Follow-up on Hedging

Follow-up on Hedging

On April 9^th I posted a piece on how I was hedging my investment portfolio to manage my risk in the market place. I had bought an ETF on the NYSE (RWM) that shorts the Russell 2000 about two weeks before I wrote that post.

I am now down just over 11 percent on that investment. In hindsight I regret making that move as it has cost me money in the in term.  However at the time I didn’t have the benefit of hindsight. I was facing an unknowable future and felt that risk was elevated in the marketplace. Looking back I now feel I put it on a little early.

So what do I do now? My feeling is that the underlying market is continuing to weaken under the surface of the market indexes. Market tops are like that. They can continue to go up, caught up in their own momentum and mathematics.The underlying breadth of the market (momentum of breadth) is weakening even as the major indexes continue their upward move. There is also some market rotation going on as the big money shifts its positions around. I'm going to hold on to my short for now and re-evaluate later on down the road. 

This is typical of the type of decisions an investor will have to make. Faced with the uncertainty of an unknowable future he will have to make a determination as of what to do based on the present market environment. If his decision doesn't work out, he shouldn't beat himself up over it. Its just part of the game of investing and dealing with a future where anything can happen. Right now my 'short' is still a 'work in progress'. As I feel the market continues to weaken I will hold on to my short and wait. Learning how to wait is a big part of investing.

The Risks of not being in the Market

The Risks of not being in the Market

People talk about the risk of being in the market but the risk of not being in the market escapes them. What I'm talking about is the time value of money which simply means that inflation will decrease the purchasing power of your cash over time. In other words a dollar in the future will buy less than a dollar would today. Even in a low inflation environment the longer time is allowed to erode away the purchasing power of your cash the farther back you find yourself.  Time is the leverage that inflation uses to rob you of your money's purchasing power.

When you make an investment be it in a stock, a bond, a house, a bank account its commonplace to compare your rate of return to the current risk free rate which is generally thought to be the yield on the government's ten year bond. At this moment the U.S. ten year bond yields 2.33 % while Canada's ten year bond yields a rate of 1.52. Historically speaking these rates are very low. The supposedly 'safety-first' investor putting his money in a one year GIC will be getting paid peanuts in return and find the purchasing power of his cash eroding away over time. 

Buffet has often said he likes to invest in 'productive assets' which brings us back to our definition of return on invested capital (ROIC)..." It is the ability of a company to create value. Value is created when a company's  return on capital is greater than the cost of that capital. Over time the additional return on capital can be re-invested in the business to help accelerate it's growth as an ongoing concern"

With current yields so low it just makes sense to invest in the stock market's 'productive assets" and protect yourself against the ravages of inflation. How to go about investing in the stock market is what this blog is all about. I wish someone would have taught me this simple but important concept back when I was in public school, it could have changed my life.

The Price you Pay

The Price you Pay

Look for safety in the price you pay

Marty Whitman


We've talked a lot about concentrating on the underlying value of a stock as opposed to its selling price. When the markets tank people are concerned about selling off their assets and fleeing for cover. Having said that, the price you pay for an asset is important. Why? Because it ties in closely with having a "Margin of Safety". https://nivag18.blogspot.ca/2016/04/normal-0-false-false-false_8.html

If you pay a low price for an asset you will be better equipped to shield yourself from the emotions of the market when it goes haywire and sells off. Because your original cost base is low you will be mentally and emotionally more secure with the asset you hold even if it goes down in price. This is an important psychological point. You can be a master at analyzing a company's fundamentals. A whiz at technical analysis and reading the charts of the companies you hold, but if you are not psychologically squared away, none of it will matter.

It pays to be a patient, disciplined  investor, waiting to get the price you want for an asset. Think of a cat waiting in the bush for just the right moment to ponce on its prey. Now think of a dog who sees a squirrel. The dog will run blindly ahead with no hope of catching the squirrel. When it comes to investing in the stock market, act like a cat, not a dog.

