Ramblings of a Portfolio Manager 8-24-2009

Ramblings of a Portfolio Manager or “No Mr. Bond, I expect You to Die”
Auric Goldfinger

It was unfortunate that we had to pen last week’s Ramblings prior to seeing the full results of the Monterey Classic Car auctions. Scanning the full data, we noted that a 1965 Aston Martin DB5 coupe sold for $341,000. Not even close to sharing the rarified atmosphere with the likes of original Shelby’s and one-off Ferraris, the Aston owns its own pedestal for having been 007 James Bond’s ride of choice in several bond films, most notably the iconic Goldfinger, released in 1964. We are unaware of any machine guns or ejector seats in the $341k recent sale but what we do know, if our HP12-C is correct, is that an owner of the vehicle, had he/she purchased it new and held it 45 years, would have gotten approximately an 8% annual return on that “investment” ignoring insurance, maintenance and storage costs. Not so spectacular for a car once named “The Most Famous Car In The World.” 007’s nemesis, Auric Goldfinger, would have scoffed at such meager returns…or would he? Americans were not allowed to own gold for investment or speculative purposes in 1964, when Bond thwarted the destruction of Fort Knox, but at the time the US Government had fixed the price of gold at $35/ounce. Plugging that number into our trusty HP and using today’s price of roughly $943/oz, we get, hmmm, about an 8% annual return, also ignoring storage and insurance costs! Over the same period, using the Dow Jones Industrial Average, the US stock market returned, a slightly better 9% including dividends but excluding taxes.* US retail price inflation for the last 45 years was half the return of these assets at 4%. The conclusion: over the long run stocks aren’t such a bad place to put your money. However, as we have noted, you can’t wear your portfolio or show it off on Main Street on a hot August night.

What prompted this simple analysis is a perpetual gold bug/market bear’s appearance on CNBC touting the yellow metal as the “best investment” over the long run. His thesis was simple: in his opinion, gold prices are perfectly negatively correlated with the US dollar and perfectly positively correlated with the inflation rate. He further forecasts that massive Government spending is pushing us into a period of hyper-inflation, which will erode the purchasing power of the dollar thereby making gold the perfect investment. In his world, Mr. Bond (US, that is) truly must die and Auric will prevail. Without commenting on his dire prediction, we do note that, as an inflation hedge, the data does support the attractiveness of gold as an investment. However, the storage and insurance costs of holding the physical asset cannot be ignored and we estimate that these would have eaten up close to half of your annual return over the last 45 years, based on current costs, meaning at best you would be tied to slightly ahead of inflation. In addition, physical gold does not trade like stocks in that there is no liquid market where bid and ask prices are readily available. That means your purchase price, even today, is subject to the retail markup of guys like those you see on TV and that you will pay more than the spot price quoted in the Wall Street Journal on the way in and will have to accept a discount to the reported spot price on the way out. Putting it all together, you would be lucky to keep even with inflation in a buy and hold strategy employing gold as a physical asset. Luckily, today we have a gold ETF that is supposed to track the spot prices of the metal, without the direct costs of illiquidity and physical storage. The ETF, however, incorporates all the costs associated with holding the physical commodity (someone has to hold it—there is no free lunch) so the security doesn’t track the spot price of gold exactly. Since the returns we reported above include periods of high inflation as well as stagflation (there hasn’t been a period of deflation since 1964) and even before transaction and holding costs gold still underperformed stocks, we suggest investing in paper rather than metal…unless, of course, your metal of choice is an aluminum-bodied DB5 with Pussy Galore as your chief mechanic. But, of course, there are other costs associated with that form of investment…

Ramblings of a Portfolio Manager 8-17-2009

You Can’t Cruise Main Street in 500,000 Shares of GE

The annual classic car auction at Monterey, CA was held last weekend. Few records were set but the sales numbers were impressive, as they have been for the last decade. One car enthusiast paid more than $7mm for a 1965 Shelby Cobra Daytona race car while another plunked down $2.75mm for a 1958 Ferrari California Spyder. Yet, as we write this the world equity markets are in full sell-off mode. The Chinese Shanghai Index closed down nearly 6% and is now down over 17% from its August 4^th high while Japan’s Nikkei index closed down 3% and the S&P 500 has fallen over 3% since Thursday. Fears over the health of the US consumer are driving the sell-off, according to market pundits. Huh?

Actually, this seeming paradox makes quite a bit of sense and says a great deal about market psychology and the current state of the capital markets. Since the 1980’s, classic cars have morphed from fun toys held by car nuts with too much money and/or time on their hands to a serious asset class for investors. We won’t comment on the advisability of investing in old motor vehicles as a retirement strategy, however, we will examine the reason for the car market’s transformation. There have been two significant periods during which classic cars were treated as assets rather than playthings. The first was immediately preceding and following the stock market crash of 1987. Back then, cheap money had fueled both the US real estate and Japanese stock markets and the beneficiaries of those booms plowed a portion of their new found wealth into high end “collectibles” such as art, and then cars. When the stock market crashed in 1987, the classic car market boomed further as money came out of stocks and sought a “more stable” return. Again, art and old cars were the targets since their values had already been rising and—presto!--cars became an asset class. That house of cards tumbled in 1989 along with real estate and the Japanese economy. The current boom in classic car prices traces back to the Barrett Jackson Car Auction of January, 2002. Immediately following the attacks of 9/11, many baby boomers, wealthy after years of a strong economy and a rising stock prices (sound familiar?), began to feel that life was too short and that it was time to buy “the cool car I always wanted in high school but couldn’t afford.” The market sell-off following 9/11 and the Enron and WorldCom scandals further solidified the asset class status as once again money sought a stable asset whose values were rising. The car market’s boom was then further fueled and perpetuated over the ensuing years by real estate wealth (again, sound familiar?) and although it has weakened in the last 12 months it has not crashed in the true sense

