Monday, June 30, 2008
In his July Investment Outlook, the manager of the world's largest bond fund offers some advice and predictions to the man he thinks will be the next president: "Dear President Obama".
I don't agree with all the politics there, but that's immaterial. What's of interest, from an investing perspective, is Bill Gross's prediction that an additional $500 billion in government spending will be needed to stimulate the economy; that this will lead to our first $1 trillion deficit, rising inflation, and rising bond yields over the next 4-8 years. "Your term will not go down in history as investor friendly.", Gross writes.
If the views of Jim Rogers and Vitaliy Katsenelson on U.S. stock market over the next several years didn't give you pause, perhaps Bill Gross's predictions will. Those who follow traditional financial planners' suggestions about asset allocation (e.g., keeping a large percentage of one's portfolio in domestic stock and bond index funds) may come to regret it.
This was Katsenelson's response to my question:
Dave, that is a great question. But I really don’t know the answer to it. As I understand commodity cycles are created by over/under investment in production. Not sure if interest in stocks (especially at the end of the secular bull market) was a cause of under investment in search and production of commodities.
Katsenelson was of course right about what drives commodity cycles. After I finished reading Hot Commodities, I wrote this response to Katsenelson:
I did a little more reading on Jim Rogers after I posted that question, and I have his answer. You hit on part of it above. According to Rogers, after the end of a secular bull market in commodities, commodity prices are dropping so stocks look more attractive as an investment; then, the lower commodity costs boost the margins of non-commodity producing companies, fueling their profits. As the secular bull market in stocks continues, demand for commodities gradual increases, but supply doesn’t increase as much, because, as you pointed out above, investment goes to stocks rather than commodities. When tech stocks, or drug stocks, or whatever non-commodity sectors are booming, few want to invest in digging a new mine for zinc or copper or whatever.
So, long story short: it’s not a coincidence that we have a secular bull market in commodities at the same time we have a secular range-bound market in stocks. Jim Rogers’s first response to this is that one should invest in commodities, but he also notes that other asset classes (e.g., stocks) in commodity-producing areas ought to do well too. That suggests a couple of ideas for a value investor in stocks: invest in companies in commodity-exporting countries such as Canada or Australia, or invest domestically in the stocks of regional business in areas that are benefiting from the boom in commodities, e.g., Oklahoma (energy) and Iowa (agriculture).
I didn't get a response from Katsenelson to my last comment above, but judging from his recent stock ideas (e.g., the menswear retailer Jos A. Bank), he doesn't share Jim Rogers's ideas for how to invest during this secular bear or range-bound market in stocks that appears to be coinciding with a secular bull market in commodities.
- Invest in commodities directly (his preferred method). Rogers created his own broad-based commodity index which has ETNs linked to it, (e.g., RJI).
- Invest in stocks in regions that are benefiting from the secular bull market in commodities.
- Invest in real estate in regions that are benefiting from the secular bull market in commodities.
There seems to be some overlap between the range-bound market in stocks that you argue started in 2000 and the secular bull market in commodities that Jim Rogers says started in 1999. Do you agree with Rogers that we are in a secular bull market for commodities? If so, is this just a coincidence that it’s happening during a secular range-bound market in stocks, or do the two normally go together? The 1970s was a time of rising commodity prices as well, and that decade was also part of the previous range-bound market in stocks, as you pointed out in Active Value Investing [Vitaliy's recently published book].
To keep this post from getting too long, I'll continue it starting with Katsenelson's response in Part II.
*In his book Hot Commodities, Rogers cautions that during a secular bull market in commodities, different commodities will peak in price at different times. For example, he notes that, although the last secular bull market in commodities didn't end until 1982, the price of sugar peaked in 1974.
Sunday, June 29, 2008
Professional investor and author Vitaliy Katsenelson argues (compellingly, in my opinion), that we are in the midst of a secular (i.e., longer than five years) "range-bound" market in stocks in the U.S., one that began with the end of the 1982-2000 secular bull market and one that will likely last about as long, if history is a guide. During this secular range-bound market, there will be cyclical (i.e., shorter than 5 years) bull and bear markets, but at the end of the secular range-bound market, major indexes will likely be about where they were when it started in 2000 (mainly due to multiple compression, i.e., market average earnings multiples will be significantly lower at the end of the range-bound market than they were at the beginning of it -- see the graphic above) . Katsenelson fleshes out his thesis in the first 31 slides of this PDF presentation (the rest of the PDF is his presentation for an individual stock idea). It's worth taking 10 minutes to page through these 31 slides and see what you think. One point I don't entirely agree with in this presentation is Katsenelson's claim that asset allocation will be of little use if we are in a secular range-bound market for stocks.