Now nothing in life is straight forward and that applies to the stock market as well. If there is an exception to the above rule it might be the company that has great metrics and allocates their capital so efficiently that it never sells off much even when the market goes down. These companies (often referred to as quality growth companies) are rare but if the business is attractive enough you might want to pay up for it. This is especially true with companies whose management allocates their capital effectively. It takes good judgement to transverse these waters. Good judgement comes from experience which comes from bad judgement. So for most investors it will be a work in progress.


Good investing will always be more of an art form than a science no matter what the quants might say.





 

The Madness of Crowds

The Madness of Crowds

When you are as old as I am and you’ve been through as many booms and panics as I have, you’ll know that to lose your position is something nobody can afford; not even John D. Rockefeller.

Elmer Harwood

Okay, you've done your trend analysis on the essential metrics of a company. You've read and studied their business model and their competitive position within the industry in which they operate. You have studied the results of the way management allocates its excess capital.  You have patiently waited to buy the stock of this company when the marketplace put it up on sale. You have repeated this process over time and have bought several other stocks to build up an attractive, diversified investment portfolio filled with productive assets bought at reasonable prices. You've done everything right and feel good because although not all of your holdings have worked out, on the whole your investment portfolio has performed well and you are making good money. 

Then, it happens, the stock market breaks and heads sharply lower. You know this happens every once in awhile and your confident that although your portfolio is taking a hit you have you the good sense and experience to hold onto your positions. The market rallies but begins to flag once more. It sells off again but its sharper this time and people begin to break and head for the exits. You don't like it but you've seen this before and hang onto your holdings. Then the market caves in bringing out the forced sellers who have to liquidate their assets to meet margin calls. Everyone heads out the door at the same time and panic reins in the streets of the stock market. You see the money you've invested in your stocks disappear fast. Another flagging rally and the market heads lower again. You're down maybe 20 or 25 percent from the top. What do you do? You tell me you hang on of course. But this is just a theoretical exercise. You are comfortably sitting at home reading this. What if it really happens and there is blood in the streets.

There are powerful psychological and biological forces that govern human behavior. This is accentuated in large crowds of people where their innate animal impulses are multiplied and feed off of one another. Remember if we create our own reality, http://nivag18.blogspot.ca/2017/03/

then a crowd will do the same if only because it will have the energy of everybody in that crowd fueling it. The careful, deliberate, civilized individual gives way to the animal cravings of the beast that lives in the heart of every crowd.

When the stock market plunges, the need for relief from anxiety creates such a strong pull that everyone will be driven to liquidate their holdings at the same time, so they can survive, like the drowning man who will reach out to grab anything to save himself.

It's important to bear these things in mind before they happen and to set up some sort of safety mechanism to save yourself from yourself when there is blood in the streets. One way to do it is as follows...http://nivag18.blogspot.ca/2017/04/normal-0-false-false-false_98.html

Invest in What’s in Front of you: Important Metrics

Invest in What’s in Front of you: Important Metrics

As a follow up to my previous post I want to say that I try to invest in what’s in front of me. When I wrote about “the marginal utility of information” awhile ago I listed seven things I look at when I’m investigating a company. Four of the items were financial metrics (revenue, free cash flow, return on invested capital and operating margin) while the other three were about placing those numbers in the specific context of the companies business model, the industry structure the company operates in as well as the capital allocation ability of its management. All of this information is available in the companies annual report. The Morningstar website is a good source of this information as well, especially for the financial numbers of a company.

Let's break down the financial metrics one at a time. One thing I should mention. You should always look at the numbers over a period of years. This is referred to as trend analysis. You want the numbers to steadily increase over time and if they don't you want to read about the companies operating history to find out why? You may even have to refer to previous annual reports...sorry.

Revenue represents the cash and promises to pay from customers for either services provided or goods delivered over the past year or quarter. It indicates how much business the company is actually doing. You want to see revenues grow over time as this is the engine for the company to grow and prosper as an ongoing business.

Free cash flow is what is left over after the company has paid all it's bill and expenses. They can raise the dividend, pay down debt, make acquisitions, buy back shares, invest in research and development and/or hire new and skilled employees. It is the ability of a company to self-fund making them less reliant on debt and raising additional equity. It makes them more self reliant. If the corporation's ongoing operations are consuming more cash  than they produce it makes them more vulnerable to their creditors and places them at a competitive disadvantage to other companies in their industry.

