Jim Rogers, dollar bull

At least in the short-term. Here he is on CNBC (which I haven't watched since we got Bloomberg TV). Hat tip: @TheStreet_LA.

The FT Editors Echo Jim Rogers on India

Jim Rogers has mentioned his doubts about India as a destination for investment on various occasions (for example, in this unfortunately undated article on his website). Friday's Financial Times included a bearish editorial on India, prompted by the accounting scandal at outsourcer Satyam Computer Services ("Satyam Scandalises"). Below are a couple of excerpts from the editorial.

India is rarely as shiny as its fans insist. The $1bn fraud perpetrated by Satyam Computer Services will not only throw the $40bn software and outsourcing industry into a tailspin, it will also raise disturbing questions about the risks of doing business in India - and even the sustainability of the country's much-vaunted growth miracle.

Only a few months ago, India saw itself as relatively immune from the global credit crisis. Some officials patted themselves on the back for going slow on liberalising capital markets, crediting their prudence as yet further evidence of the country's inexorable rise. But India now has a credit crunch of its own. Exporters are hurting and threatening to lay off 10m workers. Terror attacks on Mumbai have cast into doubt the competence of the security apparatus and shaken business and consumer confidence.

[...]

In spite of its poverty, it has sold itself as a country to which Fortune 500 companies can entrust sensitive data, banks their back offices and even patients the production of medicines. Its extraordinary success in IT over the past decade was based on the trust and credibility it established with globalised companies; the Satyam scandal has now put that at risk.

Outsourcing companies, furthermore, are keen to move up the value chain; to outsource some of their own functions and even to start acquiring the western companies whose businesses they help run. These ambitions are laudable. But like India itself, whose economic success story is built on extremely rickety social and infrastructural foundations, such grand designs can also smack of hubris.

Will the Credit Crisis lead to a Food Crisis?

In a recent post ("Jim Rogers on CNBC Europe Early This Morning") we mentioned that Rogers continues to be bullish on agricultural commodities. Another investor who remains bullish on agriculture is Aaron Edelheit. Today on his blog, Aaron Edelheit writes that low global inventories, continuing demand growth from China, and the credit crisis together are setting the table for food shortages next year ("Looming Food Catastrophe in 2009"). Regarding Chinese demand, Edelheit quotes an article by Jim Lane, editor of Biofuels Digest¹ ("It's not food, it's not fuel, it's China: Expanded study of impact of China on global corn market") that argues that demand for corn has been driven primarily by the growing consumption of meat in China (since corn is used to feed livestock):

“Even with all the growth, Chinese meat consumption is still 45 percent less than the average consumption in the US,” Lane warned. “An additional 277 million tonnes of grain would be needed to support China at parity with the US. That would take 68 million acres to grow. There isn’t that kind of arable land available anywhere is the world, whether we grow grains for renewable energy or not.”

Regarding the impact of the credit crisis, Edelheit writes,

The credit crisis is hammering South American farmers, to the extent that they cannot get fertilizer². No fertilizer, no planting of crops.

Further, suppliers are asking farmers in the U.S. for more upfront money to make sure they aren’t holding delinquent debts, causing farming to be a bit more uncertain this year.

Edelheit bases this on an article by Carlos Caminada, Shruti Singh and Jeff Wilson on Bloomberg yesterday ("Farm-Credit Squeeze May Cut Crops, Spur Food Crisis").³ This raises two questions related to one of Edelheit's holdings, Hemisphere GPS (TSX: HEM.TO): if farmers can't get credit to buy fertilizer, can they get credit to buy Hemisphere's precision agriculture equipment? Do they need credit to buy Hemisphere's equipment? Edelheit doesn't say, as he doesn't discuss his stock positions on his blog.


¹I find this sort of primary research -- the kind often done by industry-specific analysts, but occasionally done by money managers such as Edelheit -- impressive. Partly as a result of doing this sort of research, occasional commenter Daniel Wahl (his blog) invested early in some winners in the agricultural space, as I noted in a post last June ("Stress Fractures in Titanium"). Daniel has taken his blog in something of a new direction recently, as he prepares to launch a new blog, and he no longer writes about his trades, but he did note in a recent comment thread on his blog that he is still holds Hemisphere GPS, and calls on the fertilizer company Potash Corp. of Saskatchewan (NYSE: POT).

²This may have been a factor in the recent correction in the prices of fertilizer company stocks.

³Jim Rogers similarly linked the credit crisis and commodities in his CNBC Europe interview last week, noting the difficulty anyone would have in borrowing money to dig a mine today.

