When and How Will Value Strike Back?

stocks

Has the bull market erased bargains?

I was listening to an investing podcast the other day and heard an interesting conversation. The guest pointed out that during the internet bubble of 1999, there were a significantly higher number of bargains than there is today. The guest further lamented that in the current environment, the bargains aren’t as widely available as they were back then.

This is an important point. As discussed in my previous post, growth has trumped value for some time now, which is a historical aberration. The disconnect will certainly end, but it’s difficult to say when and how it will happen.

The resolution in the early 2000s of the value-growth disconnect was the ideal situation. The broader market entered a tailspin for nearly three years, but value experienced a significant bull market at the same time, seemingly disconnected from the carnage that took place in large cap stocks.

This is obviously how I would like to see the current situation shake out, but I suspect that the value bull market of the early 2000s was due primarily to the number of bargain stocks that were available because everyone was fixated over the likes of Qualcomm, Cisco, Amazon, Redhat, etc.

I decided to take a look at the data for myself. I looked at the number of earnings bargains available in 1999 and compared them to today, as well as a few other points in time in recent market history. The universe of stocks I looked at was the S&P 1500. The data is below.

number of bargains

Bargain Availability Through the Years

Bargains were available in 1999, but certainly not to the extent that existed during the financial crisis. In 1999, there were 102 stocks with an earnings yield over 10%. As a group, they returned 18.10% in 1999. The number rose to 171 in 2000, and the return was 32.47% for that year. This occurred while the S&P 500 experienced a decline of 10%.

By 2005, the number of stocks yielding over 10% shrunk to 50 and the group returned 8.26% that year, slightly below the S&P 500’s return of 11% that year.

Obviously, the greatest moment in history to buy value stocks was early 2009. At the beginning of 2009, there were 474 stocks (nearly 1/3 of the universe) with an earnings yield over 10%. As a group, they returned 62.78% throughout 2009.

The number of bargains shrunk to 158 in 2012. The population shrunk as we emerged from the financial crisis, but bargains were still more plentiful than they were in the 1999-2008 period. As a group, they returned 10.26% in 2012 and 50.96% in 2013.

Today, the number has shrunk to 64. This is lower than 1999, but it hardly seems as if bargain stocks are no longer available. They are still out there, they are still behaviorally difficult to buy, and this suggests to me that the value premium will remain alive and well. However, I think that the low availability makes it unlikely to value’s resurgence will play out like it did in the early 2000s.

That ’70s Stock Market

The key question is how all of this will play out. History suggests that bigger populations of bargain stocks bode well for future returns. It’s not an iron clad rule that you could plug a formula into, but that’s the general trend.

This suggests that value is limited but not eliminated in today’s market. It also seems unlikely that we will experience a resurgence of value as incredible as that of the early 2000s when value experienced a bull market while the broader market declined.

I would like to believe that this will occur again, but I doubt we will be that lucky.

I think a more likely scenario for the next shakeout will be something more like the 1970s. The late ’60s and early ’70s was one of those times (like the late ’90s and today) where growth trumped value and the S&P 500 soared.

In the early ’70s and late ’90s, everyone preached buy and hold while it worked and few practiced it once times became tough. In all of these eras, popular sentiment was that value investing was dead and that everyone who wasn’t buying sexy growth names was a relic of the past who just didn’t understand how magical the new era was, paying 50 times earnings makes sense because . . .  Copy machines/dial-up-internet/smart phones/blockchain, it’s a new era, markets are so efficient and competitive these days, blah blah blah.

When the shakeout went down in the ’70s, value stocks fell with the broader market. They didn’t experience a bull market like they did in the early 2000s.

For a good look at value returns during this period, I took a look at this analysis of the simple Ben Graham strategy over at Alpha Architect. I also thought a good record to examine were the annual returns of Walter Schloss, whose strategy focused on low price-to-book names. Below is a snapshot of the 1970s from the perspective of the S&P, Walter Schloss and the systematic low P/E low debt Ben Graham strategy.

70s

As you can see, in the 1970s, value delivered the highest returns, but the road was bumpy. Unlike the early 2000s, value didn’t go up while the broader market declined. Value stocks went down with everything else.

During the 1973-74 bear market, Walter Schloss held up better than both the broader market and the systematic Ben Graham approach (a variation of which I’m following with my portfolio). I suspect that Walter Schloss’ decent performance in the recession of 1973-74 is due to his zero exposure to the Nifty Fifty and I also suspect that he held a significant amount of cash.

Walter Schloss was a classic Graham investor focused on asset value. If the bargains weren’t available, he didn’t buy them. This allowed him to experience only single digit losses during the 1973-1974 period.

The systematic Ben Graham strategy didn’t hold up as well, but I think that’s likely because it was fully invested while Walter Schloss was not.