Return on invested capital is the return a corporation makes on every dollar of capital invested in the business (both equity and debt). Good companies will have ROICs in the mid teens. It is the ability of a company to create value. Value is created when a company's  return on capital is greater than the cost of that capital. Over time the additional return on capital can be re-invested in the business to help accelerate it's growth as an ongoing concern. It ties in closely with management's ability to allocate capital efficiently.

Operating Margin reflects how well a company can control its costs. the higher the margins, the better the cost containment and the higher the profits will be. It indicates how well a company is running its entire business from an operational standpoint.

Taken together theses metrics will indicate which companies are operating more efficiently for the benefit of their shareholders. The CFOs of these corporations will have the financial flexibility to build the company over time by increasing dividends, investing in R&D (constant innovation helps keep them ahead of their rivals) and make strategic mergers and acquisitions (helping the company to grow its market share and pricing power).

As everybody has access to these numbers you will often find the stocks of these companies priced to perfection. Sometimes its worth investing in them anyway but it often makes more sense to wait for a decline in the entire market. The forced selling that occurs during that time can put these stocks temporarily on sale for the value investor to take advantage of. Another investing opportunity can occur  when a good company misses it quarterly numbers causing its stock price to be punished and driven down. A small cap company can sometimes have these good metrics and be overlooked just because of it's size offering the investor another chance to buy an under valued asset.

In my next post I will finish up with the three remaining items that place the financial metrics of a company within the context of a companies business model etc.....whew.

There is no future in making Predictions

There is no future in making Predictions

Or following the predictions of others, I may add. Like the kid in the candy store who just wants to grab, the average investor wants to know what is going to happen in the unknowable future and the financial media knows it. So in their own self-interest of increasing their audience (advertising dollars) they feed this demand with a never ending supply of predictions. Short term, medium term and long term, it doesn’t matter as long as it’s a forecast.

The predictions are never followed up on, because there are too many future forecasts waiting in the wings. Of course they are almost always wrong but it doesn’t matter. So insatiable is the public’s appetite for these prognostications they don’t care about the result, they only want more of them. It’s really a fascinating  social phenomenon. Sure some forecasts turn out to be accurate but its just randomness. Like the economist who predicted 7 out of the last 3 recessions.

Then there are the predictions an individual makes for himself. Welcome to the land of 'confirmation bias'. The investor will only read or agree with opinions that are in unison with his own ignoring anything that counters his point of view. This is largely because of the investor's ego which wants to be proven right so it can thumb its nose to the rest of the world. Beware the ego, the market will  feed on its foibles and will eventually crush it. Be humble and dispassionate if you can and make no predictions about anything because part of your ego will always be attached to it.

Well wait a minute I hear you say. What about investing in a growth stock? Don't some investors run a 'Discounted cash flow' analysis to get a handle on the future cash flows of a company? I've never done this but from what I've read there are so many variables that go into the process that it ends up being like the Hubble telescope, you turn it a fraction of an inch and you're in a different galaxy.

Many investors are numbers orientated and approach investing from a left brain point of view (deductive). They are prone to believe in the precision of their numbers and make forecasts thereof. I approach investing more from the right side of my brain (inductive). I'm not a numbers guy but you can't invest without using them. I'm just saying I look at numbers to put me in the ballpark, not into my seat.

Marginal Utility of Information

Marginal Utility of Information

Informational Utility is the benefit an investor derives from uncovering information about a stock. This information largely comes from reading the annual report of a company. The information can be broken down in two ways, numerical (financial metrics) and narrative (the story of the stock).

Marginal utility is a lessening of the value of additional information. I would go further and suggest that too much information can be counter productive and actually harmful to your investment results, but it largely depends on your mindset and the way you approach a stock as an investment.

Peter Lynch once opined, “Never invest in any idea you can’t illustrate with a crayon.”, While Warren Buffet and Charley Munger have said that the riskiest thing you can do in the stock market is invest in something you don’t know a lot about. If you hold very few stocks in your portfolio (less than say eight) you might want to follow the Buffet/Munger model. If you hold more than say 10 stocks I would go with Peter Lynch’s advice.

