While some rates briefly inverted this year, there is a lot of noise in the shorter end of the curve (under 5 years). The inversion that accurately predicts recessions, the 2 year versus 10 year, has not inverted. It’s also worth noting that the inversion usually happens a year or two before the recession begins in earnest. The fact that it hasn’t happened at all leads me to believe that rates are not yet high enough to push the economy into a recession.

yieldcurve

2) There has been no discernible change in the unemployment trend. October 2018 marked an all-time low in the unemployment rate. The unemployment rate usually begins to tick upward before the onset of a recession. The unemployment rate started to rise in the first half of 2007, months before the beginning of a bear market or the start of the recession in December 2007. The unemployment rate also began to rise in the fall of 2000, the summer of 1990, and the fall of 1981. I would expect the unemployment rate to begin tipping upward if a recession was imminent.

unemployment

broader unemployment

3) Household leverage is healthy. Think about what causes a recession. Typically, it is driven by monetary policy. In a boom, interest rates are cut and households accumulate debt, which drives the expansion. In the later stages of a boom, the Fed increases interest rates. The higher debt burden plus the higher interest rates restrict the cash flow of households. As they cut back to deal with the stress on cash flows, this pushes the economy into a recession. Currently, household debt payments as a percentage of disposable income are near all-time lows, despite the recent increases in interest rates.

leverage

4) There isn’t any sign of a slip in broad economic indicators. In fact, most of them are at all-time highs. Here are a couple: truck tonnage and industrial production.

trucktonnage

industrialproduction

The Opportunity For Value Investors

In the last couple of years, I have been concerned about rich equity valuations. I invested anyway in the best bargains I could find. I invest for the market that exists, not the one that I wish for. I wish every year could offer up 2009-style bargains. I also wish pizza, cookies, and ice cream didn’t cause me to gain weight. Unfortunately, my wishes are not reality.

With that said, the recent sell-off has helped the situation. It’s not 2009 cheap, but it’s a much better situation than it has been in a long time. The Shiller P/E is down to 27.69, which is hardly cheap but is better than it has been in a few years. The latest data isn’t available, but I’m sure that the average investor allocation to equities has also declined, which is also good news for future returns.

The drawdown has produced an ample number of cheap stocks, which is great news for value investors. The high number of cheap stocks is unprecedented for a healthy economy.

In December of 2016, there were only 47 stocks in the Russell 3,000 with an EV/EBIT multiple under 5. In December 2017, the count was down to 40. There are now 90 of these stocks, which is historically very high. Such a high number of cheap stocks bodes well for value. In past years when there have been more than 80 of these, as a group, these cheap stocks have delivered an average annual return of 32%.

The year 2000, in particular, was an incredible year for the relative performance of this group. This group of stocks with an EV/EBIT multiple below 5 delivered a 28.35% return compared to a loss of 9.1% in the S&P 500. This was extraordinary out-performance. The good times made the careers of a number of value investors who were new to the game and weren’t already tarnished by the under-performance of value in the ’90s, like David Einhorn.

Everyone knows that value has under-performed for a decade and this is similar to the late 1990s. The thinking goes that this under-performance will lead to another period like the 2000s when value stocks crushed expensive stocks. For the last few years, I wanted to believe that this situation was bound to mean revert soon. The main factor that made me doubt this reversion to the mean was the low number of cheap stocks that were available.

What made value roar in the early 2000s? The ’90s bubble led to a plethora of bargains in the small-cap value universe. The depth of these bargains led to an incredible performance in the early 2000s. Looking at the dearth of cheap names in 2016-2018, my concern was that even though value had under-performed recently, I didn’t see the quantity of bargains that I knew existed circa 2000.

The recent sell-off has changed that dynamic. There were 101 stocks with an EV/EBIT multiple under 5 back in 2000. Now, there are 90. A week ago, there were 108.

This leads me to believe that we are entering a situation very similar to 2000. Just like 2000, the economy is fundamentally healthy and not in a recession. A recession would negatively impact all stocks, not merely the pricey growth-oriented names. Meanwhile, there are a massive number of bargains to choose from.

Despite my under-performance in the last two years, I am now more optimistic than ever.

I think we will see substantial out-performance for value and I think my portfolio of diversified value names should perform well. Value stocks are no longer merely cheap on a relative basis; they are cheap on an absolute basis as well.

Moreover, the sentiment that the value factor is played out and over-farmed is more widely accepted than ever before. You even see this in the behavior of so-called “value” investors. Value investors in recent years have thrown away the old metrics and adopted a “can’t beat ’em, join ’em” philosophy. “Value” guys are out there pitching Facebook, Amazon, and the like. Usually, the pitch involves wildly overoptimistic metrics plugged into a DCF model along with talk of “moats”. Excellent value investors like David Einhorn are treated like out of touch dinosaurs.