The Future

I don’t know what the future holds, but I do know that buying expensive hyped up stocks is dangerous, regardless of how seductive it looks in the throes of a late bull market. Value will outperform growth and the broader market over time, but the road will be rocky and require patience. In investing, I think patience and discipline are more important than any other characteristic, including intelligence.

While I would love to see a repeat of the early 2000s value bull market, I don’t think we will be that lucky. Due to the fewer bargains available today than were available in the 1999-2000 period, I think a repeat of the 1970s is more likely, which was painful at times, but ultimately rewarding to those who had the patience to stick with a value approach and the discipline to avoid the sexy glamour stocks.

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.

SAFM

I sold my 29 share position in Sanderson Farms this morning at a price of $143.88. After commission, proceeds for the sale were $4,165.47. This results in a gain of 63.61% from when I purchased the stock last year.

I purchased Sanderson Farm last December because I thought chicken prices could increase and the stock already had an attractive earnings yield. The gains in chicken prices exceeded my expectations and fueled SAFM’s earnings higher.

Sanderson Farm doesn’t have much of a competitive advantage or “moat”. It sells a commodity: chicken. As a cigar butt value investor, I don’t look for enduring franchises, just value. Sanderson was a good value at the beginning of the year, but the increase in chicken prices doesn’t look sustainable to me and I decided to take my profits and move on.

In terms of relative valuation, Sanderson Farms now exceeds the valuation of its competitors. When comparing relative values, I like to look at the price to sales ratio. Here is where the metrics currently stand:

Sanderson Farm: 1.0

Tyson: .6

Pilgrim’s Pride: .9

Sanderson 5-year average: .6

It seems like a good time to take my profits off the table now that Sanderson exceeds the valuation of its competitors and is 66% higher than its typical valuation. If this were a taxable investment account, I may have waited until I reached a full year to take advantage of long-term capital gains. As this is a traditional IRA, there is no reason to hold onto the stock any longer than I feel is necessary.

This sale brings my cash position up to $8,333.90, or 17% of my portfolio. I would like to avoid timing the market so I would like to deploy this soon into new equity. I am considering adding to my position in Gamestop or Dillard’s, but I’ll evaluate some other possibilities this weekend over a bottle of vintage 2017 Coke Zero.

Some possibilities I’m considering that I will research more in depth this weekend:

Companies below tangible book:

Atlantic American Corp (AAME)

Appliance Recycling Centers of America (ARCI)

High earnings yields:

Genesco (GCO)

Foot Locker (FL)

Francesca’s Holding Corp (FRAN)

Interdigital (IDCC)

If anyone has any thoughts on any of these companies, I would love to hear them!

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

The Madness of Men

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The Madness of Men

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

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

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

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

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

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

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

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

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

Euclidean Technologies Q2 2017 Letter

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

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

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

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

Conclusion

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

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

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

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

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

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

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

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

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

“Deep Value” by Tobias Carlisle

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Deep Value” by Tobias Carlisle is one of my favorite books. I have a brief review in the books section of this website, but I think it is worthy of a more in depth review. The price of the book is expensive, but it is well worth it!

Mr. Market is Crazy

For years, I’ve believed that value investing works. It makes sense to me intuitively. It’s better to buy something cheap than something that’s expensive. I’ve read The Intelligent InvestorSecurity Analysis and all of Joel Greenblatt’s books and internalized the lessons. It just makes sense to me to buy earnings and assets for as little as possible.

It also makes sense to me that markets are fallible. I spent my high school years (I graduated high school in 2000) fascinated with a seemingly unstoppable market. I was only a teenager, but it seemed crazy to me that companies producing no earnings could command such high valuations. I remember thinking at the time: “It makes no sense, but these people know more than I do about the subject.” It turns out that they didn’t. An army of market prognosticators with extensive experience and impressive academic credentials were no smarter than me, a 17-year-old kid who hadn’t even gone to college yet.

I went through a similar experience during the real estate bubble. When I looked at charts of real estate prices, I once again instinctively thought that it was insane. Homes were increasing by 30% a year when incomes were stagnant and the raw materials to build the homes weren’t going up. It made no sense. Once again, I turned to the experts. Few were raising any alarms or taking the problem seriously. Surely, a financial bubble couldn’t form in an asset as illiquid and solid as real estate. I assumed that the experts must be right and I must be missing something. After all, they were more knowledgeable than I was. Then, along came 2008.

In 2008 during the crash, I kept thinking back to Benjamin Graham’s description of Mr. Market that I read about in The Intelligent Investor. Ben Graham was right. The stuff I learned in college about efficient markets couldn’t be true. Mr. Market is crazy and Ben Graham was right all along.

Why does it work?

While I believed that value investing works and this was confirmed by my observations, I never understood why it worked. It makes sense that buying dollar bills for 50 cents will work out in the long run, but how is this value realized?

Ben Graham was actually asked this question by Congress in the following exchange:

Chairman J. William Fulbright: What causes a cheap stock to find its value?

Benjamin Graham: That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else.