I have about 17 stocks in my portfolio, over time I would like to reduce that number but my point is if you have a lot of stocks in your investment portfolio, you will probably suffer from the marginal utility of information and not be able to see the forest for the trees.

Bearing that in mind lets say you only want to focus in on the absolute essential investing information. Considering that mindset I propose the following parameters on how to approach the available information about a company’s stock. This approach will lend itself to investing in the mid to large cap area of the market.

Financial Metrics…
Revenue Growth…Free Cash Flow…Return on Invested Capital…Operating Margin.

The Story of the Stock…
Business Model…Industry Structure…Capital Allocation ability of Management.

I will expand on these pieces of information in future posts. Hey, maybe I should have written all this out with a crayon.

Dear Investment Portfolio

Dear Investment Portfolio

Dear Investment Portfolio, we’ve been together awhile now, almost 10 years. A lot of stocks have come and gone during that time leaving their inevitable impressions. Some I should have never sold while others should not have been bought in the first place. But that is how you and the market have taught me. I had to go through those hard lessons in order to grow and develop into the investor I am today. That’s not say I have reached the summit of market knowledge. I’m sure there they will be further lessons to absorb in the future. The investing experience is really a work in progress.

I have seen you bob up and down on the surface of the market as I recorded your weekly values over time. And with those ups and downs I have learned how to compose myself during the storms that can come and go in the marketplace.

You have taught me that you are really just an extension of myself…no its more than that, you are a projection of what is going on inside of me and a way of keeping score so that I can keep track of what I have learned so far.

You are unique because there is no one else quite like you out there. Maybe more than anything else you have taught me the value of extending my time frames and spreading my risk.

You are something I have created, and over time I have seen you develop a faith in myself and the universe that in the long run everything will be okay.

Hedging

Hedging

Hedging is an attempt to protect your investment positions by making a counterbalancing investment within your portfolio. Why do I mention that at this time?

One of the jobs of an investor is to evaluate the current state of the market environment. Most of the time there is nothing to be concerned about. But every once in awhile the risk of a market sell-off becomes elevated and an investor would be wise to hedge his positions if for no other reason but to protect himself from himself psychologically. A violent market selloff can be a scary thing and will tempt the individual investor to run with the herd and head for the exits. Hedging your investments ahead of time is a way to protect yourself against this before it happens.

I keep track of the momentum of the breadth of the NYSE market (advancing  - declining volume) on a daily basis and smooth this data with various moving averages. I then subtract the longer moving average from the shorter one and this produces a trend deviation indicator (a form of market momentum). I use this to help me gauge the internal trend of the market. Both the direction and level of this indicator are of equal importance.

At this moment in time (April 9 2017) the underlying market is seriously deteriorating (money is flowing out of the market). It’s been going on for awhile. I feel a sell-off is eminent. Two weeks ago I bought an ETF that shorts the Russel 2000 index (it trades on the NYSE). It is a non-levered ETF that re-balances once a year so it is safe to use. Its symbol is RWM. I bought it a couple of weeks ago and have added to it since.

This is a way of managing my risk when I feel that the risk in the marketplace has become too elevated. It has nothing to do with predicting the future and is not a forecast.

Shareholder Base

Shareholder Base

We are often looking for broken growth stories, when a once-great company is no longer considered to be great. The market tends to overreact in these cases, as growth and momentum investors move on to the next thing and the shareholder base turns. Since I wasn’t in the stock before, I’m not disappointed if something is no longer a high-flier. All I care about is the future potential relative to what I have to pay for it

Alan Schram, WellCap Partners

Most of the time we’re picking up the pieces after a high-growth company hits the wall at 80 miles per hour, having made at least one too many investments to try to sustain an unsustainable growth rate. Public markets can actually conspire to screw companies up. When you’re growing fast, you get this big p/e and pretty soon you have all the wrong investors with ridiculous expectations and do things contrary to shareholder value.

