Ramblings of a Portfolio Manager 10-12-2009

Ramblings of a Portfolio Manager or Sometimes it pays to be a fish

When at a loss for words, just add superlatives. That’s what CNBC is doing this month. Having already declared last earnings season the “most important ever” it has found itself needing to one-up its own pronouncements for the third quarter. So now we have the “most crucial earnings season in history” before us. To avoid embarrassment to the anchors, they aren’t even allowed to refer to it as such. Instead, “Jay in the booth” makes the announcement during commercial breaks. Lampooning all this is way too much of a lay-up so we’re not going there this week.

Instead, we thought we would take the opportunity to talk about what we are doing amid the media’s Halloween Hysteria. We’ve rambled about analyst expectations and media hype for several months now so a fair question to ask is how we are positioning ourselves. Our philosophy has always been to sell hype, buy pessimism. But before you dub us contrarians, realize that we’ve been in this business for over 25 years now and, perhaps, that means we’ve (hopefully) learned a few things. To use an allegory, we recognize that salmon swimming upstream strengthens the breed and ensures the perpetuation of the species--but we also recognize that only a very small percentage of the fish embarking on the journey actually live to achieve their goal. Remaining at sea, they would all survive the year but would eventually become extinct. John Maynard Keynes said it another way—the market can stay irrational a lot longer than you can stay solvent. No investment discipline (discipline being the operative word), rigorously applied, works in all market environments. So, using a mixed metaphor, even though following the herd too long often leads you off the cliff, there are times when you need to swim with the current. Flexibility is the key to survival in this business.

In the last 10 months the market has gone from extreme pessimism, to moderate doubt, to mild optimism. We responded, using the animal analogy, by starting off as salmon (not an easy thing to do, especially when at least one client called on March 6th to lambaste us for having ANY exposure to equities). This strategy unintentionally evolved us into herd animals as the market caught up to where we already were. Now, however, we are intentionally devolving ourselves back to the fish. In investment terms, early this year we recognized the extreme pessimism and bought the out of favor, low expectation cyclical stocks while everyone else favored the defensive and higher expectation growth names. As this strategy began to pay off we stuck with it, knowingly swimming with the current, as we believed that the levels of pessimism, although abating, were still quite high meaning our strategy had room to go. Now that we have returned to whisper numbers and analysts expecting companies to “beat expectations,” we are concentrating again on low expectation stocks. This doesn’t mean we have gone defensive—we believe that those stocks themselves have high expectations –but rather are lessening our exposure to technology and soft-cyclicals that have appreciated significantly over the past several months. We still think cyclical and commodity stocks, despite their recent run, still have very low expectations and will be given a “pass” on their earnings reports and so remain there. Technology, on the other hand, is fully within the whisper number realm and we are treating them with caution.

And for those who think China is a fraud (we get those calls too), we have increased our exposure to that part of the world, especially as their market has pulled back. Just remember that there are 3 times more Chinese than there are of us. So even if they were to eat, drive or yap on the cell phone 1/3rd as much as we do they would be, as a consumer group, equal to us. And their aspiration is to emulate us. Think about the potential growth ahead.

Ramblings of a Portfolio Manager 10-2-2009

Ramblings of a Portfolio Manager or Blame it on Rio.

The American Heartland was dealt a psychological blow last week when the IOC eliminated Chicago in the first round for consideration for the 2016 Summer Olympics. The winner, Rio de Janeiro, will become the first country in South America to host an Olympiad.

While the IOC ostensibly chose a Latin American country due to the dearth of Olympic games held in that part of the Southern Hemisphere, it strikes us as a little more than coincidental that each Summer Olympic venue chosen over the last several decades has tended to be where the economic action was occurring (2004 excepted, with Athens being a nostalgic choice). Sydney in 2000 in many ways signaled the passing of the economic growth torch from the US to Asia. Likewise, Beijing 2008 symbolized the rise of China in international economic status. So now we have Rio. Is Brazil where the economic now action lies? Well, the Bovespa is up 63% year-to-date versus, a paltry 8.1% for the Dow Jones (last year they were down similarly at 39% and 32% respectively). There is a not-so-subtle irony in Chicago’s loss to Rio. Barely three decades ago, Latin America was known as the deadbeat of the world. Over leveraged and unable to repay the mountains of debt piled up during their industrial and infrastructure growth phases, Brazil, Argentina, Mexico, Chile and other commodity-dependent South American countries threatened to topple the world’s (particularly US) banks. Lending was cut off and their economies sunk into recession. Any of this sound familiar?