This is the key question that “Deep Value” delves into, through an analysis of data and real world examples.

Mean Reversion

The most powerful force through which value is realized is mean reversion. I always thought of mean reversion in the sense of a stock chart, a price will revert to the mean.

What Tobias explains is that mean reversion applies less to stock charts and more to the actual performance of a business. Tobias explains, for instance, that the biggest earnings gainers of the next few years are typically the worst performing businesses. Other similar studies are brought up in the describing this tendency of businesses to change course.

Poorly performing businesses are trying to turn things around. They are not resting on their laurels. Meanwhile, changes are typically occurring in their industries that are improving things for the better.

I think it’s easiest to think of this phenomenon in terms of chemical companies and basic economics. Chemical companies can all produce the same thing. They all have the same resources. If a chemical runs up in price, all of the chemical companies are going to make more of it. At this point, all of the chemical companies are doing great and their stocks are likely to be bid up to high valuations. Eventually, the chemical will be over-produced and it will drop in price. All of the chemical companies will drop to low valuations. This situation sets the stage for the recovery. The chemical companies will inevitably scale back production. Some companies may go out of business, which will further reduce supply. The reduction in supply will eventually spur an increase in the price, which will ultimately lead to a recovery in the chemical business.

Meanwhile, news stories will be written about what a terrible business it is to produce this chemical, causing this wisdom to seep into the minds of investors. There then exists a situation where chemical companies can be purchased at a discount at a nadir in the business that is about to turn around.

The situation is doubly lucrative: a cheap stock at a point in the business cycle where it is about to turn around.

The lesson here is that human beings tend to think that the future will unfold like the past. Trends that are in place today will go on forever. This is rarely the case and it is one that Tobias demonstrates through a careful analysis of the data.

Mean reversion in business is the main force driving the realization of value.

The Illusion of “Quality”

Prior to reading deep value, I always assumed that the best course for the value investor was to combine “cheap” with “quality”. Yes, there are cheap ugly stocks out there, but many of them are dreaded “value traps”. Meanwhile, careful analysis can lead an astute investor to value investing gems: cheap companies that don’t have any real problems, companies that are growing and generating attractive returns on capital.

Tobias reveals that adding elements such as growth or high returns on capital to a value model actually underperforms cheap by itself. The ugliest value stocks are frequently the ones that lead to the highest future outperformance. This makes sense: if something is truly cheap, there must be a reason for it, and the scarier the reason then the better the bargain an investor will get. Moreover, the uglier the stock, the more likely its prospects for mean reversion.

This lesson is reinforced throughout the book with real world examples and massive quantities of data.

The Acquirer’s Multiple

Tobias’s preferred metric of “cheapness” is Operating Income/Enterprise Value (or other variants, such as EBIT/EV or EBITDA/EV). He provides data showing this metric’s historic outperformance. I found the same thing in my own backtesting, and O’Shaughnessy also verifies this in his most recent edition of What Works on Wall Street in which EBITDA/EV is given a prominent chapter.

The multiple works because it identifies stocks that are not only cheap but have healthy balance sheets. The balance sheet health allows them to survive whatever problems that the business (or industry) is enduring.

Another reason it works is that the metric is most often used by acquirers such as private equity firms.

What is Deep Value?

Another goal of this book is explaining how “deep value” is distinct from other types of value investing.

Most associate value investing with the investing style of Warren Buffett. Buffett began his career buying what he derisively called “cigar butts”, or simple cheap stocks. They were cigar butts in the sense that you could pick them up off the street for free because they were so cheap, and enjoy one last puff.

Buffett moved on from this style for a few reasons. The first was the influence of Charlie Munger, who was less influenced by Graham and was more interested in buying quality businesses.

The second was scale. Buffett became too big to nimbly buy a cheap low capitalization cigar butt, take his free puff, and move on. Frequently, Buffett had to buy up such large quantities of cigar butts where he became mired in the operational struggle.

The second was a handful of experiences that pushed Buffett in the direction of greater quality investments. In investments such as Dempster Mill (a struggling manufacturer of farm equipment) and Hochschild Kohn (a retailer forced to compete at razor thin margins in Baltimore), Buffett had to take controlling influence in each company to turn them around. In both situations, controlling a struggling company took its toll and consumed significant time from Buffett.

The experiences with Dempster and Hochschild stood in contrast to a different kind of investment that Buffett made in the 1970s: See’s Candy. See’s was a good business with a great brand. It generated high returns on capital and required little meddling. Once Buffett bought See’s and saw the benefits of high returns on capital, there was no turning back, and this became the basis for his future investment style. From then on, he bought large stakes in companies generating high returns on capital and held onto them for long periods of time to let them compound.

The 1970s and onward style of Buffett’s investing career is what most people think of when they hear “value investing”. Deep value, in contrast, is the style of investing that Warren Buffett used earlier in his career when he was managing smaller sums of capital and generated higher rates of return. Deep value is the style originally advocated by Benjamin Graham and later applied by investors such as Walter Schloss.