Everything feels right to me. The time for value is now, and I am wildly excited for the upcoming year in a way that I wasn’t previously.

Random

  • I read a number of good books this year. Chief among these is Margin of Safety by Seth Klarman. I wrote a blog post about it here. Saudi America was another great read, which I wrote about here. Here are a few other standouts I read this year:
    • Seinfeldia. If you are a Seinfeld and Curb Your Enthusiasm fan like myself, this book is a must read. It’s all about the birth of Seinfeld and the history of the show, with an inside scoop on all of the details of production.
    • Keeping at It. This was Paul Volcker’s autobiography. It was an amazing read about my favorite Fed chairman. You’ll come away with a sense of how hard economic policy is. Everything Paul Volcker did now seems so clear, but at the time it was extraordinarily hard and uncertain.
    • Brat Pack America: A Love Letter to ’80s Teen Movies. I grew up on a steady diet of movies from my favorite decade, the 1980s. This was an in depth homage to all of them. The author clearly has a deep love of the decade and the movies and music it produced. It shines through in this book. He ties each movie into larger cultural trends which were happening at the moment. He also interviews many of the creators of these movies and visits the real life locations in which they happened. Highly recommended.
  • I found myself watching Star Trek III a lot this year. It is such an underrated movie in the wake of Star Trek II. This is the ending and it should be heart warming to every nerd out there.

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.

Macro Environment & Upcoming December Rebalance

Jitters

October’s price action seems to have given many investors the jitters. Mr. Market doesn’t quite need a defibrilator or even Pepto Bismol, but he is at least popping a Tums. This expansion and bull market have been long. They are going on 10 years now, which is relatively unprecedented. Unemployment is at historic lows. Meanwhile, the Fed is raising rates, which is usually the beginning of the end.

Valuations don’t help with the anxiety. Everyone knows that valuations are stretched. The CAPE ratio currently stands at 30.94, giving the market an earnings yield of 3.23%. The average investor allocation to equities is presently 44%, giving us an expected 10-year return of 2.3%. In other words, the realistic return that investors can expect over the next 10 years is probably somewhere in the vicinity of 2-4%. This does not provide much of a premium to the 10-year treasury yield, which is currently 2.993%. The AAA corporate bond yield is now 4.14%, a significant premium to what we can expect from equities.

yields

A 2-4% return for US stocks isn’t going to happen in a straight line and it isn’t going to be evenly disbursed across all stocks. Stock market return averages are an average of abnormal returns. There are going to be years when stocks will advance by 30%, and there will be years when they decline by 50%. The decline will likely coincide with a recession.

Recession Watch

At the same time, while it’s evident to me that valuations are stretched, I do not believe we are going to have a recession in the upcoming year. This is the main reason I am comfortable remaining 100% invested in stocks that I feel are at attractive valuations, including cyclical stocks.

I believe that the Federal Reserve is the cause and cure of every recession. Right now, the yield curve is flattening but has still not inverted. The Fed typically chokes off an economic expansion by tightening too much. They then usually save the day by aggressively responding to the downturn by cutting rates, often overshooting and causing other problems. This seems to have been the case in the mid-2000s.

Despite the tightening of the last year and the flattening of the yield curve, the curve is still not flat and it is still not inverted. Scott Grannis recently had a great post about this here.

curve

Typically, once the yield curve inverts, we get a recession within a year or two. Right now, the 10 year is at a .22% premium to the 2 years. This implies that the Fed hasn’t yet taken things too far with rate increases. A recession, therefore, does not appear to an imminent danger. To put this in historical perspective, this is where the yield curve was in 2005, 1997, and 1988.

Another thing that tends to happen before a recession is that the unemployment rate shifts its trend. The unemployment rate began to change direction back in 2000, long before the beginning of the recession in 2001. It also did this in 2007 before the Great Recession went underway. There is no sign that the unemployment has shifted course.

unemployment rate

This is further evidence that a recession is not imminent.

Another indicator that I look at is household debt payments as a percentage of disposable income. This shows you the sensitivity of households to rising interest rates. This is not worrisome at all.

households

December Rebalance

Hopefully, this gives context to decisions I am going to make in my portfolio in the upcoming month.

I am currently gearing up to rebalance my portfolio in December. I will sell many positions that are on their 1-2 year birthday and replace these positions. I have my eye on many stocks, which are listed below. If anyone has done any work on these securities, I would love to hear from you.

I’ve spent the last few weeks researching the below positions. They meet my quantitative criteria, and I am attempting to determine whether or not I feel they are likely to recover from the problems that the market perceives.

candidates

My opinion on the likelihood of a recession impacts what kind of stocks I own. In particular, it will determine whether or not I will buy stocks that are cyclical and closely tied to the performance of the macroeconomy. An example of this would be a company like Micron (MU), a cheap position that bears suspect is cheap because it is at a cyclical peak. Another example would be Thor (THO). These would be positions I wouldn’t own if I thought a recession was going to occur in the upcoming year. Some examples of cyclical positions on the above list that I am looking at include Manpower Group (MAN) and Hollyfrontier (HFC).