Fast-forward 25 years and Latin America looks to be the hot place to invest (and play Olympic beach volleyball). How did this happen? A combination of sovereign debt forgiveness, currency devaluation and strong (commodity-based) economic growth, which helped the region catch up to their debt payment burden. A resumption of lending by international banks contributed to that strong economic growth. So now that the US is piling on huge amounts of debt is there a potential historical parallel? Perhaps. But it is important to remember that in the early 80’s the Latin American “deadbeats” were (and still are) emerging economies with much of their economic potential still ahead of them, leaving them headroom to outgrow their troubles. The US in 2009, by contrast, is a very mature economy with a population growth near zero. While productivity gains and technological innovation may yet contribute to positive GDP gains here, it’s going to take some significant growth to catch up to the obligations we are now incurring. As Speedy Gonzales would say, Arriba! Andale!

Ramblings of a Portfolio Manager 9-28-2009

Ramblings of a Portfolio Manager or Shocked, Shocked to Find That Gambling is Going on in Here!

That should have been the headline on the left column of page C1 of the Wall Street Journal today. In case you didn’t accidentally do a face-plant into the paper this morning, as we did while jogging, let us paraphrase: The column heading was “Profits Poised to Surprise Again.” Basically, the thrust was that an Investment Strategist of a well known (and still surviving!) white shoe investment firm went from extremely bearish to bullish over the weekend. His rationale: he expects third quarter earnings to be “better than expected.” Now, having been on Wall Street for 25+ years we have NEVER heard anyone question the inherent paradox of this phrase. We’re not sure but think that is why sell-side analysts rarely survive on our side of the Wall Street Chinese Wall and why Louie probably never made a dime outside of Rick’s.

What we are sure of is that this strategist is smart and, no doubt, well educated. So are a lot of politicians. But that doesn’t stop either from succumbing to the group think of the profession. In either case one eventually becomes desensitized to the fact that you are the cause of the problem you are trying to solve. It’s like perpetual amnesia in which you keep forgetting that itchy rash was caused by your scratching of the itchy rash. So let’s pretend we aren’t English majors and dissect the phrase “better than expected.” Obviously, “expected” is what Wall Street analysts have in print for earnings estimates. “Better” than those estimates means companies will report earnings and/or sales that are higher than those estimates. So why don’t analysts eliminate the paradox by raising their expectations for sales and earnings when they expect those numbers to be beaten? Safety in numbers. Period. Sticking one’s neck out is risky in this business—if you are aggressive and right, you get little credit. If you are aggressive and wrong, well, Mme. Lafarge is ready with the Guillotine. If you stay with the herd and the Company beats expectations, investors are too happy to notice your original conservative mistake; wrong and you are in very good company. Reversion to the mean is a powerful force in the investment game.

This behavioral characteristic once was a very exploitable artifact of the market and generated some very successful investment models employing earnings revisions. Good analysts willing to step out from the crowd, however slightly, usually signaled a larger-than-expected earnings surprise and, thus, stock under or out performance. Over the years, analysts’ behavior eventually produced what is known as the “whisper” number (you’ve heard that phrase on TV before, no doubt.), which arbitraged away the advantage of earnings revision analysis. So now that we are on the second derivative of “better than expected” companies have to beat the “whisper number” for their stock prices to move ahead.

What does this all mean for the upcoming earnings season? Well, first of all, the tail turning of the last holdout bear gives us reason to be nervous. So does the comment just released on CNBC: “is buy and hold back?” What do they think has been working since March?!?! More significantly, however, the fact that expectations have moved beyond the numbers in print means we have a pretty lofty set of whisper numbers to meet or beat. Another quarter of “beat on the bottom line, miss on the top” will most likely not be tolerated this time around. With every economic sage telling us that the recession is over, investors no doubt will be seeking confirmation—and that confirmation will have to come in the form of rising sales that beat the Street whispers.

Ramblings of a Portfolio Manager 9-21-2009

Ramblings of a Portfolio Manager or What to expect when you are expecting?

We’re probably guilty of some sort of copy write infringement here. No, no-one here is expecting a new family addition. We’re speaking specifically of the much anticipated market correction and corporate earnings season. Having failed as of yet to receive the first, we are fairly confident of delivery of the second. Will they perhaps coincide?

The thesis of the “too far too fast” crowd is that stocks are now discounting a V-shaped recovery (yes, we know we promised no more consonants) to economic conditions that will not materialize. While we do accept that markets are discounting mechanisms we disagree as to what they are, in fact, discounting. As we write this, an incredulous TV talking head is complaining “how dare the stock market forecast the economy?” Well, Madame, that’s what it’s supposed to do!