Jeffrey Ubben, ValueAct Capital

Shareholder base…now there is a subject not too many investors think about. It’s probably more important to the holders of smaller growth orientated firms but its something every investor should be more aware of.

Over the last 35 years or so, the marketplace has become largely institutionalized. The retail investor is in the small minority (a minority I’m proud to be a member of). Institutions (pensions and mutual funds) have an established law or belief system that makes them a power onto them selves. They often say one thing (we are here to serve you) but have hidden agendas (we are here to serve ourselves). Behavior which would be looked down upon in an individual is accepted practice in the world of institutions. These same institutions have brainwashed the investing public into believing the myth that handling their own financial affairs is too complicated and risky. So over time they have come to dominate the investing landscape.

These institutions are in the business of growing assets under management. In order to achieve this they continually try to attract new money by trying to out perform the market on a quarterly basis. This puts an emphasis on short term performance. If the quarterly numbers are not met fund managers could lose their jobs. They have bills to pay and kids to put through university just like everybody else so there is a tendency to do the safe thing. To buy stocks when the market is going up and sell them when the market is going down. “We can all go down together, but I can’t let them go up without me”. Needless to say this does not help their long term performance as it guarantees mediocrity. Another problem is if their funds under management get too big they basically become the market (shadow indexers). Another problem with expanding size is the growth of investment committees where everything needs to be vetted out resulting in further mediocrity. Good long term investing is a solitary game.

The implications of all of this, is that it spills over to the equities they hold in their funds. If a CEO’s company fails to meet his quarterly numbers these institutions dump the stock and move on to the next hot thing. The price of the stock becomes the thing, not the intrinsic value of it.  The result of all of this is a market dominated by short term performance with many CEO’s striving to meet their quarterly numbers at the expense of long term value creation (cutting R&D and advertising budgets). The strong CEO’s who put an emphasis on the long term fundamentals of their companies often see their stock punished and driven down by the lemming like behaviour of these institutions. The media has bought into this game as well as they too put an emphasis on the short term results of the marketplace.

Keep all of this in mind the next time you see a stock you hold beaten down for missing their numbers. 

Now that I have that off my chest lets talk about the minority, the long term value investors. The funds they run have low portfolio turnover as they hold their positions for a long time (years instead of months). They perform due diligence of a company by studying the business Model, the industry structure the company is in and the capital allocation ability of the management. They are concerned with the intrinsic value of a company (the present value of all the cash it will generate in the future). If you are looking for investment ideas these are the people to keep track of and they are the type of shareholders you want holding the same stocks you hold yourself.

Don't let the financial industry or the press take your power away from you. Investing for yourself can be an empowering experience.

 

Price versus Value

Price versus Value

The following is an excerpt from one of Bruce Flatt’s letters to the shareholders. Bruce Flatt is the CEO of Brookfield Asset Management. In it he explains how his team at Brookfield handle the investor problem of weighing the price of an asset against its intrinsic value. By the way in stead of reading and being manipulated by the mainstream media, a good idea is to read what the CEO’s of good companies actually have to say about the businesses they run. You will find the reading far more valuable and insightful.

‘Value investing is, in essence, the arbitrage between “Price” and “Value.” The goal of a value investor is to arbitrage price differentials between the Price put on assets, whether that be in the public or private market, and the Value of those assets. Unlike classic arbitrage, however, value investing is not risk free, and profits are not instantaneous or certain. And while simple to understand, it takes years to develop the discipline, patience and judgment required to successfully implement a value investing strategy.

We are great believers that over the longer term, the Price of a security will equal its Value. However, in the short term, for many reasons, Price often does not equal Value. Investors in the stock market, of course, have a daily mechanism to determine the Price of assets which are quoted. For private investments, the Price is not quoted daily, but is influenced heavily by the supply and demand of capital.

Price is more difficult to ascertain in the private markets – particularly during periods of market volatility, and it can be higher or lower than long-term values. This is usually dependent on the supply and demand of capital, which is in turn influenced by investor attitudes. In robust markets, there is generally more capital than there are assets. This forces the Price higher, even to the point where it exceeds Value. In stressed markets, if a sale is necessary, the Price can be much lower than Value. The 20% post-Brexit mark-downs offered to retail investors in UK property funds for liquidity is an example of this.