I’m also looking at cheap retail positions like GAP (GPS) and Chico’s (CHS), even though they have been historically graveyards for my portfolio.

It also determines whether I am comfortable holding cash. When a recession is imminent, I will likely move more of my portfolio to short-term treasuries while I wait for compelling bargains to appear. A 1-year treasury is expected to yield 2.69% right now, which compares favorably to what I expect from US markets over the next decade.

Of course, I fully acknowledge that my predict the future is as good as anyone else’s. This is the reason that I always attempt to purchase undervalued securities with a margin of safety. A margin of safety is very much a margin for error.

I’m also eagerly anticipating the next recession. While I would like to avoid some of its damage, I suspect this is the moment when I am going to find truly compelling bargains, which are now in short supply in the US. It will be an opportunity to buy sub-liquidation net-net’s extraordinarily cheap security on an earnings basis, as well. It will be an opportunity to do very well, and I’m looking forward to it.

Hopefully, this sheds some light on my thought process as I select new stocks to fill my portfolio in the upcoming month as we look to 2019 and my portfolio (and this blog) turn 2 years old. Let’s hope the “terrible twos” doesn’t affect my money.

Random

  • I have been reading Paul Volcker’s book, Keeping at It. It’s a great book from a man that I believe is the greatest Fed chair of all time. I wrote about it here.
  • I gave up sugar back in October. So far I’ve lost 10 pounds since making that choice. I fell a bit off the rails on Thanksgiving when I ate a significant amount of pie, but what the hell? That’s what Thanksgiving is for. I haven’t eaten any sugar since.
  • I started watching “The Man in High Castle” and have really been enjoying it. It makes me really appreciate the sacrifices made by the Greatest Generation. If it weren’t for their efforts, the horrific world featured in that series would be a reality.
  • I was saddened to hear about the loss of George H.W. Bush. Looking back on him, whether you disagreed with him or not, he was an exceptional human being who treated the opposition with respect. He was the last President of the World War II generation, and that’s why I think his Presidency feels like a distant, bygone era. That generation had a better perspective on life. That’s why their passing brings a real sense of loss. I think their perspective comes from seeing a World War and living through a Depression. These were experiences so intense, so palpable that Boomers, Gen Xers, and Millennials can’t relate to these experiences on any level. Our worries are trivial compared to worrying about the Nazis winning World War II, or starving to death in the Depression. After going through times like a Depression and World War, they didn’t sweat the small stuff the way that we do. They realized that the stakes weren’t so high and you didn’t need to vilify people because you disagree with them about minor things like taxes, budgets, whatever. I really believe that things were better with that generation in power. People who vehemently disagreed with each other, like Tip O’Neal and Ronald Reagan, could hang out after work and still get along. I wish things were like that now. We weren’t entrenched into competing camps convinced that the other side was evil or bent out to destroy the country because they happen to disagree. I wish that’s a perspective that we could bring back. I wish I could have that kind of perspective. I worry that’s not possible, because it’s a perspective you can only earn from going through the sort of horrible times that they went through in their youth.
  • I’ve been listening to a lot of a synth band called Electric Youth. They sound straight out of 1984, and I love it.

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 2018 Update

Q3 Performance

Overall

Another quarter, more underperformance.

Value investing continues to underperform, and I continue to make mistakes. Regarding value’s underperformance, YTD to the 50 cheapest stocks in the S&P 500 has returned 3.62%. The 50 most expensive have delivered a 17.95% YTD return, outperforming the S&P 500.

I believe this will end, but I have no idea of when or how this will happen. The current cycle has looked like 1999 to me for nearly three years. I always suspect we’re close to that magical March 2000 moment, but it never seems to happen and expensive stocks continue to rip.

It looks like we’re late in the bull market to me, but no one really knows. There are no clocks on the walls, and everyone is flying blind, despite their assertive declarations to the contrary.

The only thing that I can do is continue to pursue my strategy: cheap stocks, good balance sheets, high probability of mean revision.

As for my mistakes, the biggest one appears to be abandoning my strategy a year ago for 20% of my portfolio and buying a bunch of international indexes that wound up vaporizing my money. The meltdown in Turkey caused me to wise up (or capitulate, depending on your perspective) and get back to the basics – buying individual value-oriented U.S. stocks.