Can we draw any conclusions from this history lesson? The strongest message we take is that the classic car market needs to correct, if history is any guide, and the fact that it has yet to do so signals that, perhaps, money is still seeking returns uncorrelated to the stock market. That, we view, as a longer term positive for stocks as it means investors most likely still doubt the recent rally and that skepticism, which is healthy to any market longer-term, still abounds.

Ramblings of a Portfolio Manager 8-10-2009

Summer has finally arrived on the East Coast!

No joke—last week we had our first 5 day stretch without rain here since Memorial Day. The mushrooms growing under the Ark we constructed in the office parking lot are in danger of shriveling. Might this favorable stretch of weather have any implications for the direction of the capital markets the rest of the year? Before you think we have gone off the deep end and are beginning to employ astrological charts in our investment process (and you still might be right here), hear us out.

Earlier this year we commented on the “sell in May and go away” myth. That quaint notion, borne of a simpler time before cell phones, laptops, wifi and DSL in the Hamptons, had its place in the white-shoe days of Wall Street, when market participants mutually made an unspoken, passive pact to do no harm during the summer months, when everyone’s attentions were focused elsewhere and communications with the office were slow and infrequent. The strength and volume associated with this current summer rally attests to the fact that the old gentlemen’s agreement regarding summer break is long dead. Still, with many of the near-term potential market catalysts such as quarterly earnings reports and significant monthly economic data now behind us and, most importantly, with congress on vacation (meaning fewer dangerous trial balloons) we may yet get our summer doldrums—they just may occur all in the month of August.

The market’s recent rally has many an “expert” calling for a pullback, retracement, profit-taking session or any number of other terms suggesting a reversal of the uptrend. We don’t disagree with the need for time to digest. Our anecdotal evidence is that a good deal of this rally can be attributed to short covering, in that many of the best performers are low quality, high short interest stocks trading under $5. We also note that retail investors are starting to belly up to the trough, judging from the volume and trade size in some of these higher flying issues, although the money market data and funds flow data have yet to bear this out. Both data points are classic causes for concern. Yet “digestion” doesn’t mean that stocks have to fall back to some technical preordained level to allow the rally to advance further. Treading water (now there’s a good old Wall Street technical term for you) sometimes works just as well to relieve the gas pains. True, the ownership profile of stocks may change in a sideways movement phase, but that isn’t necessarily bad. We disagree with the notion that retail investors being last to the party is a bad thing—especially if they help the “smart money” out of their positions during a flat spot in the market. All that would be happening there is that the cash horde changes hands from individuals to institutions—and we would strongly take the contrarian point of view as to which side is the “smart money”—and retail investors can be much stronger hands than institutional holders for any number of reasons. So, putting this thesis together with our August doldrum theory from above, we have good reason to believe in a small market sell-off at best and a boring (amen!) few weeks ahead of us.

Ramblings of a Portfolio Manager 8-3-2009

Ramblings of a Portfolio Manager or Farewell Earnings Central! We hardly knew Ye…

As some may discern from our weeklies, we often like to take shots at the financial media. With our aging eyes, such a large target is rather hard to miss…and in this business, where hitting the mark 5/8^th of the time constitutes a good record, we’ll take all the easy shots we can. So it was with a wry smile that we listened to CNBC declare “the most important earnings season ever” officially at an end with the closing of their Earnings Central news desk last Friday. Funny, we were unaware of any SEC regulation promulgating that all quarterly corporate earnings be reported by July 31^st. US companies are on many different fiscal years (particularly the retailers), with quarters ending in every month of the year, not just the convenient months of December, March, June and September. But if the pros at CNBC say that earnings season is over, then who are we, or any of the 100 or so publicly traded retailers out there, to argue? Not that anything such companies as Wal-Mart, Target or JC Penny have to say about the state of their business would shed any light on the health of our economy and, thus, the fate of the capital markets. It is folly to argue with someone with a larger pen or a taller pulpit so we humbly submit to the wisdom of the press…not!

Sorry, while not wishing to appear contrarian, or in any way in disagreement with the almighty media, we humbly submit that the “most important earnings season ever” has yet to begin. Investing in an economy that is 60% dependant upon the consumer as we regularly do, we would argue that the fate of the retailers will give us a better read on the future than how well Goldman Sachs did in high frequency trading last quarter. So far this year, the retailers have followed the playbook of the rest of corporate America—reporting lower-than-expected sales with better-than-expected EPS thanks to cost cutting. While that type of expectations management may have worked just fine with the likes of Goldman or Intel (which is more than slightly leveraged to the consumer by the way) this quarter, it will not get the companies serving you and us, or the stock market in general, very far. That is, if we get earnings reports from the retail sector similar to what we have been hearing thus far from the rest of the economy but without positive forward guidance, our little market rally may be in jeopardy. So stay tuned…but not to CNBC it would appear.