Inversely, we are often asked how it is that we are able sell assets above our IFRS values. The answer usually lies in the fact that we only try to sell assets in robust capital environments, catching the window where Price is greater than our view of Value.

In summary, Price is merely a function of the supply and demand characteristics for capital that is looking to be invested in a sector of the market, or in a specific asset or stock. Price is often influenced by topical news of the day, market sentiment, availability of capital, and other factors that may or may not have any relevance to the Value of a specific security.

Value, on the other hand, is the net present value of the future cash flows of a business or asset, based on assumptions for future growth and discounted at the appropriate risk rate for that particular investment strategy. The difficulty in ascertaining Value is that there is no absolute value for anything, so there will always be a wide range of views over an asset’s growth profile and the appropriate discount rate. The experience and discipline we have in determining these factors for real assets is one of the key attributes of our franchise’

Resource Conversion

Resource Conversion

          One exercise we go through on all our most interesting ideas is what we call balance-sheet optimization. It’s our term for debt recap. What can management do, fully under its control, with the capital structure to create value? Use Microsoft as an example. It has $60 billion of cash on hand, very little debt and throws off something like $30 billion in free cash flow per year. The equity has been trading at 8 to 10 times earnings and the company can issue debt at less than 3.5%, so there’s a huge difference between the cost of debt and the cost of equity. As an exercise, what would happen if it went to a net $60 billion debt position? Given the free cash flow, that’s still a modest capital structure. They take the $120 billion in cash proceeds and buy back a significant amount of their equity. With a lowered cost of capital and shares outstanding cut in half, if we run that through our cash-flow model – assuming no growth – we come up with a share value in the low to mid $40s, versus around $28 today.

          We look at this as our downside protection and also as a way to distinguish our analysis. It’s difficult to out-predict the Street consistently on Microsoft’s growth over the next five years, but very few analysts focus on value creation through the capital structure, so it can provide us with a different perspective on how to value the stock.

         

          Stephen Goddard, The London Company

Welcome to the world of corporate events. I was introduced to this world by reading Marty Whitman, the founder of Third Avenue Management. He wrote that there are more ways to create shareholder value other than focusing on the operational side of a company. In other words everything you have read so far in this blog pertains to the company as an ongoing concern. According to Whitman a company can create value through corporate restructuring by engaging in mergers, acquisitions, spinoffs, buyouts, recapitalizations, liquidations, changes of control, and other activities that generate wealth by putting a companies resources to other uses.

Now this is all fascinating stuff for sure but unfortunately Whitman can’t write to save his life. Reading him for the first time was a somewhat dirge-like experience but what he writes about is so important you should make the effort to familiarize yourself with him. Luckily for me along came Joel Greenblatt with his ‘You Can Be a Stock Market Genius’, a truly great book on investing in the stock market. What Whitman described as resource conversion Greenblatt referred to as corporate events. If you choose to investigate this area of investing I suggest you start with Greenblatt’s book. It’s a much easier and fun read. After I read Greenblatt’s book I went back and tried to read Whitman again.

Under this approach the quality and quantity of a companies assets, become an important factor both in valuing the company along with considering its growth prospects. This is especially important when dealing with larger more established companies.

To gain insight into valuing this type of company an investor must look beyond the company as an ongoing concern (operational earnings) and consider the potential of a company redeploying its assets in mergers, acquisitions, spinoffs and liquidations. A company can also act as financiers when they decide to go private, incur debt and distribute cash to their shareholders.

Consider Brookfield Asset Management as an example how a company can manage its assets to enhance shareholder return…

They obtain equity from clients looking to invest in real assets, then use the company’s global reach to acquire distressed but high quality assets. They do this when capital is scarce and the assets they seek are generally on the market below their replacement value. They then finance those assets on a long-term and low-risk basis. They further enhance the cash flows and values of those assets through their leading operating platforms.

Needless to say I own several of Brookfield’s subsiduaries.