Trades

This quarter, I sold all of my international indexes and bought specific U.S. stocks that I thought were undervalued. I was also paid out for my shares of the net-cash situation Pendrell. I reached a one year birthday on my position in Foot Locker and re-evaluated the position. The stock has been fantastic to me, and I’ve taken many of my gains off the table as it ran up over the last year. Evaluating the position on its birthday, it looked much more expensive than when I bought it a year ago, so I exited the position. I still think it’s a reliable company, but it is too rich for my tastes.

With the money from these sales and portfolio events, I purchased the below positions. Each position is linked to a blog post in which I outlined my reasons for buying it.

  1. Sanderson Farms
  2. Thor Industries
  3. United Therapeutics
  4. Reinsurance Group of America
  5. Micron
  6. MetLife

Of these buys, I am most excited about Micron, which strikes me as absurdly cheap. It is, in fact, the cheapest stock on an EV/EBIT basis in the entire S&P 500.

Overall, I still think Argan is the most compelling bargain in my portfolio, and the thesis continues to pan out.

Goodbye, Cruel World

I initially pursued my international strategy for two reasons: (1) In Q4 2017, about 60% of the cheap stocks I was screening were in the retail sector, and I didn’t want to have that level of concentration in one industry. (2) The US valuations look terrifying to me, so I thought an excellent way to diversify would be to buy cheaper foreign markets.

So what happened?

Many of the cheap retail stocks I didn’t buy went on to perform magnificently. Here are a few picks I didn’t invest in because I had 20% of my portfolio devoted to international indexes:

Williams & Sonoma (up 32% YTD)
Best Buy (up 16%)
DSW (up 31.26%)

I ignored my thesis about the retail sector (that the popular “Amazon eats the world” hypothesis was wrong, and retail valuations were unusually cheap) and pursued another strategy that wound up falling apart.

Experience the carnage:

international indexes

Nearly every one of them declined, due to a combination of weakness in those markets and strength in the US dollar. I lost $1,090.30 overall on the experiment, which is 2% of my portfolio. Meanwhile, the stocks that I otherwise would have invested in did better.

I abandoned my strategy and underperformed as a result.

With all of this said, I still think that low CAPE ratio international indexing is a viable option that will outperform in the future. I also know it’s not for me. I need to understand my investments. I don’t know anything about the monetary policy or political situation of Turkey or Russia. I don’t know anything about foreign currency speculation. In short, I don’t know enough about the positions to stick with them when times get tough, as they are right now.

I also bought these indexes for all of the wrong reasons. Mainly, I am freaked out by the valuations of US stocks and thought this would be a way to diversify away from the risk of US overvaluation. The truth is, with the US comprising over 50% of the global market cap, when the US pukes, everything else is going to go down with it. There won’t be a place to hide, even among cheap international markets. And that’s what I’m terrified of — I’m not concerned about a gradual underperformance of the U.S. versus the world, I’m worried about the markets puking in a 2008 style event. Aside from hedging strategies, there isn’t much way to avoid this inevitable pain.

Should I just shut up and buy the damn screen?

I tweeted this back in April, and I think it’s true:

tweet

For my stock selection, I need to understand the companies to remain invested in them. I know if a sell-off is related to an actual problem (i.e., the woes of my sold Francesca position) or if it’s pure market noise (i.e., volatility in Argan). My understanding of the companies helps me stick with the strategy. Research helps me behaviorally.

Behavioral folly is also the reason I don’t go full quant even though I am very quantitative in my approach. I start with a screen of cheap stocks, research the output of the filter, and try to identify the opportunities which I think are best.

This approach has flaws due to the “broken leg” problem. One of the best examples of this is Joel Greenblatt’s brokerage service that was designed to help people implement the magic formula strategy. Greenblatt established a brokerage firm that would automatically invest in the magic formula for clients. Some clients automated the magic formula stock selection, while others chose from the list. The clients who picked their stocks from the magic formula list underperformed. Those who purchased the screen outperformed the market. Joel Greenblatt explains it here.

Why did this happen? In short, investors avoided the scariest looking stocks, which were the ones that provided the best returns. I don’t think this phenomenon only applies to amateur investors. I think it’s the main reason that many value investors underperform simple quantitative “cheap” strategies. You’ll often hear of exceptional value investors outperforming the stock market, but they often underperform the lowest deciles of cheap. They underperform simple metrics of cheap because, to avoid value traps, they often pass over the best opportunities in the market because of how terrifying they appear.

The evidence indeed suggests that I should go “full quant” and buy the damn screen. The reason I don’t do this is that I don’t feel that I would be able to stick with a “full quant” strategy. I want to understand what I invest in so I can stick with the plan through thick and thin.

The low CAPE strategy is a quant strategy as is merely buying cheap stocks. I recognize the compelling logic of a full quant approach, but I can’t fully embrace it because I want to understand the companies themselves. It might worsen my results over the long run, but at least I’ll be able to stick with it.