"Risk Management and Hooke's Law"

Last week's Investor's Business Daily listed the Hussman Strategic Growth Fund as the best performing growth fund so far this year (with a year-to-date performance of -5%, if memory serves). Dr. Hussman was perhaps too modest to mention that in his weekly commentary, which is (as usual) worth reading, "Risk Management and Hooke's Law". In the excerpt below Hussman refers to Hooke's Law,

There's a general relationship in physics called Hooke's Law, which applies to springs: “as the extension, so the force.” My impression is that the stock market behaves much the same way. When investors are very skittish, the market may behave like a very loose rubber band, generating little tension even as it moves significantly away from fair value. But as risk aversion abates, the tension becomes much more like a stiff spring, and the potential to return forcefully toward normal valuations becomes enormous, particularly when the distance from fair value is large.

[Geek's Note: Adding up the cumulative tension described by Hooke's Law gives you a measure of the “potential energy” stored in the spring, which is proportional not to the distance the spring is pulled, but to the square of that distance. This observation has a nice analogy to finance, in terms of how investors should scale into a falling market. Taking the basic dividend discount model as an example, if the growth rate is 6% and the initial yield is 3%, it takes a 25% drop to increase long-term returns from 9% to 10%. From there it takes another 20% drop (40% cumulative) to increase long-term returns to 11%. From there, it takes a drop of 16.7% (50% cumulative) to increase long-term returns to 12%.]

For those who may not remember, Hooke's Law was named after the the physicist Robert Hooke, who was a contemporary of Isaac Newton. Hussman's mention of Hooke reminds me of a comment a friend of mine made years ago, when we were both students in a philosophy class on Baruch Spinoza. The class was mainly about Spinoza, but also covered the work of other rationalists of the same period, such as Gottfried Leibniz. Newton came up at one point during the class, because of a dispute Leibniz had with the Newtonians (Newton wouldn't correspond with Leibniz directly). My friend mentioned that Newton's famous quote, "If I have seen farther than others it is because I have stood on the shoulders of giants" was actually meant as a dig at Robert Hooke, who happened to be a hunchback. I don't know if that's true, but Hooke and Newton did have a bitter rivalry¹.

Back to Hussman's commentary, the paragraph below is consistent with comments made by Jim Rogers on CNBC Europe last week, as we noted in a recent post ("Jim Rogers on CNBC Early This Morning"),

Given the enormous expansion of government liabilities we are observing worldwide, it is unlikely that we will observe a long-term absence of inflation once the recent drop in monetary velocity abates. “Monetary velocity” declines when investors hoard government liabilities as safe havens – this suppresses inflation pressures by supporting the value of government liabilities, including currency. But velocity can also shoot higher once credit fears subside. So one of the casualties of easing credit fears is likely to be weakness in the U.S. dollar, and a concurrent strengthening in commodities – particularly precious metals, which serve as a currency substitute. Given the pricing of precious metals shares here, it would not be unexpected to see the XAU roughly double within the next 12 months from these levels.

¹Update: My friend offered me the following elaboration via e-mail,

Here are a couple of links, 'verifying' the claim. 'Course with the Internet, you never know...

http://everything2.com/index.pl?node_id=787876
http://boleo.wordpress.com/2008/02/11/standing-on-the-shoulders-of-giants/ (this is a long one, but traces the origins of the saying before Newton)

...but, I didn't doubt its veracity, because I heard it from a very reliable source: Dr. Jerry Lettvin, he of 'What the Frog's Eyes Tells the Frog's Brain' fame (a seminal paper that eventually led to the development of modern-day cognitive science studies).

He taught an honors seminar at Rutgers on Leibniz, which a friend of mine was taking at the time. We had tea at Jerry's house in Highland Park once. He is a fascinating character, to say the least:

http://en.wikipedia.org/wiki/Jerome_Lettvin

This'll round out your post-

Jim Rogers on CNBC Europe Early This Morning

No kind words from Rogers about the officials who have been handling the financial crisis in the U.S. and elsewhere. To add insult to injury, he mangles NY Federal Reserve Bank president Timothy Geithner's name in the process. Rogers says he's still long commodities (particularly agriculture) and short U.S. Treasury bonds, since he expects higher inflation (and higher interest rates) when the economy recovers.

Technical issues prevent me from embedding the video, but here's a link to it: Jim Rogers on CNBC Europe, 10.22.08

Edelheit Echoes Jim Rogers

Aaron Edelheit makes two predictions in a recent post ("Looking Out") on his blog; the second one echoes Jim Rogers:

I see two major sea changes coming due to the current financial crisis.

1) When things normalize in credit land (and it has already started normalizing, albeit very slowly), there is going to be a slew of M&A activity.

2) The next commodity bull run will be mind numbingly explosive.

[...]

The second point is based upon the printing of money and debasing of currencies from every major government in the world, combined with the fact that we are still in relatively short supply for most commodities once the world starts to grow again, I think the next run in commodities will be enormous.

[...]