Deep value is buying cheap for the sake of being cheap and allowing mean reversion to return the stock to its intrinsic value.

The Buffett style of investing is certainly preferable because it generates higher compounded returns for longer periods of time, but it is extremely difficult to find businesses that generate high returns on capital that will not succumb to the forces of mean reversion. It is also a crowded trade, as all value investors are attempting to marry quality with cheapness.

Practical Application

Tobias maintains an excellent free stock screener keeping track of the best-ranking stocks according to the acquirer’s multiple, which you can use to systematically implement a value investing strategy. The large cap version is free, he also offers a paid version for the all-cap universe.

Recommendation

It’s rare that a book comes along that changes my mind and makes me see things from a different perspective. “Deep Value” was one of those books. I’ve read it three times so far and each time I gain a greater insight into the ideas that it conveys. I can’t give it a higher recommendation.

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.

“Ready Player One” by Ernest Cline

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Years ago, I heard about a book called “Ready Player One“. I fully intended to check it out, but forgot about it and was sidetracked.

A short time ago, I read that Stephen Spielberg was working on a movie adaptation of the book and thought I had to check it out for myself.

Boy, was that a great decision! “Ready Player One” was one of the most fun books I’ve read in years.

The Book

“Ready Player One” is set in a dystopian 2044.  The world finally hit “peak oil” decades earlier and the world has been consumed by an energy crisis ever since.  The energy crisis triggered a worldwide depression and increases the occurrence of war, famine. The middle class has essentially disappeared and the poor live in trailers stacked high into the sky.

To escape from the world, users go to the OASIS. The OASIS is a virtual world. Users can put on a pair of virtual reality glasses and be transported to any place, limited only by their imaginations. Most fictional worlds are covered — there are authentic recreations of different universes: Star Trek, Star Wars, Firefly, Middle Earth, Blade Runner . . . just to name a few. Most of humanity spends all of their time in this virtual universe, mainly because the outside world is so horrific and the online world is so completely immersive.

At the beginning of the book, the creator of the OASIS (James Halliday) dies. With no living heirs, he leaves behind his entire fortune and controlling interest in the OASIS to whoever can find it in a series of puzzles embedded in the OASIS. Halliday creates a series of quests and puzzles in the OASIS for whomever can solve them. They are all rooted in his obsession with the 1980s and early video games.

The protagonist of the book (Wade Watts, known in the OASIS as Parzival) is one of millions of people looking for Halliday’s Easter Egg. He’s poor and growing up in a stack of trailer homes. As you might imagine, he’s up against significant competition, including a rival multi-billion dollar corporation intent on seizing the OASIS and Halliday’s fortune for themselves by any means necessary.

The Fun

The book is incredibly fun. Not only is it a great adventure with interesting characters and a compelling vision of the future, but it is a deep nostalgic trip into the 1980s. It includes references to everything imaginable from the decade. The protagonist’s virtual meeting room in the OASIS is modeled after the living room from “Family Ties“. One of the quests involves the movie “War Games”. Things covered include Rush, Pac-Man, obscure video games like “Dungeons of Daggorath“, pizza shop arcades . . . actually, it’s hard to think of what facets of pop culture from the ’80s aren’t covered. The protagonist even drives a Back to the Future inspired Delorean in the Oasis. Naturally, it is capable of space flight and light speed!

I grew up completely absorbed in the pop culture of the 1980s and the decade has a special place in my heart, so that’s probably a major reason why I loved this book. It was also nice to read a book written by fellow geek who loves the decade even more than I do. My video game experiences are mostly from the NES and SNES era, but I could still appreciate all of the Atari references.

Recommendation

If you’re looking to kick back and go on a rip roaring adventure, I can’t recommend this book enough. It’s the perfect summer read. Definitely check it out before the movie comes out next year.

Next on the agenda is Cline’s second book, Armada.  I’ll let you know what I think when I finish 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.

Q2 2017 Performance Update

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

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Inside My Portfolio

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

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

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

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

The Market

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

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

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

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

As they say: misery loves company!

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

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

Ranking the Fed

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Writing about Alan Greenspan’s record made me wonder if there was a way to measure the performance of a Fed Chairman, systematically without biases.

The Misery Index

The Fed has a dual mandate: maintaining both price stability and maximum employment. Back in the ’70s, these factors of unemployment and inflation were added up into what was known at the time as “the misery index.” The job of the Federal Reserve is to keep both unemployment and inflation low (i.e., keep the misery index low). It hasn’t always succeeded:

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In the early 1960s, the US economy experienced both low inflation and low unemployment. Inflation steadily trended higher and peaked in the 1970s.

In the 1970s, the United States faced a phenomenon known as stagflation, simultaneously high unemploymentwhichand high inflation. It perplexed economists, as traditionally there was a trade-off between unemployment and inflation. The cure for inflation was unemployment, the cure for unemployment was some inflation. In the 1970s, this relationship broke down, and both soared to next heights.