The Downside of Excessive Diversification
An observation I've made over the last year is that during a period when most stocks and most sectors are performing poorly, excessive diversification can be a liability. With his own money, Joel Greenblatt is a concentrated value investor: he has written that he feels comfortable keeping 80% of his assets in 5-8 well-researched, high-quality companies. For his Magic Formula methodology though, he recommended that non-expert investors diversify more broadly, buying a total of 20-30 stocks over a period of several months. A problem with this, from my experience, has been that there haven't always been 20-30 stocks worth buying on the Magic Formula list. Many of the "good" (high ROIC) stocks recently haven't been "cheap" (high earnings yield), as investors have flocked to the relative handful of winners, and many of the "cheap" (high earnings yield) have been cheap for a reason: in some cases they had no consistent earnings but ended up on the list because one windfall quarter (e.g., from a legal settlement) distorted their trailing twelve month EBIT numbers; in other cases companies were facing negative macro trends that would be reflected in their earnings over the coming year or more, etc.).
An example here is the retail sector. Last year around this time, a number of retailers appeared on the Magic Formula list. If you bought a large basket of them, you would have probably had poor performance since then. But if you had bought Wal-Mart (as Greenblatt himself did), you would have had a 20%+ return on it. I didn't think of this at the time last year, but in hindsight, Wal-Mart was well-positioned to benefit from the weakness of the American consumer over the next year. With economic headwinds* affecting consumers (I consider the resulting weakness of the U.S. consumer a macro trend), it makes sense that many of them would spend less, while spending a higher percentage of their budgets at a lowest-cost retailer such as Wal-Mart.
A few data points I've seen that support the advantage of running a more concentrated portfolio in this sort of market:
- One of the professional investors who bucked the trend and posted solid results last year was Bruce Berkowitz, who manages a concentrated portfolio in his Fairholme Fund. About 50% of the fund's assets were in cash and its two largest positions.
- Another professional investor, Ken Heebner, who manages the CGM Focus Fund, had spectacular returns last year running a relatively concentrated portfolio (although, in Heebner's case, his out-performance was due more to his astute attention to the relevant macro trends).
- One of the only individual investors on the Yahoo! Finance Message Board who claims to have had 70% cumulative returns over the last year. The difference in his application of the strategy? He confined his portfolio to 10 holdings that he chose from the Magic Formula list after doing his own homework.
- Two of the individual investors I have corresponded with on investing websites (one of whom I've mentioned previously here, Daniel Wahl) had good-to-excellent performance over the last year with portfolios of fewer than 10 stocks each.
*These four economic headwinds, specifically: the negative wealth effects due to the real estate bust, high debt levels, lower access to credit, and rising energy prices.
There you have two reasons to bet on a significant increase in federal spending on infrastructure in the U.S. over the next few years:
- We need it.
- It will create jobs (which can help replace the ones lost in residential construction and other industries hit by the real estate and credit busts).
What companies might benefit from this macro trend in U.S. infrastructure spending when it comes? One may be Perini Corp., (PCR), a Magic Formula company I invested in earlier this year (perhaps a little too soon). Here's a link to a description of Perini's infrastructure subsidiary, Perini Civil. Massachusetts-based Perini Corp.'s merger with Tutor-Saliba (announced via this press release in April) will result in a combined company with a presence in infrastructure from coast to coast. From the April press release:
"Perini’s civil construction projects include portions of the Boston Central Artery/Tunnel project ($650 million); New Jersey Light Rail Transit ($142 million) and rehabilitations of the Triborough, Williamsburg and Whitestone bridges in the New York City area ($443 million). In addition, Perini has started work on the Harold Structures mass transit project in Queens, NY ($139 million) and express toll lanes along Route 95 in Maryland ($87 million)."
"Tutor-Saliba’s major ongoing and completed building projects include the Las Vegas Wynn Encore Hotel ($1.3 billion); the San Francisco International Airport reconstruction ($1.1 billion); the UCLA Westwood Hospital ($537 million); Planet Hollywood Towers in Las Vegas ($490 million) and the Los Angeles Police Headquarters building ($234 million)."
Saturday, June 28, 2008
The Magic Formula
For those unfamiliar with the Magic Formula, it's Joel Greenblatt's Buffett- and Graham-inspired mechanical system of buying a basket of "good" and "cheap" stocks. From Graham, Greenblatt got the emphasis on buying a basket of cheap stocks. In the Magic Formula, Greenblatt uses earnings yield, defined as EBIT/Enterprise Value, to measure "cheapness". Greenblatt uses EBIT instead of earnings to account for differences in interest payments and taxes among different companies, and he uses enterprise value instead of price to account for different levels of net cash or net debt. From Buffett, Greenblatt got the emphasis on finding "good" companies, defined as companies with high returns on tangible capital. Greenblatt calls this return on invested capital (ROIC) and defines it as [EBIT/(Net working capital + Net fixed assets)]. Greenblatt set up a website, Magic Formula Investing.com, to make it easy for individual investors to follow this system. The site ranks its universe of thousands of (mostlyAmerican) stocks by earnings yield and by return on invested capital, and lists those stocks that have the best combined scores (i.e., not necessarily the "cheapest" or the "best", but the stocks that represent the best combination of "cheap" and "good" according to the system).
