Are Markets Efficient?

1mg9bcfgo6

My high school interest in the stock market led me to major in Finance in college.  Hoping to learn juicy insights into beating the stock market, I was instead taught the efficient market hypothesis, or EMH.  The efficient market hypothesis states that markets are largely efficient at assessing risk and dishing out returns.  Over time, equities perform better than other asset classes because equities are riskier than other asset classes.  Returns are a compensation for risk.  Basically, business students pay a lot of money to learn that they don’t have a chance against an index fund.  Fortunately, I went to a state college for this advice.

Eugene Fama and Kenneth French, the architects of EMH, performed research which showed that value investing delivers higher rates of return but attributed this to the increased riskiness of value investing.  Value investors disagree and contend that their approach actually reduces risk because they demand a margin of safety from their investments.

I don’t have  PhD.  I don’t have a Nobel Prize. I’m just a working stiff with a blog and a brokerage account.  My analysis is lacking in sophisticated mathematical modeling, but I agree with the value crowd based on common sense.  Just look at the price ranges from the last year of a few large and stable American companies:

Apple: $118.69 to $89.47 – 24.62% difference

American Express: $75.74 to $50.27 – 33.63% difference

Caterpillar Inc: $56.36 to $97.40 – 43.47% difference

I find it difficult to believe that the underlying value of these business experienced such a wild fluctuation in the last calendar year.

One could also look to the entire market as a whole.  Look at the performance of the S&P 500 over the last 26 years:

1990 – 2000: Up 318.42%

2000-2003: Down 27.66%

2003-2007: Up 47.26%

2008-2010: Down 19.88%

2010-2016: Up 90.43%

Did the actual underlying economic output of the United States experience such wild swings over that time period, as the markets seemed to believe?

Here is the total economic output of the United States since 1990:

U.S. Bureau of Economic Analysis, Gross Domestic Product [GDP], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GDP, December 31, 2016.

capture

It certainly doesn’t look like the actual economy of the United States experienced anywhere near the wild volatility that the United States markets experienced from 1990 to 2016.

I don’t believe that the markets are efficient.  It seems to me that Ben Graham’s characterization of Mr. Market, the crazy manic depressive shouting prices for businesses based on his mood, is closer to reality than the efficient market popularized by EMH.

I believe that astute investors can find mispriced stocks.  Fortunately, most of the investing community believes in EMH because this is what is written in Finance textbooks.  This a good thing.  The more people that believe that markets are efficient, the less competition there will be for value investors.

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

 

 

Is Retail Dead?

retail

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

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

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

Wal-Mart: 14.98 times earnings

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

Gamestop: 6.79 times earnings (a stock I own)

Amazon: 171.87 times earnings (!)

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

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

FY ending 2016: $648 million

2015: $618.30 million

2014: $573.50 million

2013: -44.90 million

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

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

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

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

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

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

Projecting Market Returns

pexels-photo-127642

Market prognosticators frequently opine in the direction of the markets based on public policy, what Millennials are doing, whether Euro will do this and the Yen will do that, who won the Super Bowl, if it is an election year, etc.  They have no idea what they are talking about.

The more accurate forecast models take a hard look at value.

Shiller P/E

One method is the Shriller P/E.  It was designed by Yale economist Robert Shiller.

Looking at the market in terms of the current P/E can be misleading depending on where we are in the business cycle.  For instance, during a recession, earnings plummet and P/E ratios rise even though the market may be undervalued.   During a boom, earnings are temporarily inflated, which can cause the market to appear cheap when it may in fact be quite expensive.  Shiller accounted for this by comparing price to average earnings over the last 10 years, accounting for the impact of economic gyrations.

Gurufocus maintains a nice  tracker of the Shiller P/E here.

Market Capitalization as Percentage of GDP

A better method is looking at the market in terms of its value in relation to GDP.  Buffett popularized this method in a 1999 article in Fortune.  Buffett was able to use market valuation as a percent of GDP to assess market values.  He assessed the market correctly at the time and declared the market to be overvalued.

The methodology is easy to understand.  The market derives its value from earnings and US companies can only earn what the US economy can actually produce.

Gurufocus maintains a tracker for this metric here.

A Better Method

The GDP method is more accurate than the Shiller PE, but it is still an imprecise instrument.  For instance, the GDP model predicts a range of returns over the next 10 years of +4.6% to -8.2%.

Recently I came across a market valuation model that was even more compelling at the Philosophical Economics blog.  This model instead looks at the average equity allocation.  The idea is that during a bull market, valuations increase as investors move their money from other asset classes into stocks.  As the equity allocation increases, the market runs out of fuel for higher valuations and future returns are diminished.