This is why the misery index peaked in the late 1970s and early 1980s. Inflation has not crept back in a meaningful way since its defeat in the early 1980s. Most increases in the misery index since the beginning of the 1980s are due to increases in unemployment.

misery

Ranks

I decided to rank the chairmen by the net change experienced in the misery index during their tenure. By this measure, no chairman can match the record of Paul Volcker. His tough monetary medicine (double digit interest rates) caused a brutal recession in the early 1980s, but this was the medicine that the economy needed to finally break inflation.

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Regarding the average level of the misery index, the best chairman was William McChesney Martin. The data I used only covered a portion of his tenure in the 1960s. It would likely look even better if I included the 1950s. Martin presided over a period of simultaneously low unemployment and low inflation. The next best by this measure was Alan Greenspan.

By the metric of unemployment, Martin also experienced the lowest average unemployment rate. The lowest inflation rate was experienced by Janet Yellen. Inflation has been declining under her tenure, with inflation being virtually zero in 2015 due to the collapse of oil prices. The decline in inflation during this decade defied the expectations who expected the massive monetary easing of the Bernanke era to result in high levels of inflation.

Are the Rankings Fair?

Trying to empirically measure the performance of the Federal Reserve is a difficult task. My preferred measure is not the absolute level of misery, but the net change in the misery index during the tenure. By this metric, Paul Volcker is the winner.

Some might say that a chairman like Volcker is uniquely advantaged with this list because his starting point for unemployment and inflation was so staggeringly high. I would counter this and say that Volcker deserves the highest ranking for what he accomplished. In retrospect, it might seem like Volcker’s actions were obvious (tighten the money supply to restrain inflation), but this was a monumental challenge. He made the incredibly difficult decision of focusing solely on inflation. The medicine was tough for the economy: double digit unemployment and interest rates. Volcker’s policies caused an immense public backlash. Construction workers sent Volcker 2×4’s to protest his policies. The public was outraged, but Volcker’s tough medicine worked. He broke the back of inflation and unemployment soon followed.

Ronald Reagan also deserves credit for standing behind Volcker. It is quite tempting for a President to encourage the Fed to loosen monetary policy. Nixon did this in the 1970s, which helped create the stagflation problem in the first place. George H.W. Bush put similar pressure on Alan Greenspan, who didn’t give in. George H.W. Bush blamed his election loss on Greenspan. The temptation was massive for Ronald Reagan to try to twist Volcker’s arm in 1982. We remember Reagan as being popular, but at that point in the depths of the recession, Reagan had a 40% approval rating. He didn’t give in despite the public outcry, and neither did Volcker. They both deserve immense credit for that.

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

“The Map and the Territory” by Alan Greenspan

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I recently finished Alan Greenspan’s 2013 book, The Map and the TerritoryThe book is Greenspan’s attempt to explain what went wrong in 2008 and why it shocked most economists.

Greenspan Hate

Since 2008, it has become quite fashionable to hate on Alan Greenspan. Right wingers in the mold of gold bugs and Ludwig von Mises acolytes look at him as someone who fine-tuned the economy into oblivion. Left wingers look at him as a libertarian ideologue who was close friends with Ayn Rand and stripped the financial sector of regulation and let banks do whatever they want, leading the economy into oblivion.

In the current environment of bipartisan vitriol, it seems crazy that back around the year 2000, Greenspan was lauded as a genius and the greatest Fed chairman of all time. The title of Bob Woodward’s 2000 book about Greenspan reflects the popular sentiment: MaestroGreenspan was the Mozart of economics, solely responsible for the economic miracle of the late 1990s.

When someone’s reputation becomes that pumped up, it’s bound to mean revert.

Mean reversion can be quite nasty. The praise heaped on Greenspan in the late ’90s and early 2000s was more than he deserved. Similarly, the hatred heaped on him lately is also not deserved. What is amusing is that the recent criticism simultaneously paints him as both an interventionist and a libertarian ideologue. Greenspan hatred is bipartisan, but the reasons for the hatred are completely contradictory.

The Record

I think that Greenspan made some mistakes, but they have to be weighed against his triumphs. His record as Fed chairman was often exemplary, even considering the mistakes he made at the end. He wasn’t an ideologue. He was a pragmatist who tried to navigate the mess of our government to achieve the best possible result. My guess is that he started out as a gold-bug Ayn Rand libertarian, but realized that purist libertarian idealism wasn’t compatible with getting jobs in government where he could actually wield influence. He wanted to actually influence public policy, not just talk about it. To be effective, he had to be open to compromise.

That Greenspan era is referred to as “The Great Moderation“. The Great Moderation was an amazing economic achievement. The Greenspan era was one of infrequent shallow recessions, low inflation, low unemployment, climbing asset prices and resiliency in the face of multiple crises.