After reading Joel Greenblatt's The Little Book that Beats the Market in late 2006, I began investing the better part of my money according to the methodology in the book in early 2007. During this time, I read a number of books on value investing (e.g., The Essays of Warren Buffett, Benjamin Graham's The Intelligent Investor, etc.) that reinforced some of the principles of Greenblatt's Magic Formula.
I knew enough about the boom in commodities to be sure to include some of the handful of commodity companies that appeared on the list, but also included companies in other sectors. Aside from the commodity companies, all of which did well, and a couple of small cash-rich drug companies that were bought out for modest premiums, virtually every other stock in the portfolio plummeted. Judging from the lamentations on Yahoo! Finance's Magic Formula Investing Message Group, this has been a common experience.
In fairness to Joel Greenblatt, he did warn in his book that his Magic Formula system (like any mechanical system) wouldn't work all the time, and could under-perform the market for a few years in a row. In the book (pp. 71-73), Greenblatt also alluded to the hot-cold-hot roller coaster performance of O'Shaughnessy's screens in the 1990s, and to a period of under-performance experienced by his friend and fellow money manager Richard Pzena (neither O'Shaughnessy nor Pzena is mentioned by name in the book, but their identities are fairly clear from the descriptions). Nevertheless, the jaw-dropping Magic Formula losses last year (in what was, admittedly, an awful year for most broad-based value strategies) contrasted sharply with the back-tested performance of the Magic Formula system in Greenblatt's book. Over a 17-year testing period, the all-cap portfolio (with a minimum market cap of $1 million) only had one down year (the bear market year of 2002), and that year it merely had a single-digit loss.
After analyzing some of my losers, and see what some successful investors did differently, the lessons I took away were the importance of paying attention to the relevant macro trends, and that in a market when most stocks and most sectors are performing poorly, excessive diversification can be a liability.
Another article in Perth Now points to a macro trend worth noting: "Population explosion makes Perth the prime mover". Excerpt:
A NEW study has found Perth is growing at the fastest rate of any city in Australia's 200-year history.
Monash University population expert Bob Birrell said Perth's population would increase by 43 per cent between 2005 and 2021, taking the number of people living in the city from about 1.5 million to more than 2.1 million."It's a massive task for building infrastructure."
Dr Birrell said that would constitute the fastest rate of growth of any Australian city, at any time.
"This is absolutely massive, completely unprecedented,'' Dr Birrell said.
Time to start researching what local companies will benefit from this macro trend (infrastructure companies obviously are the first to come to mind), and then drill down further for potential investment opportunities. I'll post a follow-up after I've done some homework on this.
Friday, June 27, 2008
The current issue of The Atlantic has an excellent article by Jonathan Rauch about the herculean efforts by GM to field its plug in hybrid, The Chevy Volt, by 2010: "Electro-Shock Therapy". According to the article, the estimated sticker price of the Volt will be about $35k. The Chevy Volt will be able to travel 40 miles round trip powered solely by its electric battery (it will also have a small gasoline engine to recharge the battery for longer trips). Since GM estimates that most Americans' commutes are under 40 miles round trip, will the advent of plug-in hybrids such as the Volt in 2010 reduce demand for gasoline (and hence, oil) significantly? Not for a few years at least, as I see it. Although a Chevy Volt may use negligible amounts of gasoline, the cost of owning the car may make it more cost-effective for most Americans to continue to driving their current cars or buy conventional used cars. Even if gas is $5 per gallon in 2010, it may well be more cost effective to buy an older used Honda Civic or Ford Focus for under $10k and pay ~$75 per week to fill it up with gas, than it will be to drop $35k on a new plug-in hybrid (consider, too, that lingering effects of the credit crunch/deleveraging and higher interest rates may make it more difficult and expensive to finance new car purchases in 2010). The cost of new plug-in hybrids will be more prohibitive for drivers in poorer parts of the world.
Eventually, the arithmetic will shift in favor of plug-in hybrids, particularly as they become available for lower prices as used cars. In 2013, for example, it may be more cost effective to buy a used 2010 Chevy Volt than to keep driving a conventional (though still fuel efficient) car. I anticipate this sort of lag time, driven mainly by high switching costs, will delay the wide adoption of plug-in hybrids for at least five years, so I don't see this sort of technology materially reducing demand for oil over the next five years.