The key reason this makes sense is the relationship between interest rates and returns.  As interest rates rise, it seems natural that investors would decrease their equity allocation and put more of their funds towards bonds.  If bonds are dishing out high rates of return for little risk, why take the risk of owning equities?  This is precisely what happened in the 1970s and early 1980s, when interest rates soared and equities were punished.  It also set the stage for an extraordinary period from 1982 to 2000, in which declining interest rates from historic highs fueled one of the greatest bull markets in history.

Interestingly, as Buffett pointed out in the earlier referenced 1999 article, earnings and economic growth were actually less in the 1980s and 1990s than they were in the 1960s and 1970s.  The only difference between the two periods is the direction of interest rates.

The model can actually be plugged into a simple equation:

Expected 10 year rate of return = (-.8 * Average Equity Allocation)+37.5

Looking at the most recent data, the current average equity allocation is 40%.  Plug this into the equation and we get the following result: (-.8 * 40) + 37.5 = 5.5% expected 10 year rate of return

The metric is tracked here and is updated quarterly.  If the equity allocation were to rise to 45%, that implies that the next ten years will deliver a paltry 1.5% return.  That would hardly seem sufficient compensation for the volatility risk in equities.

So What?

Generally I like to remain agnostic about the market and focus on bargain stocks.  However, my 401(k) plan is dedicated to index funds and I think it makes sense to look at market valuations.  An overvalued market combined with an overheating economy is certainly cause for concern and something investors should remain cognizant of.

tumblr_mztrt5j8jz1sfie3io1_1280

They heard that the average equity allocation went down in the most recent quarter

The model described in this post should reduce your fears when the market drops.  A market drop simply means that future returns are going to be higher.  Drops in the market are cause for celebration, as you can now buy stocks that will deliver a higher rate of return.  I would certainly buy more if the market were to plunge 50% tomorrow.  I’d also probably start scrounging whatever cash I had on hand and piling into the market.

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

Portfolio Stats

stats

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

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

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

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

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

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

Understanding the Economy

A few years ago, hedge fund manager Ray Dalio provided a very useful template for understanding the economy.  The video is above and I think it is incredibly useful as a template for understanding where we are in the economic cycle.  I encourage everyone to watch the video.  I think you will find it enlightening.

To sum up Ray’s thesis: debt drives the economic cycle.  Without debt, the economy can only grow as fast as productivity.  It is debt that drives booms and recessions.  Debt allows the economy to grow beyond the productivity rate, which hovers around 2% in the long run.  When debt levels become too high and begin to restrain cash flows, households and business restrict spending and this causes the economy to contract.

2008 and 2% Growth

The Dalio template explains what happened in 2008 and the aftermath.

In the short term (5-10 year) business cycle, borrowing increases.  As borrowing increases, cash flows because increasingly tightened.  When the cash flows tighten enough, a recession occurs.  The Federal Reserve responds by lowering borrowing costs, restoring borrowing and creating a new economic boom.  Throughout these booms and busts, debts continuously increase.  In 2008, we approached the end of a long term (80 year) debt cycle, in which debts became so high and interest rates were already so low that the conventional monetary tools no longer worked.  This was the beginning of a decade of deleveraging, in which businesses and households shied away from debt after such a tumultuous experience.  During such a time in which new debts cannot drive the economy, the best that the economy can do is grow at its productivity rate.

There has been a lot of head scratching in the last decade about why the economy can’t grow faster than 2%.  Dalio’s template explains it.  It has nothing to do with taxes, regulation, culture, etc. It is caused by the deleveraging. Without debt, the economy can’t grow faster than the productivity rate, which averages around 2%.

Deleveraging

capture

The data  supports the thesis that businesses and households are deleveraging.  The S&P 500 debt to equity ratio fell to its lowest level in 30 years.  Households went through a similar deleveraging process, as documented in the chart above.  Households now have the lowest debt payments as a percentage of disposable income that they have had since the early 1980s.  Incomes have increased, households cleaned up their debt levels and interest rates have died. Every business and every household that had a lot of debt in 2008 went through hell in the recession. The memory has not been lost. 0% interest rates and quantitative easing weren’t enough to spur borrowing, causing a lot of confusion among economists and policy makers. The cause ought to be obvious: no one wants to get burned again because the memories are fresh.

This has been bad for economic growth since the crisis, but I think it improves the long term prospects of the US economy.  Economist Hyman Minsky theorized that stability is destabilizing, because stable times encourage increasingly reckless lending and borrowing. We experienced this truth in 2008. If Minsky is right about stability, then the opposite must be true for instability. Instability is stabilizing.  Less debt means a lower likelihood of a 2008 economic shock. A more healthy attitude about debt and borrowing might prevent a wild economic boom, but the lack of such boom times also prevents catastrophic economic shocks.