Resiliency is a key point. During his tenure, the United States faced the following crises: the crash of 1987, the Asian financial crisis, the demise of Long Term Capital Management, the collapse of the dot com bubble, the savings and loan crisis and 9/11. While the markets experienced some wild gyrations over these events, the real economy barely noticed. Even after the collapse of the dot com bubble and 9/11, unemployment peaked at only 6.3%. To put that in historical perspective, 6.3% was the unemployment rate in 1994 and 1987 during times of expansion.

The failures are the focus right now. The failures include: believing that banks wouldn’t take excessive risks with capital (a preposterous position in retrospect), fighting the regulation of derivatives (covered in this excellent Frontline documentary). He likely took interest rates too low for too long in the wake of 9/11 and the dot com bubble (as has been theorized by the economist John Taylor). Indeed, low rates in the early 2000s might be the very reason that the recession of that period was so shallow. The Great Recession might very well have been the bill coming due for having such a relatively easy recession earlier in the decade.  None of that can be proven, of course.

Although, imagine if Greenspan did not respond to the collapse of the dot com bubble and 9/11 and didn’t let interest rates plummet. He would have been blamed for making a recession worse than it needed to be at a time when we had low inflation and could have handled lower rates because inflation was so low. It all would have been to lessen the severity of a future recession which, in this alternate universe, might never have even happened. Hindsight is 20/20, which is an advantage of being a pundit and a cost to getting your hands dirty and taking positions in the public arena, as Greenspan did.

As for regulations, Greenspan should have pursued tougher regulation of banks and regulated derivatives. Although, it is important to keep in mind that this would have put him at odds with all the banks and the entire Washington establishment. The Clinton administration and the Republicans in Congress back in the ’90s loosened restrictions on banking and didn’t want to regulate derivatives. There was a bipartisan consensus on these issues back then, as demonstrated by the passage of Gramm-Leach-Biley. The deregulation combined with public policy that actually encouraged risky lending as a form of social justice was simply toxic. A good example of this is the Community Reinvestment Act and its intensification under the Clinton adminstration.

If Democrats are on board with deregulating, then who is going to stop it? When it comes to tearing down regulations, Republicans are the gas and Democrats are the brakes. In the ’90s, there were no brakes. It was all gas, with predictable long term results. Greenspan should have sounded the alarms, but I don’t think that one man (albeit, a very influential man) could stop an out of control Mack truck barreling down a highway.

Everyone deserves blame for the financial crisis. Certainly some more than others, but most people had a hand in it. The regulators failed, Washington failed, the banks failed. More importantly and less discussed is the fact that we failed. We failed as citizens to appropriately monitor our institutions. Growing up back in the ’90s, I was always amazed at the complete and total lack of interest that most adults had in current affairs. Civic engagement fell off a cliff. The voters were asleep at the wheel while our politicians made reckless decisions. A democracy is only as strong as its participants. We weren’t paying attention when Washington was engaging in reckless actions. We gladly borrowed the money without doing the arithmetic, but then blamed the banks when the bills came due. Nearly everyone had a hand in what happened. Greenspan failed, but one man is not singularly responsible for our collective failing as a society to appropriately monitor our institutions and act with financial prudence.

The Book

This is a book review, so I suppose I should actually review the book and stop talking about Greenspan!

The book itself is a real tour-de-force of ideas. Greenspan takes the reader through a tour of his thoughts and insights into the economy, which are too numerous to list them all. The book does contain a few very big ideas, which I’ll discuss here.

Much of the book is devoted to retelling the story of the crisis and the mistakes made. Greenspan doesn’t come out and say: “I screwed up and I am sorry”, but I think it amounts to that. He discusses how we need stronger regulations. He laments the bailout and the actions of the banks. He also makes a strong argument that we need to address the risks posed by too big to fail institutions.

He even talks about better ways to deal with the environment and takes the reader through a seemingly crazy experiment of trying to determine the actual weight of GDP.

Animal Spirits

It’s clear that Alan Greenspan spent most of his career trying to reduce the economy to equations, to mathematical arrangements that can be measured. That’s why it is fascinating in the book to see him examine the importance of flesh and blood human beings to the economy. John Maynard Keynes referred to human emotions driving economic activity as animal spirits. Humans don’t always make sense. 2008 helped Greenspan wake up and realize that animal spirits are key even if they can’t be measured.

That’s why the first chapter is called “Animal Spirits”, as Greenspan catalogs all of the ways that human emotions affect our economic judgement, which isn’t a surprise to most of us, but is indeed a revelation to economics that have spent their careers trying to reduce human behavior to beautiful mathematical models.

Greenspan tries to quantify some of these emotional judgments. For instance, he observes that the yield curve (where longer maturities supply higher interest rates), has been firmly in place throughout the history of civilization.  The earnings yield of the US stock tends to stay around 5-6% over long stretches of time, implying that this is the human preference of return for the risk of owning equities. (Sidenote: This might explain why Jeremy Siegel observes that the long-term return of equities after inflation is around 6% for nearly 200 years in his book Stocks for the Long Run.)