I set out on this blog to pick stocks within the low P/E, low debt/equity 1970s Graham framework. That’s what I’m going to stick to despite the temptations to abandon it. I am not knocking the low CAPE index approach, the magic formula, or the Acquirer’s multiple strategies. I just don’t think I’d be able to stick with a purely quantitative approach if it ever turned against me.

Random

This is hilarious. “He just wanted to spend time with his family . . . and his robot. Like a normal guy.”

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.

PCOA (Pendrell)

I was paid out for my lone share of Pendrell @ $689.19, which I bought in December because it was trading at net cash. This isn’t a “trade” as much as it is a portfolio event. There was a reverse stock split and tiny shareholders like me were paid out in cash.

This brings my cash balance up to $1,093.81. I am not sure how I am going to deploy it. I may rebalance my country indexes around 9/30 (they were mostly purchased in October 2017) and include this cash in the new positions that I purchase with those proceeds instead of buying something right now. I’ll also have owned Foot Locker for a year on 9/25 (a position that has been very good to me) and may sell that.

This would get me on a cycle of quarterly activity with a big rebalance in December (the blog started in December 2016, when I purchased the original 20 positions). My intention is to hold positions for at least a year unless they increase significantly or the fundamentals deteriorate.

I’m itching to sell Turkey. I clearly made a mistake with that one and should probably adhere to stricter quality criteria for international indexes.

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 2018 Performance

quarterlyperformance

My streak of underperformance continues. I have no idea when it will end. All I know is: you can’t time this stuff. You just have to stick to it. Over time, markets reward disciplined rules-based value-oriented approaches. I think Cliff Assness put it best when he said in a recent interview that you should “find something you believe in and stick to it like grim death”. I believe in this stuff. It’s logical, time-tested, battle-tested. I’m not going to abandon it because of underperformance.

Value tends to do best coming out of a recession. If I had to guess, I won’t really see any outperformance until we see another recession and the recovery from it. That’s going to take anywhere from 5 to 10 years. Of course, that’s not how things worked out in 2000. The outperformance of value actually started before the recession. There simply isn’t any way to know or time it. I just have to stick to it.

This is my key advantage as a small investor. A professional enduring my underperformance would be in serious trouble with their investors. In an effort to keep their job, they would start to buy more popular positions. They would start to hug the indexes. They wouldn’t be able to ride something like this out and be cool with it. This is why most professionals underperform.

What’s my edge? I don’t have an informational edge. The only edge that I have is behavioral, which is something most professional investors can’t afford to have. I can handle the stench and dive into the dumpster. I can ride out the underperformance. If I can’t, then I might as well put this IRA into an index fund.

In short, I have to stick to it like grim death.

Sells

After staying put for the first quarter, I did much more trading this quarter. You can read a list of all of the trades here. I’m trying to stick to some concrete, easily identified sell rules. Those rules are:

  1. I can sell on an operational slip. For me, that is an operational loss. When I’m buying a stock on the basis of EV/EBIT, what is the position worth if EBIT begins to fall apart?
  2. I can sell if I held the stock for at least a year.
  3. I can sell as part of an annual rebalancing or a price increase of more than 50%.

For the operational slip rule, this was a result of the lessons I learned from my positions in IDT, Manning & Napier, and Cato Corp in 2017. All gave me early warning signs of a problem in the form of a decline in operating income and I ignored it.

Selling is one of the hardest elements of deep value investing. You can go with a very simplistic system such as Greenblatt’s magic formula, in which he recommended holding a stock for a year and then selling it unless it was still undervalued. Graham recommended selling after a 50% gain or after holding for two years.

My method is a combination of the two along with an element of downside protection by getting out of positions in businesses that post operating losses.

A deep value portfolio is going to be a high turnover portfolio. I am not buying stocks of companies with deep moats and high returns on invested capital. These are companies with problems that are causing an undervaluation. My goal is to buy when sentiment is poor and sell when sentiment has improved. I also sell when the fundamentals deteriorate. This is a major reason that the account I decided to track on this blog was the IRA, so I wouldn’t have to worry about tax considerations.

My sell rules aren’t perfect. My sale of Francesca’s, for instance, is looking like a mistake. Even though it will result in mistakes, I think sticking to it will help to cut off the bleeding in the worst positions. I will probably add to the rules over time as my experience grows.

Many investors hate rules. I love them. Rules keep me honest. Rules keep me out of trouble. There are thousands of investment ideas. It’s important to have strict guidelines or it will be easier to do dumb stuff. Guidelines and rules keep me honest. They keep me from straying from a tried and true path.

Buys

After selling for various reasons (price pops, operational slips, etc.), I bought a number of positions in the past quarter. They are all listed below. I also included links to my brief write-ups on each position, explaining why I found the idea attractive.

They check all of my boxes: (1) statistically cheap, (2) clean balance sheet, (3) poor sentiment, (4) potential for improvement.