The 1970s show us what can happen. Oil went from $1 to $4. Then pulled back to $2, before going to $20. Could $750 oil be in our future by 2015? I think its more likely than $20 oil.

$750 oil in 2015 seems unrealistically high to me -- I haven't heard anyone quote an estimate that high -- but I agree that oil will probably go significantly higher in the next several years. Of course, given the inherent operational leverage in commodity-producing companies, even a much more modest increase in oil prices would lead to large increases in profits. For a simplified example, consider an oil E&P with cost of production of, say, $40 per barrel (this is a lot higher than the cost of production of the E&P I own, Vaalco Energy, but it makes the arithmetic simpler). If oil prices go from $80 to $120, that would be a 50% increase in the price of oil, but that would represent a 100% increase in the (pre-tax) earnings of the E&P (assuming its cost of production and production rates held steady), since its profits per barrel would have doubled from $40 to $80.

From Joel Greenblatt to Jim Rogers, Part IV: Conclusion

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. This is the last in the series.

Trying to Find Good Companies When they are Cheap and Poised to Benefit from Macro Trends

Joel Greenblatt's method of screening for good (as defined by ROIC) stocks that are currently cheap (as defined by EBIT/EV) makes intuitive sense. The idea of buying stocks that are poised to continue benefiting (or, even better, start benefiting) from macro trends makes intuitive sense as well (at least it does to me). What I have tried to do so far this year is buy only the Magic Formula stocks that I think have the potential to benefit from macro trends. This has been a challenge, because these sorts of stocks have been relatively scarce on the Magic Formula list.

Why This Sort of Stock has been Hard to Find on the Magic Formula List

Part of the reason for this is that good companies that are benefiting from macro trends often don't stay cheap long. One such example is Graham Corporation (GHM), a small cap company based in Batavia, NY that manufactures vacuum and heat transfer equipment. That may not sound too exciting, but this sentence from Yahoo! Finance's description of Graham's business will give you an idea of the macro trend tail winds behind the company (emphasis mine):

Graham Corporation's products are used in a range of industrial process applications comprising petroleum refineries, chemical and petrochemical plants, fertilizer plants, pharmaceutical plants, plastics plants, liquefied natural gas production facilities, soap manufacturing plants, air conditioning systems, food processing plants, and other process industries, as well as power generation facilities, including fossil fuel, nuclear, cogeneration, and geothermal power plants.

I had my eye on Graham in March, when it was trading in the mid-$30s, and planned to buy it the following month, when I was scheduled to make my Magic Formula trades. Before I was ready to buy it, Graham announced blowout earnings and the stock shot up 20 points, taking it off the Magic Formula list. It's up another 20 points since. Since then, I haven't seen any company on the Magic Formula list positioned to benefit from as many macro trends as Graham Corp.

Another reason it has been relatively hard to find stocks poised to benefit from macro trends on the Magic Formula list is that the list excludes most foreign stocks and ADRs¹. The reason for this is simply that Greenblatt didn't have the data to back-test his system with non-North American stocks; he has said that he still believes that the strategy of buying good stocks cheaply should work in other markets as well.

Combining Joel Greenblatt's Value Methodology with Jim Rogers's Insight that we are in a Secular Bull Market in Commodities

The secular bull market in commodities that Jim Rogers describes (see my earlier post Jim Rogers versus Vitaliy Katsenelson, Part I) is the mother of all macro trends. Since Rogers has written that non-commodity producing companies operating in regions benefiting from the secular bull market in commodities may profit indirectly from it², one way to find more Magic Formula-type stocks benefiting from macro trends may be to apply the Magic Formula screens to stocks in countries benefiting from the secular bull market in commodities. I suspect that a basket of high earnings yield, high return on invested capital stocks in a country such as Australia will outperform a similar basket of American stocks over the next several years. I haven't found (yet) a website that I can use to screen for Magic Formula-type stocks in other countries, but I did recently buy stock in a foreign company after (incorrectly, as it turned out) crunching the Magic Formula metrics on it myself. That company was Alloy Steel International (AYSI.OB), and since I've already threatened to write a post about it, you can expect that post soon.

Although I continue to look for stock ideas on the Magic Formula Investing website, I no longer limit myself to it, and am more concerned with finding stocks that appear to be undervalued based on their future prospects and positioned to benefit from relevant macro trends.

¹In practice, the Magic Formula list has been a little inconsistent with respect to foreign companies. Although it doesn't list any ADRs, it does occasionally list foreign companies that are listed directly on the Nasdaq, e.g., ELOS (Israel), and CAST (China).

²E.g., if an iron mine is operating full tilt and paying a lot of overtime, the miners may have more cash to spend at local restaurants, retailers, etc.

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.

From Joel Greenblatt to Jim Rogers, Part I: The Magic Formula

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 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.