Greenspan marvels throughout the book at the extent to which human emotions drive economic behavior. He observes that the cultural diversity of Europe is a major reason for the Euro’s struggles as a currency to unite the region. Culture plays a role in determining the savings rate of a country (does the country value consumption in the present over long term saving?) as well as the effectiveness of regulation (is the culture permissive towards corruption and cheating?).

The Entitlements-Savings Trade Off

The most interesting point that Greenspan makes in the book is that there is a trade-off between entitlement spending and savings. This makes intuitive sense because in societies with generous entitlement programs, there is less incentive for people to save money. If you know that the government will pay for your retirement, what is the point of foregoing consumption in your youth to save for retirement? Should a 30 year old pick a vacation or increased 401(k) contributions? Our tendency is definitely towards the vacation and a generous safety net only makes that choice more appealing.

In fact, Greenspan demonstrates that the sum of total savings and entitlement spending adds up to 28-32% of GDP. Over time, as entitlement programs expand and the population becomes older, increases in entitlement spending reduce the nation’s savings rate. Every dollar that we spend on entitlement programs like social security and Medicare is one less dollar that we save.

In 1965, for instance, about 5% of GDP was social benefits and 25% of GDP was saved. A total of 30%.  By 1992, about 10% of GDP was devoted to social benefits and 20% of GDP was saved. Again, a total of 30%, with the increased social spending crowding out private savings. In 2010, the amounts converged. 15% of our GDP went to social spending and 15% of our economy was devoted to savings.

Due to increased entitlement spending, national savings declined from 25% to 15%.

This is bad because savings is the raw fuel of investment. That’s less money for banks to lend, that’s less money available to issue corporate bonds, that’s less money that can be raised in the equity markets. The less capital that is available, the less investments are being made in the future productive capacity of our economy.

I think Greenspan argues pretty conclusively that there is very likely a trade off between the two. Does this mean we should tear down our entitlement programs completely to maximize our savings rate? Of course not. With that said, entitlement reform should be pursued to contain the growth of entitlement spending before it endangers the federal budget and crowds out private savings.

I think this shows a larger trade off at the core of all public policy, which we like to pretend doesn’t exist. What liberalism offers in its most extreme form is a society with maximum safety and public comfort (i.e., generous safety nets, government funded retirement, a universal basic income). What conservatism offers in its most extreme form is a society with maximum dynamism (i.e., high economic growth and creative destruction). It seems foolish to think that we can have it all: have government take care of everyone’s materials need in a dynamic and fast growing economy. This trade off is at the core of our public policy debate. We should stop pretending that the trade off doesn’t exist.

Conclusion

You should read this book! Even if you dislike Greenspan (I’m imagining Ron Swanson on the right and Lisa Simpson on the left), it doesn’t hurt to get his perspective. He was at the center of most economic policy for the last 50 years and has some useful insights. I also think it’s impressive that he took the time to write this book and take us down his own intellectual journey in the wake of 2008. Most people develop their opinions about the world around the age of 20 and barely budge after that. Greenspan is 91 years old and approaches everything with an open mind, ready to look at the data and reevaluate his opinions. The world would be a better place if we all took that approach.

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.

Can a Small Investor Beat Wall Street?

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One of the common responses I hear when I tell people that I buy and sell stocks using my own analysis goes something like this:

“Why even bother? There are so many smart people researching these stocks with far more time to devote to it than you. They have better information and can do more homework. You might as well buy an index fund.”

Indeed, there are many people trying to beat the market and Wall Street spends a vast amount of money on research and analysis, which is likely superior to the analysis that I have the time to do.

The Data

I decided to step back and check the actual data about Wall Street recommendations. I wondered what would happen if you systematically bought baskets of each Wall Street recommendation (buy, sell, etc.), held on to them for a year and then re-balanced annually. The results from the Russell 3000 universe are below:

Wall Street Analyst

If Wall Street analysis were on point, there would be a more linear result. Each basket should outperform the next.

Instead, the actual data produces this choppy result. Neutral ratings outperform buys and strong buys. Meanwhile, those rare “strong sell” ratings actually outperform the sell recommendations.

This analysis of Morningstar star ratings comes to a similar conclusion. Morningstar assigns star ratings to mutual funds (5 stars are the best, 1 star is the worst). The paper linked to analyzes the resulting returns after Morningstar issues the rating. The 5 star ratings outperform the 1 star ratings, but in the lower end it gets lumpy. The 1 star rated funds outperform the 2 and 3 star funds.

Also, consider this tidbit of stock market history which is quite shocking: in November of 2001, more than half of Wall Street analysts rated Enron as a buy or better.

Why This Result?

