From Joel Greenblatt to Jim Rogers, Part III: The Importance of Macro Trends

The intent of this series of posts is to put my later posts about specific investment ideas in context, by describing the evolution of my thinking on investing over the last year and a half, as I've made mistakes and tried to learn from them. I'm going to break this up into a few posts, just to keep each post from being too long.

The Importance of Paying Attention to the Relevant Macro Trends

Another lesson I picked up over the last year and a half was the importance of paying attention to the relevant macro trends when evaluating potential investments. It's important to remember here that the Magic Formula is a backward-looking screening system: it uses trailing 12-month data to calculate earnings yield and return on invested capital, on the theory that, more often than not, trailing data are predictive of future performance. The impact of relevant macro trends can determine to what extent this will be true. For example, a wallboard company might have had impressive trailing twelve month earnings at the beginning of 2006, due to the residential construction boom that peaked during the previous year, but those trailing earnings wouldn't have been a good guide to its earnings during the construction bust to come. Below is an example of a mistake I made last year by not paying attention to the relevant macro trend.


Anatomy of a Mistake

I originally wrote the following postmortem on the GuruFocus website on April 24th. Since then, the stock is down a little bit more (it closed at $11.78 today), but otherwise nothing has changed materially.

Recently, I've written about the importance of acknowledging and addressing relevant macro-trends when evaluating investment opportunities. This doesn't mean that I think one should only invest in a company when the relevant macro-trends or macro-environment are in its favor; I would consider investing in a company facing negative macro-trends or a negative macro-environment if I thought those negative macro-trends were fully priced-in, or if I thought those negative macro-trends were nearing an end.


One example of an investing mistake I made by not paying attention to the relevant macro-trend was my investment in Barrett Business Services Inc. (BBSI) at $24.28 per share last year in my Magic Formula portfolio. Today BBSI closed at $12.50 per share.


Barrett is a staffing/PEO firm serving small and mid-sized businesses primarily. When I bought the stock last year, Barrett Business Services was fundamentally a solid company: no debt, lots of cash, a no-nonsense CEO who had steadily built the company up over 27 years and owned 25% of the company's stock, etc. That's all still true today, but nevertheless, it was a mistake to buy the company when I did, because I didn't consider the relevant macro-trend.


The relevant macro-trend in Barrett's case was the real estate bust in California. Although Barrett has operations in several regions of the country, and clients in different industries, most of its business comes from California. Because California experienced one of the biggest real estate booms in the country, it also is experiencing one of the biggest real estate busts, and the effects on California's economy have been worse than on the national economy so far (on today's conference call, Barrett's CEO estimated that California's unemployment rate is now about 7.5%). Also, during economic downturns, outsourced/temporary workers are often the first to get laid off, so Barrett was quick to feel the consequences of this (conversely, as Barrett's CEO pointed out on today's call, outsourced/temporary workers are also the first to get hired during an economic upturn).


Ideally, the best time to invest in a company like BBSI would be just as the negative macro-trend was ending, but of course there is no way to time that exactly. That doesn't mean, however, that I can let myself off the hook for buying BBSI when I did. The magnitude of the real estate bust in California was obvious at the time, and I should have connected the dots and realized how this would lead to a deterioration in California's labor market.


On today's conference call, Barrett's CEO discussed how he would be using this economic downturn (as he had used previous downturns) to increase market share and position Barrett to do well during the next economic upturn. I have no reason to doubt that. I would consider investing more in BBSI within the next few months, assuming it's still on the Magic Formula list. It was still a mistake for me to buy BBSI when I did though, at the beginning of the current downturn.

A counter example of a stock I bought last June that was facing a positive macro trend is the oil royalty trust BPT that I posted about here earlier today and last Friday. Not surprisingly, I am up 50%+ on BPT over the same time frame that I am down 50%+ on BBSI.

Another 52-Week High for BPT

On CNBC earlier today, the anchors noted that only 6 NYSE stocks were making new highs today (versus 400+ making new lows). BPT must be one of the six. It's currently trading at $106.05. BPT is still trading at less than 9.5x next year's estimated earnings though.

What's Up Today: BPT, And a Few other Stocks

Despite the Dow moving into cyclical bear market territory today (closing at 11,346.51) and the decline of the S&P 500 and Nasdaq along with it, 15 of the 21 positions in my enterprising portfolio (my main stock portfolio; I am in the process of consolidating this into a more concentrated portfolio) are up today. I'm still down from my purchase price on many of these, especially the ones I bought last year, when I was still rigidly adhering to Joel Greenblatt's Magic Formula investing system (more on that in a later post), but the lack of correlation between this portfolio and the broader market indexes is partly a result of changes in my investment methodology over the last six months. Specifically, I began paying close attention to relevant macro trends for various stocks, and limiting my investments to those positioned to benefit from those trends. Some examples of those macro trends include the secular bull markets in energy, metals, agriculture, and the related infrastructure boom overseas, particularly in China.

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).
  

Despite these factors, I still think XOM is a value at these prices will probably do well over the next year. Nevertheless, I agree that there are investment opportunities in the sector with more potential, and the ideal sort of company to find would be an attractively priced small cap E&P with proven resources in a politically stable country such as the U.S. or Canada.