Using the widely tracked S&P 500, stock prices right now are slightly ahead of where they were on Election Day 2008 and 11% below where they were on
September 15th, when Lehman Brothers declared bankruptcy. The index is still 32% below its peak, achieved in October of 2007. For our purposes we assume that we are more or less back to where we were on Election Day. Well, if one can remember that far back, we had already witnessed the collapse of Fannie Mae, Freddie Mac, Bear Stearns, Washington Mutual and Lehman Brothers. The Federal Reserve was forced to guarantee money market funds as some had already “broken the buck,” Congress had reluctantly approved $700 billion for the TARP and the 30 day T-Bill sported a negative yield (yes, you paid Uncle Sam to hold your money). We would argue that those were some fairly dire conditions with a correspondingly extreme negative market sentiment. Of course, things did get worse for stock indices, much of which can be attributed to deleveraging of hedge funds and headline risks from the opening shots of the Geithner Treasury. Nevertheless, despite the rapid ascent from March 6th, we are no better off stock-price-wise than we were when Obama was ahead at the polls on Election Day. That says to us that stocks are hardly discounting a rosy scenario; certainly not a return to pre-Lehman economic conditions.

So far September hasn’t lived up to its reputation (it’s not over yet) but a reminder that October is when most big crashes occur. So what can we expect as earnings season rolls around? Are investors expecting (and stock prices discounting) significantly improved earnings? Well, that’s a big debate around here. So far Fed Chairman Bernanke has declared the end of the recession, the Purchasing Managers Index has crossed 50, signaling growth, and we have the 4th consecutive monthly positive set of Leading Economic Indicators. One would think, then, that investors will be expecting earnings to follow the positive economic news…or will they? Now that it is confirmed that we have hit bottom and are on the mend, there is still the potential that investors will give companies a “free pass” for missing expectations on the promise of better numbers to come. So, perhaps, what we should expect is not so much earnings reports as earnings guidance. Any downplaying of expectations, whether based on fact or well-intentioned sandbagging, may well engender the market swoon we have all so long come to expect.

Ramblings of a Portfolio Manager 9-14-2009

Ramblings of a Portfolio Manager or Every Rally Has a Golden Lining?

We published no Ramblings last week as we took Labor Day off to roast a pig and to ruminate on the state of the capital markets. While cooking our tasty ruminant we found a number of things to chew upon but, in particular, we noted that the Calendar placed us solidly in September while the market indices showed us solidly in the black! What about the doomsayers’ daily history lesson regarding September’s evil legacy and it’s strong correlation to the omnipresent “too far, too fast” market indicator? And, if the market is truly going up on positive sentiment, why is Gold soaring, the dollar sinking and interest rates dropping? Are we are in economic Bizzaroland?

Actually, these seemingly contradictory moves in asset classes make sense and say a great deal about where the market sees the economy 6 months to a year out. Let’s start with Gold, as the move in this asset class is intertwined with the others. There are usually 3 reasons why investors like to hold Gold: 1. as an inflation hedge; 2. as a safe haven to hedge against the risk in other asset classes (like stocks and bonds) and 3. due to weakness in the US Dollar. Taking each in turn, Inflation: currently, most credible forecasts see tame inflation (deflation is off the table for now) over the next 6-12 months as the economy is expected to recover slowly, keeping wage growth in check, and these expectations have not been increased in the last month. This outlook is buttressed by the lack of movement in 10 year treasury inflation spreads and the still historically low velocity of money (meaning banks still aren’t lending). The lack of significant inflation outlook is also one reason why US interest rates have been coming down. Safe Haven: the volatility index, or VIX, a measure of fear in the stock market, has been trending down and is now at a one-year low—almost to pre-crisis levels—as are credit default spreads, suggesting that fear of shocks to other asset values is not significant. By the way, although it has been positive lately, the long-term correlation between Gold and stock prices is pretty much zero, debunking the pretty metal as a safe haven in a stock market storm. Weak dollar: Gold’s correlation to the US dollar is inverse and much stronger than its correlation with stock prices. The same holds true for Oil, which has also been climbing in price as of late. Weakness in the dollar, we believe, is behind the asset class paradox we have been seeing this month. The US Dollar has been taking it on the chin as of late as inflation fears remain muted and a huge supply of US debt is expected to hit the market. Lack of fear has also reduced the demand for US currency as a safe haven, driving down its price relative to other currencies. Of course, the Fed has signaled no expected increase in interest rates in the near future, thus dampening demand for the dollar.