This leaves one to speculate: why do we get this result? I think there are three key reasons:

1. Human nature makes us extrapolate the present into the future. Analysts aren’t immune to this tendency.

Any analyst can look at Amazon, for instance, and tell me that they are doing a great job at growing their revenues. Any analyst can look at the retail sector and tell me that retail is hurting as more consumers shift their buying preferences online. In 2006, any analyst could tell you that the financial sector was enjoying a nice upswing and would also provide you with a very convincing explanation (i.e., the “financial supermarkets” created in the wake of Gramm-Leach-Biley were leading to higher returns on equity for banks) or that the energy sector was doing well thanks to advancing oil prices (they would probably say that oil would continue to increase due to growing demand from emerging market economies and peak oil). In 1999, any analyst could have looked at the growth in fiber-optics and told you that JDS Uniphase was doing very well and would continue to do so because the rapidly growing information economy would fuel greater demand for fiber optic cable. Analysts are frequently deceived because they underestimate the tendency of things to change. Some have expressed this sentiment with greater eloquence.

When you look at a Wall Street research recommendation, what you’re seeing is the conventional wisdom. The conventional wisdom is usually an extrapolation of what is going on right now into the future. The conventional wisdom usually becomes more ingrained when we listen to really smart people provide convincing explanations for why the trend will continue.

Things change and the conventional wisdom is frequently incorrect. It is human nature to take trends and extrapolate them into the future. This worked for our ancestors trying to evade a predator, but it doesn’t work when trying to predict changes in the modern world. The tendency of trends to reverse (for great businesses to falter, for bad businesses to turn around) defies the ingrained expectations of human nature.

2. Wall Street doesn’t care about valuation as much as it should.

Valuation plays another role. Stocks with “strong buy” recommendations are frequently overvalued. Of the 32 analysts covering Amazon, for instance, 23 of them have a strong buy recommendation. Clearly, valuation isn’t even considered the analysis, as Amazon currently has a P/E ratio of 179.84. Amazon might continue it’s ascendancy, but history shows that stocks with such lofty valuations frequently under-perform. Amazon’s business may continue to succeed, but that doesn’t mean that the stock is a good investment when the lofty valuation is taken into consideration.

3. Wall Street prizes access to management.

Wall Street values good relationships with companies. Sell ratings or critical analysis hurts the relationship that banks have with companies. As this Bloomberg article explains, relationships are the reason that only 6% of the 11,000 Wall Street recommendations are sell ratings.

Relationships are critical to Wall Street. A good relationship with a company means that the Wall Street banks are more likely to underwrite deals for those companies, such as mergers and acquisitions, which generate high fees for the banks. Good relationships can also improve their odds in being selected to underwrite new loans for that company, another important source of income.

Another reason is that they want access to management to get better information about the companies. They feel that access to management is a critical component of gathering information about potential investments.

My unconventional view is that talking to management can be counterproductive. Management is always going to say things that are positive about the company no matter what, so what’s the point of even entertaining them? CEOs typically get their jobs not because of any technical expertise, but because they are masters at dealing with people. They are typically wildly charismatic people.

Charisma is usually not matched off with any real expertise or insight. When Wall Street analysts talk to management, they are simply being charmed by a charismatic person into believing a more optimistic portrayal of the company than is actually deserved. I think an investor is better off going to sec.gov and reading through the financial data published in quarterly and annual reports rather than allowing themselves to be manipulated by a charismatic management team.

The great Walter Schloss had this to say about meeting with management: “When I buy a stock, I never visit or talk to management because I think that a company’s financial figures are good enough to tell the story. Besides, management always says something good about the company, which may affect my judgment.”

Conclusion

My conclusion is simple: small time investors can win at this game even though we are at an informational disadvantage. This is because much of the Wall Street “analysis” is clouded by behavioral biases, an under-appreciation for value and a tendency to be manipulated by management.

A small investor can also operate in corners of the market where Wall Street banks fail to look, as their focus is usually on extremely large companies that can generate fee income.

Moreover, as has been discussed previously on this blog, Wall Street is increasingly short term oriented. In a world where investors obsess over their returns on shorter and shorter time periods, an investor with a long term outlook and willingness to under-perform in the short run is at a significant behavioral advantage.

I’ll end this with a quote on this subject from the master himself, Benjamin Graham:

“The typical investor has a great advantage over the large institutions . . . Chiefly because these institutions have a relatively small field of common stocks to choose from–say 300 to 400 huge corporations–and they are constrained more or less to concentrate their research and decisions on this much over-analyzed group. By contrast, most individuals can choose at any time among some 3000 issues listed in the Standard & Poor’s Monthly Stock Guide. Following a wide variety of approaches and preferences, the individual investor should at all times be able to locate at least one per cent of the total list–say, 30 issues or more–that offer attractive buying opportunities.”

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

I am a value investor. My outlook is inspired by the ideas of Benjamin Graham. This site is a real time chronicle of my portfolio and an outlet to share my ideas. I hope you enjoy.