  1. Ultra Clean Holdings
  2. Big Lots
  3. Jet Blue
  4. Aaron’s 
  5. Unum Group
  6. Argan

Macro

I’m fully invested, which makes me nervous when U.S. stocks are as expensive as they are. I’m trying as hard as possible to ignore macro stuff and stick to buying undervalued stocks.

Now I’ll proceed to look at it anyway.

allocation

For US stocks, the average investor allocation to equities stood at 42.82% at the end of Q1 based on the latest data. That’s a slight improvement from 43.63% at the end of Q4 2017. This suggests a 3.2% rate of return from US stocks over the next 10 years. This is the same as than the 10-year treasury yield (3.2%) but much less than the current yield on AAA corporate bonds (4%).

Bottom line, the market is expensive. That should be news to no one. That doesn’t mean it’s going to crash. That doesn’t mean we’re going into another Depression. It means they’re expensive and returns are going to be fairly low over the next ten years. The road to those returns is unknowable.

Expensive markets don’t crash just because they’re expensive. Usually, there is an event that triggers the sell-off. Usually, the event is a recession. I think about rich valuations in the sense of “the bigger they are, the harder they fall”. To fall, you still need something to push you.

The most common cause of a recession is the Fed tightening too much, which is why the yield curve is a useful indicator. The 2 year vs 10-year yield curve still hasn’t inverted, implying that a recession is not imminent. We’re likely entering a very juicy stage of the business cycle (think 1969, 1989, 1999, 2006).

yield

There also hasn’t been an uptick in unemployment, another indicator that a recession is about to begin. Unemployment continues to drop. With a tight labor market, some employers are experiencing inflationary pressures (Eric Cinnamond mentioned others on “the investor’s podcast”). This suggests to me that the Fed won’t stop tightening and at some point, they’re going to push the yield curve into an inversion and trigger a recession.

unemployment

Nonetheless, the fact that I don’t expect a recession in the next year makes me comfortable with the fact that I’m fully invested and have positions in some deeply cyclical industries. The market could easily crash 20%, but I don’t think we’re going to see a really nasty recession that would trigger a 50% drawdown in the next year.

Random

1. I saw “Solo” and didn’t understand the criticism of it. It was fun and it checked off on all the fan boxes: we saw how Han met Chewie, how Han obtained the Millennium Falcon, etc. We even saw the Kessel Run! It was certainly better than “The Last Jedi”. My suggestion is to not listen to the haters and see it.

2. I hope Gamestop gets bought out. This has been one of my long-suffering positions and there are signs on the horizon that the situation is improving.

3. Argan is the position I am most excited about. It certainly seems like a “no-brainer” at this valuation and considering the quality of the company. Still, I’m trying to keep an equally weighted 20 stock portfolio and I am not taking a position that is too concentrated. We’ll see if I come to regret that.

5. My day job has been pretty hectic this quarter but it seems to all be working out. I work in operations for a bank. I was promoted last December to a section manager role and faced an internal audit and headcount exodus right after getting the job. I was able to hire new people who are working out well and I received news this week that I passed our internal audit, which was a relief. I hope the rest of the year is a smoother ride now that those hurdles are gone.

6. My personal highlight of the last quarter was taking a week off of work, going to the beach, and spending my time reading “Margin of Safety” by Seth Klarman. Good times.

7. I also caught a couple of really good under-the-radar movies. Thoroughbreds was a really twisted tale that you should check out. It was unlike anything I’ve ever seen before (American Psycho for rich entitled high schoolers?) Just don’t expect to feel good about human nature when it’s all over. I also really dug Lady Bird, a funny movie about a high school senior in 2002 plotting to get out of Sacramento and go to college. That was actually a feel-good movie. I recommend it!

8. Deutsche Bank really worries me. The bank looks like it is in a slow-motion collapse. It’s one of the biggest banks in the world and I don’t know how the global economy would handle it if the bank fell apart.

9. I’ve really been enjoying the Focused Compounding podcast with Geoff Gannon and Andrew Kuhn. They avoid a lot of the trendy topics that are geared towards big investors that seem to dominate the podcast landscape these days (sorry guys, I don’t care about venture capital or angel investing because I’ll never be able to do it and I think most of them are lucky gamblers anyway). They focus on individual stocks and situations that small investors can take advantage of. This one and “The Investor’s Podcast” are my go-to’s. I look forward to listening to them whenever they pop up in my feed.

10. Politics is nauseating and it is getting worse. When I was in my 20s, I loved politics. I was a news and political junkie. That hasn’t been the case for most of the last decade. It’s becoming increasingly impossible for people to empathize with the opinions of others. This is very apparent on Twitter and I follow people on both sides of the aisle. Everyone thinks the other side isn’t just wrong, they’re evil and need to be destroyed. All of this anger and vitriol isn’t good for people’s state of mind. Both sides have a mob mentality. I don’t know how we’re going to snap out of it. To paraphrase Charlie Munger, ideology is turning our brains into mush.