We went through a similar experience in 1929, the last time we reached the end of a long term debt cycle. The difference between 1929 and 2008 was the response of the Federal Reserve. The Fed responded disastrously in 1929. The Fed turned an economic panic and recession triggered by a deleveraging into a Great Depression, as Milton Friedman proved. This time, it appears that in 2008 the Fed responded appropriately. That is why we have been able to go through a relatively tranquil deleveraging, in which debts decreased and the economy grew in a limited capacity at its productivity rate.

Turnings

I was fascinated by Dalio’s template of the long-term 80 year debt cycle because it matches perfectly with William Strauss and Neil Howe’s generational theory. The theory describes history in terms of 80-100 year cycles. The cycle of history also seems to match Dalio’s observations about the long-term debt cycle, in which debts continuously accumulate throughout the ups and downs of a long term cycle and then culminate in a period of deleveraging, lasting roughly a decade. Check out Strauss and Howe’s excellent book if you want to understand the debt cycle in a better historical context.

Strauss and Howe also discuss a high that follows a crisis (deleveraging). When the delveraging is over, a roughly 20 year period of financial tranquility follows. Yes, there are recessions and the normal stock market bull and bear markets, but nothing of the magnitude of a 1929 or 2008. Instability is stabilizing and everyone making the decisions has fresh memories of the deleveraging. This prevents corporate managers from acting like the reckless managers of the 1990s/2000s or the 1920s.

The last decade has usually been described as a slow growth period of malaise. I think this misses the mark. The seeds have been planted for a future sustainable economic boom because the paring down of debts and the memories of the crisis lowers the likelihood of an economic shock. The Fed’s actions – far from being reckless as is typically described – were exactly the monetary medicine that the economy needed. This was the medicine that Fed failed to deliver in the early 1930s. The deleveraging was inevitable in the 1930s, but we didn’t need to have a Depression. We could have had a period like the decade we just experienced.

So What?

How do I use this template to influence investment decisions?  Generally, I am agnostic when it comes to the macro economy. As long as I have a diversified portfolio of cheap stocks that are financially healthy, I should outperform the market over long stretches of time.  The market will rise over time as long as the economy continues to expand.  The slow and steady expansion of the economy is its natural impulse, as people are always looking for more productive ways to produce goods and services and the population will continuously expand.

With that said, I think it is important for investors to remain cognizant of our position in the debt cycle. For instance, if debt service ratios are approaching new highs, a recession is likely to happen soon. In that environment, it makes sense to steer clear of heavily leveraged firms or firms that are heavily cyclical. If debt levels are combined with high market valuations, avoidance of market indexes may be prudent.

I hope you find the Dalio template as insightful and useful as I do.

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

 

 

 

Final 2016 Purchase

cup-of-coffee-laptop-office-macbook-89786

I purchased 144 shares of Steelcase Inc. (SCS) at a price of 17.9432 yesterday.  Steelcase has an earnings yield of 7.79%.  This makes my fund nearly 100% invested.

I will give the current portfolio investments a year to work out and re balance next December.

Additionally, this morning I received a $24.51 dividend on IDT.

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

MSGN: A Promising Spin Off

I purchased 119 shares of Madison Square Garden Networks today at 21.40.  MSGN currently has an earnings yield of 10.11%.

Spin Offs

I became aware of MSGN because it is a spin off.  Spin offs are when companies take divisions of their firm and spin them off to operate as a separate entity.  Companies do this for many reasons.  They may believe that the firm will receive a higher valuation if valued separately.  They may want to unload debt on the entity.  Regardless of the reason, spin offs are an attractive area to invest.  Spin offs have been proven as a group to beat the market.

The best explanation of a spin off strategy is detailed in Joel Greenblatt’s book You Can Be a Stock Market Genius.  It is a great book despite the ridiculous title.  In the book, Joel gives many real world examples of spin offs he purchased for his fund and details his rationale for doing so.  It also explains in depth the reasons that spin offs outperform better than I can.

As stated previously, spin offs outperform the market.  If you don’t feel like doing the homework involved in investigating spin offs individually, there are ETFs that specialize in owning these entities.

With this said, proceed with caution.  My belief is that the metric which best captures risk is not beta, but the debt-to-equity ratio.  As mentioned earlier, while spin offs outperform for many reasons, parent companies like to load up these entities with debt.  It’s like divorcing your significant other and then saddling them with all of your credit card balances.  I’m sure there is a more complex explanation in corporate jargon that makes this sound better.  In a downturn, this debt can become a dismal drag on performance.  One of the spin off ETFs (exchange traded fund), the Guggenheim Spin Off ETF (CSD), saw a 2/3 erosion in price during the recession in 2008.  Even despite that loss, the ETF has still outperformed the market.  While they outperform the market, spin offs will require a healthy supply of Pepto Bismol during recessions.