So why are rates dropping and stocks rising? Rates, as we have discussed, are trending lower as inflation outlooks have been downsized and the Fed remains on hold. There is also a growing sense that Obama’s $Trillion Health Care package is on the ropes, suggesting smaller than originally expected future US borrowing. Stocks, on the other hand, are following simple Graham and Dodd fundamental analysis: lower rates increase the present value of earnings and dividend streams, thus making stocks more valuable In addition, a weak dollar means that US exports are more competitive in the global market, signaling greater future international demand and higher revenues for our multinationals. It’s no surprise, then, that industrials have been the best performers this month. In the absence of any negative information, thus, stocks are trending higher. Really, it is as simple as that.

Ramblings of a Portfolio Manager 9-1-2009

Ramblings of a Portfolio Manager or Is China History?

A good technician will tell you that the trend is your friend…until, of course, it isn’t. That helpful advice is now being delivered in shiploads with respect to the Chinese stock market. Now down over 23% from its July peak, the Shanghai Index took a nearly 7% hit on Monday. Smelling blood, the technicians and other skeptics came out in droves to proclaim all sorts of doomsday scenarios both for the Shanghai as well as the Dow, complete with detailed sets of new support and resistance levels. We note more than a few of these chartists enjoyed the ride up and now, having missed calling the top, are frenzy-feeding on the blood scent of a chart that has rolled over.

Forgetting the entrail readers for a moment, the real issue upon which to focus is whether the direction of the Shanghai has any direct relationship to the state of the underlying Chinese economy and if the well-used but largely debunked phrase of decoupling can be (hopefully) applied to the US market. As always, the answer to the first question largely dictates the answer to the second. A brief background is in order: The Chinese economy went into a “slump” before the US officially hit the skids. “Slump,” however, is a relative term. The big run in Chinese equities came to an end on October 9^th, 2007, after a nearly 5-fold rise in a little over 20 months. Much of the rise was declared to be at the time, and in restrospect truly was, based on speculation by domestic retail investors. Of course, those speculators got started somewhere and the massive Chinese infrastructure build ahead of the Olympics certainly gave them a reason. The ensuing double-digit GDP growth only fanned the speculative flames. When the torch went out and the country was no longer in the global spotlight, the window-dressing spending stopped, things softened and the market followed accordingly. 11 months later our economy experienced its AIG/Lehman hangover and the Shanghai continued its slide along with the US markets.

Hind-sight is always 20/20 and looking back, it is easy to see that the Chinese market was overly optimistic about the long-term growth prospects of the underlying economy during the bull run of 2005-2007 (remember the NASDAQ in 1999??). But hindsight also tells us that Chinese stocks got overly pessimistic late last year as our economy headed into the toilet. How can we say that? Well, unlike the US, China has vast currency reserves, no crippling national debt, a government body that can act swiftly without endless partisan and special interest debate (they shoot dissenters you know) and a strong motivation to keep the economic boom intact (farmers rioting in the streets doesn’t play well on the BBC). And the Chinese Government put all these advantages to work in a much more stimulative set of initiatives than our borrow, spend on pork and tax program, with much more favorable expected outcomes. So much of this year’s climb in the Shanghai, in our humble opinion, has been warranted. But did Chinese investors get overly optimistic once again? Probably. Trees don’t grow to the sky, is a favorite saying of old-timers on Wall Street., meaning that no market goes straight up forever. So, now that we have a fairly sizeable sell-off in Chinese equities, are they now overly pessimistic in their assessment of the future state of the economy? Most likely. The Chinese Government, as we mentioned, has the means and motivation to keep the spending tap open and there is no reason to suspect that they will turn it off any time soon (they’ve got no Milton Friedman-types sounding inflation alarm bells over there). So the Chinese engine of growth, we believe, still has at least ¾ a tank full of gas. What about the relationship to our markets? Here again, history can be a guide. When China tanked in 2007, the pundits decried a decoupling of our economies and markets. Didn’t happen. When the Chinese economy and markets started to turn ahead of those in the US earlier this year, the same pundits once again rang the decoupling bell. Didn’t happen. And in the early stages of the Chinese market sell-off in July/August, the optimistic “decouplers” came out once again. Not looking like that is going to hold true either. So, if, as we believe, the dip in Chinese equities is the pause that refreshes and has more to do with investor sentiment than the actual future of Chinese GDP growth, then we humbly suggest taking advantage of the decoupling myth, when it proves itself as such, over the next few months.

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…