Similarly, lag times on the supply side will likely delay large expansions in oil supply for several years. As the FT's Lex column noted at the beginning of the year ( "Peak no Evil"), the world still has plenty of oil. The issue is that a lot of it is expensive and difficult to access. Although there have been huge recent discoveries (e.g., Brazil's Tupi and Carioca fields off the coast of Rio de Janeiro), it can take 5-10 years to bring these new supplies of oil on stream. In the meantime, production at currently producing fields will continue to gradually (and in some cases, steeply) decline.
Because of these lag times involved in reducing demand for oil and increasing its supply, I am confident that -- although there will be cyclical corrections between now and then -- oil prices will be higher 5 years from now than they are today. Oil prices may well be significantly lower (maybe $70-$80 per barrel?) 10 or 15 years from now, as new supplies will have come on stream and new technologies will have led to more efficient use of petroleum products.
One of the 15 stocks that is up today made a new all-time high, BP Prudhoe Bay Royalty Trust (BPT). Shares of this trust had been flirting with the triple-digit mark for the last few months, but finally closed above $100 per share today at $100.77. Despite the 50% total return for this trust over the last year, its stock still looks inexpensive, trading at only about 9x next year's estimated earnings. This is true, incidentally, of two other, radically different oil stocks I own: the integrated mega cap major ExxonMobil (XOM) and the small cap E&P Vaalco Energy (EGY) -- both trade with enterprise values at similarly low multiples to next year's estimated earnings. This demonstrates a point I and others have made recently, that despite the huge run-up in oil prices over the last year, the current high oil prices haven't been priced into many oil stocks yet. Perhaps this is because the biggest oil bulls have been investing in the commodity itself, via ETFs, and perhaps it's because many market participants believe oil will soon revert back to $70 or $80 per barrel.
Depletion is a concern for all American royalty trusts, of course, particularly one such as BPT that derives its royalties from a field as old as Prudhoe Bay. For detailed analysis and predictions on BPT's production and depletion rates, I recommend the occasional posts by "RoundRobinJack" on BPT's Yahoo! Finance message board. Here is a link to his latest Production/Distribution Update. More broadly, this man's posts demonstrate that although most comments on Yahoo! Finance message boards may be uninformed cheer leading, bashing, or just plain spam, occasionally you find an obviously knowledgeable poster whose comments are well worth reading. Just as with investing, sometimes you have to sift through the junk bin before finding something of value.
Of these three oil stocks, I currently have a GTC limit sell order on XOM. As Daniel Wahl has pointed out in correspondence with me, and in a post on his blog, integrated majors such as XOM have a few strikes against them, limiting their ability to benefit from the oil boom:
- Refining components. While the integrated majors may benefit on the exploration and production side of the business, their exposure to refining (where rising crude prices squeeze "crack spreads", i.e., profit margins on refined products) remains a liability.
- Their enormous size. This makes it difficult for new oil and gas discoveries to 'move the needle' in expanding the company's reserves.
- Their need (again, because of their size) to expand exploration and production in more politically unstable parts of the world, where their assets are subject to expropriation (e.g., as was the case with Exxon in Venezuela last year).
I was reminded of this scene recently when reading Daniel Wahl's blog. I first became familiar with Daniel from his posts (as "DanielW") on GuruFocus. Daniel has had some big winners over the last year with options on Potash Corp. of Saskatchewan (POT) and stock in Hemisphere GPS (HEM.TO, or HEM on the TSX). A couple of primary sources of research that Daniel links to on his blog (and, I assume, influenced his decision to invest in these companies) are a precision agriculture forum (where farmers chat about high tech equipment that helps them farm) and the USDA's Economic Research Service. The web is full of sites on investing, of course, and your local Barnes & Noble has plenty of books and magazines on the subject as well. But seemingly mundane sources of real-world information can sometimes be better sources of successful investment ideas, as Daniel's examples show.
I could write a ham-handed sentence here connecting the dots between the two paragraphs above, but I trust the sort of reader who will find this blog interesting will have already connected those dots himself.
Recently, I had two epiphanies I should have had a long time ago:
- As much as I enjoyed a good argument or debate, this wasn't a profitable use of my time.
- Instead of being frustrated by policies I disagreed with, I could find ways to profit from them through investing.
As for the title of this blog, Hackensack is where I live. It's also the name of the river that runs alongside the city. Inspired by the example of The Atlantic, I figured I'd name my blog after this local, smaller body of water.
I plan to write about investing, politics (occasionally -- I am a recovering political junkie), and various other subjects that I find of interest, and -- more importantly -- think others might find of interest. Comments and criticisms will be welcomed and encouraged.