For those who want to investigate spin offs individually, a great list is maintained at this site.  I will frequently take a look at this list as a starting point to do research.  I’ll then do a search to read news articles about the deal and any other analysis that has been done to evaluate the opportunity.

Why MSGN?

MSGN is the cable network division of Madison Square Garden.  This was spun off from the main MSG entity about a year ago.  The primary owner of MSG is the Dolan family.

It looks like the Dolans, who sold Cablevision a year ago, wanted to hold onto the prime iconic piece of New York real estate that is Madison Square Garden but simultaneously realize that cable is a dying business and want to rid themselves of it.  Hence their sale of Cablevision.

By spinning off MSGN, they isolate the entity for a potential buyout from another firm while continuing to hold onto the property that they feel has a future.

Earlier this year, Starz was bought out for 20 times earnings.  Why wouldn’t someone pay a similar multiple for MSGN, which is at half that valuation?

Even if I am wrong, MSGN has an attractive earnings yield and I am comfortable with it in my portfolio.  The only downside is the debt load, but considering that every other company I own has a healthy balance sheet, I am comfortable with this risk.

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

Monday Buys

pexels-photo

I was able to find some quality bargains over the weekend and purchased the positions effective today.

FNHC.  Federated National Holding Company.  103 shares @ 18.5

DDS.  Dillard’s.  40 shares @ 63.80

FAF.  First American Financial.  68 shares @ 37.26

IESC.  IES Holdings. 129 shares @ 19.5

STS.  Supreme Industries.  160 shares @ 15.85

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

Yesterday’s Purchases

SAMSUNG CAMERA PICTURES
SAMSUNG CAMERA PICTURES

I compromised a bit yesterday and took in some stocks with higher valuations than I would prefer, but I am comfortable with the overall valuation of the company vs. what I paid for it and its historical value.  Each pick also has a healthy balance sheet with little to no debt.

I hope that the Fed decision will prompt further selling through end of the month and I can find better bargains before year end.  Currently the fund is 65% invested and will likely stay that way until I can identify more quality bargains with appealing balance sheets.

American Eagle Outfitters (AEO) – 150 shares @ $17.065

Earnings Yield = 7.62%.

Sanderson Farms, Inc. (SAFM) – 29 shares @ $89.6

Earnings Yield = 6.98%

TopBuild Corp (BLD) – 67 shares @ $37.915

Earnings Yield = 7.8%

 

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

Today’s Stocking Stuffers

christmas

Today’s purchases were all companies trading at attractive yields with healthy balance sheets and consistent earnings.  Benjamin Graham recommended an earnings yield at least double the typical investment grade corporate bond, which is now 3.77%.  Double that would be 7.54%.

I’m finding that it is much harder than in past years to find quality bargains after the run up in the markets.  It figures that as soon as I launch this site, the markets are uncooperative!  I may not be able to become fully invested before January 2017 due to the lack of attractive options, but that’s okay.  I’m sure Mr. Market will be in a different mood eventually.

My objective is to complete my purchases on an annual basis and give the stocks a year to work out with an annual re balancing every December so I can take advantage of the January effect.  If I cannot become fully invested by year end, I will likely purchase some short term treasury instruments.  At the moment, 49.56% of the fund is now invested.

37 shares of Valero (VLO) @ $67.58

Earnings Yield = 7%.  Dividend Yield = 3.57%.  The earnings yield is bit lower than I typically demand, but when combined with the dividend yield, share buybacks and the apparent bottoming of oil prices I think it is a good value.

337 shares of Manning & Nappier (MN) @ $7.51

Earnings Yield = 8.9%.  Dividend Yield = 8.48%

129 shares of IDT Corporation (IDT) @ $19.75

Earnings Yield = 9.31%.  Dividend Yield = 3.92%

81 shares of Cato Corp (CATO) @ $30.70

Earnings Yield = 8.60%.  Dividend Yield = 4.34%

171 shares of United Insurance Holdings (UIHC) @ $14.90

Earnings Yield = 9.23%.  Dividend Yield = 1.59%

65 shares of Cooper Tire & Rubber Company (CTB) @ $38.80

Earnings Yield = 10.96%.  Dividend Yield = 1.08%

61 shares of Greenbrier Companies (GBX) @ $41.75

Earnings Yield = 14.08%.  Dividend Yield = 2.07%.

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

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.