11. Last, but not least, Captain Kirk’s finest hour.

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 2018 Performance

Q1 Performance

q1 2018

For the first quarter of 2018, my portfolio declined by 3.46%, and the S&P 500 dropped by 1.22%. My strategy still isn’t delivering any outperformance from when I started. I’ve discussed the reasons on this blog. I think a bulk of it is due to value investing’s underperformance as a strategy and specific errors that I’ve made with stock selection.

I believe the outperformance will come, but there is no way to tell when it will happen. It’s not something that you can time. I just have to stick to it and be patient.

Sentiment Shift

With that said, it feels like the sentiment is starting to shift in a way that might benefit value stocks.

For years now, the market has been rewarding cool, growth-oriented companies with higher and higher valuations. You know their names: Facebook, Apple (although Apple is odd in that it sometimes trades at a dirt cheap valuation), Amazon, Google, Netflix, Tesla, Nvidia. I would even lump cryptocurrency’s run into this bucket as an example of the sentiment.

Cool things rarely reward investors. Nearly all growth companies eventually run into problems that investors can’t anticipate or imagine. The higher their valuations (i.e., the higher the expectations), the harder they do fall once they run into the problem, which is inevitable. It appears that the stars of this bull market are simultaneously hitting those problems.

Tesla, for example, has been a star of this bull market. Its rise is due to a cool product and a popular CEO. The rapid rise in Tesla stock to absurd valuations gave Elon the currency to issue new shares and debt to keep the company afloat. Meanwhile, the company has never been profitable or generated significant cash flow. That sentiment appears to be shifting.

A friend of mine owned a Tesla and took me out for a ride in it once. It’s an impressive vehicle. The iPad instead of a console, the quick and silent acceleration. All of it is super cool. With that said, auto innovation is quickly commoditized. Think about it: your bottom of the line economy car (think about a Nissan Versa or a Toyota Yaris) has all of the features that a luxury car had in the ’90s. I’ve never been a “car guy.” For me, every car does 80 mph (which is all you can get away with on a highway) and has all the features I need. Why spend any more money than I need to? Tesla’s innovations are fresh and exciting, but in 10-20 years it’s just going to be standard. The big automakers are going to copy and compete away Tesla’s innovations. In the long run, it’s probably road kill. In the short run, the stock is at absurd valuations.

Facebook Is Bad For You

Facebook is running into problems as well. The problem which has been brewing for years is privacy concerns. Facebook presents its business model as a benevolent force aimed at “connecting humanity.” The reality is that it is an addictive product whose goal is to get people to turn over information about their lives, which Facebook then sells to advertisers. The perils of that business model came to a turning point in the recent scandal with Cambridge Analytica. I don’t know if the scandal will disrupt Facebook’s business model. As long as people continue to upload their life’s details to the site voluntarily, Facebook will have something that they can monetize. With that said, recent events do appear to be having an impact:

delete

I dropped my Facebook account a couple of years ago. Privacy was a part of it, but for the most part, I felt like Facebook was bad for me.

For me, I felt like Facebook was rotting my brain. That was the cost I was paying. The benefit was the connection with friends and family, but even that was entirely superficial. I also found myself wasting a lot of time on the app.

Regarding “brain rot,” a lot of it had to do with politics. The odd political opinions of my relatives and friends were making me dislike them. I thought to myself: did I become friends with these people because I agreed with their politics? Should a family member’s weird political opinions make me love them any less? The answer was, naturally, no.

Moreover, the bizarre beliefs I read on Facebook were hyperbole. The hyperbole on Facebook pollutes people’s outlook on the world. I also had to admit; the same thing was happening to me. I was confining myself to a shrinking bubble of information, and the increasing intensity of it all was polluting my mind. I found myself emotionally reacting to political posts instead of thinking critically about them.

The other odd thing I noticed was increased envy and jealousy. It’s unconscious, but it happens. No one posts their real life on Facebook. No one goes on Facebook and says “I had a huge fight with my husband today and I think he’s a jerk.” No one goes on Facebook and says “My children have so poorly behaved today that it makes me feel like I’m a bad parent.” No one goes on Facebook and says “My career feels like it hit a dead end and it makes me question my life choices.” However, these examples are all natural feelings that most people go through.

When you only see people post mostly “good” things about their lives, you start to think that your own life is inadequate, even though their life is probably as challenging and screwed up as your own. Think about it. Is life the happy pictures – the wedding albums, the graduation pictures, smiling families at events (the stuff that people put on Facebook) – or is it more nuanced than that? Every life has pain and disappointment. That’s not a bad thing – it’s just life.

People aren’t sharing their problems publicly on Facebook, but problems are still happening. We’re all human, and we all have issues. Social media makes us forget that and makes us feel inadequate.

I think more people are going to realize what I realized a couple of years ago. Facebook rots your brain and kills your self-esteem.

One of the most significant challenges in life is preventing your emotions from fooling you. Social media can make that an even more difficult task than it already is.

I digress. For growth stocks, the sentiment does appear to be shifting. We’ll see if it lasts.

Macro

Capture

The average investor allocation to equities

At the end of last year, the average investor allocation to equities in the United States was 43.787%. We are now beyond previous sentiment peaks, and current valuations had only been higher in 1998-2000. The 43.787% metric implies that in the next ten years we can expect returns of roughly 2.5%. The 10-year treasury yields 2.74%, so stocks no longer offer a premium over bonds.

The road to those returns is unknowable, but I think most investors are going to be disappointed in their returns over the next decade.

curve

The spread between the 10 year and 2-year treasury. When the 2 year has a higher yield than the 10 year (an inversion), it implies that monetary policy is too tight and will probably trigger a recession.

Concerning recession risk, the yield curve has not yet inverted, but it is in the process of flattening as the Fed raises rates. The lack of inversion means that a recession is unlikely over the next year. Eventually, however, the Fed’s tightening will cause a recession as it always does. The Fed is the cause and cure of every recession.

What this means for the short-term direction of equities is anyone’s guess. It does reduce the risk that equities will go down in a 2008-2009 style 50% drawdown. If the market does decline, it will probably be more like the 2000 decline. The economy was healthy, but valuations were absurd.

Of course, this bull run might just be getting started, and valuations may get even more insane. Over the short run, it is unpredictable, but we can infer from valuations that long-term returns will not meet investor’s expectations.

The Return of Volatility

After remaining dormant for a long time, volatility returned in force back in February. Volatility spiked, the market went down a little bit (10%), and everyone lost their minds. For people who were crazy enough to “short” volatility, they suffered a permanent loss of capital.

What’s funny about the whole ordeal was that the market decline was pretty tame and the rise in volatility was actually pretty normal in a historical context:

volatility

The return of volatility: angels and ministers of grace defend us

It was also really funny to me that so many tried to develop an explanation for the February decline. The reality is that there still isn’t agreement on what caused the crash of 1987! If we can’t fully understand what caused the crash of 1987, how can anyone say with authority what caused a 10% hiccup in February?

Everyone overreacted and lost their minds over a pretty normal event.

Volatility is your friend. Volatility is Mr. Market overreacting to events and losing his mind. You want to take advantage of Mr. Market, not be ruled by his mood swings. Too many investors fail to understand that the volatile nature of stocks is the reason that they offer opportunities to purchase mispriced assets.

If you can’t handle volatility – if you can’t handle very normal events like the one in February – then you don’t belong in the stock market. Bottom line, if you can’t afford to lose half of the money invested, it shouldn’t be in stocks.

Stocks are going to suffer a massive decline at some point. You can’t predict when that will happen, but I guarantee that in the next 10 years there will be multiple episodes when stocks suffer gut-wrenching declines. If you can’t handle them, then stay the hell away from the market.

It’s a good thing that most people can’t handle volatility and have no stomach for the gut punch that stocks frequently deliver. As long as most people are like this, Mr. Market will continue to offer attractive opportunities to people with the right emotional temperament.

My Portfolio

Below is a list of all of my open positions and the percentage change since I bought them:

list

Random musings:

  1. Retail: My retail stocks continue to weigh on my portfolio with the notable exceptions of Dick’s Sporting Goods and Foot Locker. Both companies delivered somewhat decent news, which was enough to deliver some solid gains. The two cheapest stocks in my portfolio (Francesca’s and Gamestop) continue to disappoint. Big Five isn’t doing quite as bad as those two, but it is still making me wince. Amusingly, Francesca and Gamestop are the two stocks that I am the most excited about. They are both priced for roadkill and any whiff of good news is going to send the stocks soaring (I hope).
  2. The international index ETFs I purchased for countries with low CAPE ratios are all doing very well and delivering solid performance. Russia and Singapore are doing the best, while Poland is the only one that is down.
  3. I didn’t do much this quarter. I did one trade, a small purchase in Argan. I had $1,000 in cash left from a distribution from Pendrell (odd lots were paid out when the company de-listed) along with some dividend payments. I decided to deploy it in Argan, which is an absurdly cheap stock with an enterprise value that is less than 1x its operating income. The timing was lucky, as the stock surged almost immediately after I bought it.
  4. Aflac was fairly volatile this quarter due to some lawsuits from former employees. The stock had a brief decline and then bounced back. It doesn’t seem to be a big deal and the stock continues to be one of the cheapest in the S&P 500.

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.